I'm generally a 'risk tolerant' investor, so have our SMSF money invested in the Vanguard 'High Growth' diversified Index fund, and have some margin loans (funded with a home equity loan) that are invested in ETF funds and some CFS geared equity funds (so, using home equity to fund a margin loan to fund a geared share fund is what would sometimes be termed 'triple geared' !).
Anyhow, an opinion piece in today's SMH about the immediate impact of the nCoV outbreak on China's industry (basically it's shut down until 14 Feb) and longer term outlook (the WHO daily SITREPs on nCoV cases doesn't show any major reduction in the rate of reported spread, and there may be under-reporting issues in Indonesia, and in the Chinese figures themselves) for a prolonged impact on Chinese GDP and therefore global trade and GDP, highlighted to me that aside from being a major health concern, the nCoV pandemic exposes the Chinese and global economies to increased risk. Far from Chinese industry getting 'back to normal' after 14 Feb, the continued increase in nCoV cases suggests that either a) the 'shut down' will be extended, having a major impact on economic expectations and hence share markets, or b) factories re-open as planned, but the spread of nCoV will therefore be harder to control and may have a significant long-term impact on Chinese economic performance and hence the equity markets.
Overall, there seems to be considerable down-side risk and no up-side potential (aside from health stocks such as CSL). Therefore I decided to 'rebalance' my portfolio by reallocating our SMSF from the High Growth option to a mix of Conservative (70%) and Bond (30%) options, and by selling off my geared share fund investments (and use the proceeds to pay off my margin loans and reduce my home equity loan balance). I monitor how things go over the next 3-12 months to decide when to increase my equity weighting again.
Although this will result in some capital gains tax liability, I've learned from the GFC that when its time to reduce investment risk, taxation issues should not be the tail that wags the dog.
Time will tell if this was a prudent investment decision, or an overreaction.
Being invested in 'cash' might also provide an opportunity to make some undeducted contributions into my superannuation, before my total super balance hit the 'cap'.
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Showing posts with label risk. Show all posts
Showing posts with label risk. Show all posts
Thursday, 6 February 2020
Tuesday, 14 September 2010
Portfolio Update
An updated snapshot of my specific stock and mutual fund investments is shown below. The current situation is far from ideal - with an extremely high loan:value ratio (LVR) of almost 100% (pre-GFC I had been maintaining the overall LVR around 65% by buying additional investments as the value of my portfolio increased. That strategy was based on expected long-term ROI of 10%+ and occasional bear market dips of 10%-25%). Unfortunately I had to sell off some of the more liquid stocks to avoid margin calls in early 2009, and so the portfolio hasn't gained as much during the stock market rebound as it lost on the way down.
Also, the portfolio now includes a large amount of illiquid holdings such as ING Private Equity, the Ord Minnett Hedge Funds (now mostly invested in bonds and fixed interest), and the Macquarie 'Select Opportunities' Fund (also now mostly invested in cash, with current NAV about 15% below the capital protected amount that should be paid out in 2014). Altogether around $162,000 of the $500,000 invested has limited upside potential, while I'm stuck paying about 8%+ interest on the investment loan balance! As these investments reach the maturity dates I'll cash them out and be able to reinvest the funds (or, more likely, reduce the outstanding loan balances).
The portfolio no longer includes my 'investments' in managed agribusiness funds (Timbercorp Pine Forest, Rewards Teak and Rewards Sandlewood projects) which all went out of business.
Overall, my worst investments have been in 'managed' funds, with 'tax effective' agribusiness schemes performing the worst (~100% loss), ING private equity losing around 50% of it's value since launch/rights issue (although it may recover a bit), Macquarie equinox down about 15% (but should pay out the capital protected amount on the 30 May 2014), and the Ord Minnett 'Hedge' Funds currently frozen until maturity (OMIP 220 matures 30 Jun 2015, OMIP 320 matures 30 Dec 2016, and OMIP SL matures 30 Jun 2017) - but at least they locked in some profit via the 'rising guarantee' mechanism prior to the GFC.
Lessons learned?
1. Gearing (or investing using 'other peoples money') is great when things work out as expected, but the downside risk can be extremely painful. Unfortunately, with margin loans you can be forced to liquidate investments at the worst possibly time - IE. selling out at the bottom, rather than being able to invest when the market is down. In hindsight, I should have avoided borrowing more against the rising value of my portfolio as the bull market matured, and should have taken profits and paid off loans when the market had done well and upside potential was less obvious (eg. in 2007)
2. So-called 'expert' managers are better at protecting their fees than they are at managing portfolio risk. If you can't pick the best stock investments yourself, what makes you think you're an expert at picking the best managers? Most under perform the market, after taking fees into account. And some are real shonks (but can write a great looking prospectus).
3. The 'fine print' is often so voluminous and incomprehensible that you don't really understand the risks involved. For example, I had expected hedge funds would have returns uncorrelated with the stock market, and would be able to make profits during a severe bear market by shorting stocks and indexes. In reality, hedge funds tracked the market down, and ended up being frozen due to the capital guarantee requirements. I had also expected the risks in agribusiness investments were mainly crop yields and lower than expected prices when the timber matured (and the exorbitant up-front management fees and investment advisor commissions). In reality, it turned out that when the management company went broke, the investors ended up 'owning' trees on land that had the leases terminated - so immature trees had to be sold off at fire-sale prices by the management company liquidator, rather than being able to be retained by the investors until maturity.
4. Be very wary of tax considerations affecting your decision making. I decided not to sell off some of my portfolio in 2007 due to potential capital gains tax liability (and the potential impact of the extra 'income' on family tax benefits). Instead I tried to be 'smart' and protect my portfolio from a possible bear market by buying Index put options in March 2007. Eventually those options expired (Dec 2007) just before the market crashed, and my lack of experience trading options meant I didn't have put options in place during 2008.
5. In theory, investing in a dozen high-risk, high-return investments should work out OK, as sufficient diversification will reduce the overall risk. In reality, the risk-premium was insufficient and the diversification proved to be illusory (the investments negative returns turned out to be highly correlated during a global recession).
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Also, the portfolio now includes a large amount of illiquid holdings such as ING Private Equity, the Ord Minnett Hedge Funds (now mostly invested in bonds and fixed interest), and the Macquarie 'Select Opportunities' Fund (also now mostly invested in cash, with current NAV about 15% below the capital protected amount that should be paid out in 2014). Altogether around $162,000 of the $500,000 invested has limited upside potential, while I'm stuck paying about 8%+ interest on the investment loan balance! As these investments reach the maturity dates I'll cash them out and be able to reinvest the funds (or, more likely, reduce the outstanding loan balances).
The portfolio no longer includes my 'investments' in managed agribusiness funds (Timbercorp Pine Forest, Rewards Teak and Rewards Sandlewood projects) which all went out of business.
Overall, my worst investments have been in 'managed' funds, with 'tax effective' agribusiness schemes performing the worst (~100% loss), ING private equity losing around 50% of it's value since launch/rights issue (although it may recover a bit), Macquarie equinox down about 15% (but should pay out the capital protected amount on the 30 May 2014), and the Ord Minnett 'Hedge' Funds currently frozen until maturity (OMIP 220 matures 30 Jun 2015, OMIP 320 matures 30 Dec 2016, and OMIP SL matures 30 Jun 2017) - but at least they locked in some profit via the 'rising guarantee' mechanism prior to the GFC.
Lessons learned?
1. Gearing (or investing using 'other peoples money') is great when things work out as expected, but the downside risk can be extremely painful. Unfortunately, with margin loans you can be forced to liquidate investments at the worst possibly time - IE. selling out at the bottom, rather than being able to invest when the market is down. In hindsight, I should have avoided borrowing more against the rising value of my portfolio as the bull market matured, and should have taken profits and paid off loans when the market had done well and upside potential was less obvious (eg. in 2007)
2. So-called 'expert' managers are better at protecting their fees than they are at managing portfolio risk. If you can't pick the best stock investments yourself, what makes you think you're an expert at picking the best managers? Most under perform the market, after taking fees into account. And some are real shonks (but can write a great looking prospectus).
3. The 'fine print' is often so voluminous and incomprehensible that you don't really understand the risks involved. For example, I had expected hedge funds would have returns uncorrelated with the stock market, and would be able to make profits during a severe bear market by shorting stocks and indexes. In reality, hedge funds tracked the market down, and ended up being frozen due to the capital guarantee requirements. I had also expected the risks in agribusiness investments were mainly crop yields and lower than expected prices when the timber matured (and the exorbitant up-front management fees and investment advisor commissions). In reality, it turned out that when the management company went broke, the investors ended up 'owning' trees on land that had the leases terminated - so immature trees had to be sold off at fire-sale prices by the management company liquidator, rather than being able to be retained by the investors until maturity.
4. Be very wary of tax considerations affecting your decision making. I decided not to sell off some of my portfolio in 2007 due to potential capital gains tax liability (and the potential impact of the extra 'income' on family tax benefits). Instead I tried to be 'smart' and protect my portfolio from a possible bear market by buying Index put options in March 2007. Eventually those options expired (Dec 2007) just before the market crashed, and my lack of experience trading options meant I didn't have put options in place during 2008.
5. In theory, investing in a dozen high-risk, high-return investments should work out OK, as sufficient diversification will reduce the overall risk. In reality, the risk-premium was insufficient and the diversification proved to be illusory (the investments negative returns turned out to be highly correlated during a global recession).
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Wednesday, 4 August 2010
Asset Class Performance - when risk is underestimated
I remember reading Bernstein's views on expected asset class performance back in 2006 - he basically held the view that stock and other growth assets were overpriced, as expected returns didn't justify the high prices. While he didn't explicitly "call" the GFC, I certainly wish I adopted his views and wound back my stock market gearing (continuing to invest in stocks using other people's money made no sense if the returns for the next decade were going to be 5% or less, rather than the "historic average" of around 11%)...
As it turns out, Bernstein was right and I was wrong (although I almost redeemed myself by having index put options in place during 2007 - pity I didn't get around to rolling them over in Dec '07...). The actual asset class performance figures for the past ten years (data from Pitcher Partners) make depressing reading (to 30-Jun-10):
When you take into account the extra cost of trading shares (or fees for investing via managed funds), it really wasn't worth taking on any investment risk during the past decade.
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As it turns out, Bernstein was right and I was wrong (although I almost redeemed myself by having index put options in place during 2007 - pity I didn't get around to rolling them over in Dec '07...). The actual asset class performance figures for the past ten years (data from Pitcher Partners) make depressing reading (to 30-Jun-10):
......................1 YR.....3YRS......5 YRS.....10 YRS Australian Shares ....13.1%....-7.9%......4.5%......7.0% International Shrs.....5.2%...-11.5%.....-2.2%.....-4.6% Aust Listed Property..20.4%...-23.8%.....-8.0%......2.9% Australian Bonds.......7.9%.....7.7%......6.1%......6.4% Cash...................3.9%.....5.6%......5.8%......5.5%
When you take into account the extra cost of trading shares (or fees for investing via managed funds), it really wasn't worth taking on any investment risk during the past decade.
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Friday, 24 April 2009
If a tree falls in the forest and the manager is in administration, will I get paid?
Timbercorp (TIM.AX)today announced that it has gone into voluntary administration. It has about $500m in assets and owes about $600m - sounds like it's gone bankrupt. It cites the changes to the tax rules regarding agricultural investments, the GFc etc. etc. for going broke - the usual 'the dog ate my homework' excuses that managers everywhere use to explain why it isn't really their fault that a company has gone bust. (Otherwise how could CEOs and top management move on to their next highly paid job with big 'performance' bonuses?).
I have about $22,500 invested in managed agribusiness investments - $12,500 in hardwood (Eucalyptus) forests via Timbercorp, and $10,000 in Tea Tree and Sandlewood plantations managed by Rewards. I've valued the investments at the amount originally invested as the projected incomes from agricultural investments are always sky-high but highly risky. In theory my tree plantation investment managed by Timbercorp should keep most of it's value, as I own the trees and pay the management,insurance and land rental fees annually (which from now on should be handled by the administrator). But when the trees mature and require logging, the value of the timber may be greatly reduced as Timbercorp was supposed to harvest the trees using in situ chipping technology to maximise revenue from the timber. Although wood chip prices have held up well to the end of 2008, I think the $12,500 'book value' for my timber investment may prove to be optimistic.
Year ..... GTP Wood Chip Index
1992 ..... 159.36
1993 ..... 159.36
1994 ..... 161.44
1995 ..... 171.89
1996 ..... 176.89
1997 ..... 173.47
1998 ..... 176.89
1999 ..... 165.51
2000 ..... 162.67
2001 ..... 170.63
2002 ..... 169.49
2003 ..... 177.46
2004 ..... 180.87
2005 ..... 184.28
2006 ..... 184.28
2007 ..... 189.40
2008 ..... 207.40
Aside from charging huge management fees, I've found that many 'alternative' investments have very poor risk mitigation. In the good times investors get very modest returns while the management companies skim off most of the 'excess' profits, and in the bad times the investor is left with a worthless investment shell. The management company goes out of business and the managers keep all the bonuses paid out in previous years. Ideally the investors should be able to 'vote with their feet' by investing with managers that offer good value - but there don't seem to be very many alternative investments around that provide good value. We'll see whether or not investing with two different managers and three different agricultural products was sufficient diversification in this area. Fortunately the agribusiness investments only account for around 3.% of my net worth, so even a total write-off of these investments would have little impact compared to the vagaries of the Australian and international stock markets.
At least I didn't buy shares in Timbercorp itself (ASX code TIM). After hitting a high of $4 a share in 2006, they fell all the way down to 4c a share before a trading halt was imposed prior to the announcement of going into voluntary administration.
I have about $22,500 invested in managed agribusiness investments - $12,500 in hardwood (Eucalyptus) forests via Timbercorp, and $10,000 in Tea Tree and Sandlewood plantations managed by Rewards. I've valued the investments at the amount originally invested as the projected incomes from agricultural investments are always sky-high but highly risky. In theory my tree plantation investment managed by Timbercorp should keep most of it's value, as I own the trees and pay the management,insurance and land rental fees annually (which from now on should be handled by the administrator). But when the trees mature and require logging, the value of the timber may be greatly reduced as Timbercorp was supposed to harvest the trees using in situ chipping technology to maximise revenue from the timber. Although wood chip prices have held up well to the end of 2008, I think the $12,500 'book value' for my timber investment may prove to be optimistic.
Year ..... GTP Wood Chip Index
1992 ..... 159.36
1993 ..... 159.36
1994 ..... 161.44
1995 ..... 171.89
1996 ..... 176.89
1997 ..... 173.47
1998 ..... 176.89
1999 ..... 165.51
2000 ..... 162.67
2001 ..... 170.63
2002 ..... 169.49
2003 ..... 177.46
2004 ..... 180.87
2005 ..... 184.28
2006 ..... 184.28
2007 ..... 189.40
2008 ..... 207.40
Aside from charging huge management fees, I've found that many 'alternative' investments have very poor risk mitigation. In the good times investors get very modest returns while the management companies skim off most of the 'excess' profits, and in the bad times the investor is left with a worthless investment shell. The management company goes out of business and the managers keep all the bonuses paid out in previous years. Ideally the investors should be able to 'vote with their feet' by investing with managers that offer good value - but there don't seem to be very many alternative investments around that provide good value. We'll see whether or not investing with two different managers and three different agricultural products was sufficient diversification in this area. Fortunately the agribusiness investments only account for around 3.% of my net worth, so even a total write-off of these investments would have little impact compared to the vagaries of the Australian and international stock markets.
At least I didn't buy shares in Timbercorp itself (ASX code TIM). After hitting a high of $4 a share in 2006, they fell all the way down to 4c a share before a trading halt was imposed prior to the announcement of going into voluntary administration.
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Wednesday, 25 March 2009
Dumb and Mrs Dumber
Last year I saw the CEO of Bris Connections on a nationally televised business show answering questions about the risk of "mom and dad" investors buying the partly-paid shares in his company for only a few cents, and not realising that there were two $1 calls due on the stockholders in the next year.
Sure enough, there are now many investors crying foul and trying to sue all and sundry for not saving themselves from their own greed and/or stupidity. For example, one couple bought 200,000 of the shares for only 0.3c each (total outlay $600+$19.95 brokerage), They are soon due to pay up the first $290,000 call on their shares, which would allegedly cost them their home (presumably because they could be sued if they don't pay the call amount, and their only asset is their $450,000 house).
Now, I must admit I find their claim of total ignorance a bit hard to swallow. The relatively large brokerage cost on a $600 parcel of 0.3c shares and the daily volatility of these shares suggests that this was a purely speculative gamble, rather than a long-term investment. And despite their claims that the online brokerage site didn't "warn them" that they would have to pay another $2 per share when the calls fell due, they would have seen that that shares were partly paid when they placed their order.
Anyhow, there was plenty of publicity (such as the CEO interview) to ensure that the calls due on these shares were public knowledge. It appears to be just another case of greedy investors taking a punt on a highly risky investment, and then trying to sue anyone involved in the transaction that has big enough pockets (usually a bank).
Sure enough, there are now many investors crying foul and trying to sue all and sundry for not saving themselves from their own greed and/or stupidity. For example, one couple bought 200,000 of the shares for only 0.3c each (total outlay $600+$19.95 brokerage), They are soon due to pay up the first $290,000 call on their shares, which would allegedly cost them their home (presumably because they could be sued if they don't pay the call amount, and their only asset is their $450,000 house).
Now, I must admit I find their claim of total ignorance a bit hard to swallow. The relatively large brokerage cost on a $600 parcel of 0.3c shares and the daily volatility of these shares suggests that this was a purely speculative gamble, rather than a long-term investment. And despite their claims that the online brokerage site didn't "warn them" that they would have to pay another $2 per share when the calls fell due, they would have seen that that shares were partly paid when they placed their order.
Anyhow, there was plenty of publicity (such as the CEO interview) to ensure that the calls due on these shares were public knowledge. It appears to be just another case of greedy investors taking a punt on a highly risky investment, and then trying to sue anyone involved in the transaction that has big enough pockets (usually a bank).
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Monday, 19 January 2009
Stock Market Storm Sinks Life Savings
A brief report in the SMH outlines the horrendous impact of the bad investment advice dished out by Storm Financial, who advised many retirees to borrow against their mortgage-free homes in order to use margin loans to invest large sums in the stock market at the tail end of the bull market. While the self-serving (fee generating) "advice" provided by Storm seems completely inappropriate for many of their clients circumstances and actual risk tolerance, I'm sure that many of the investors rendered bankrupt have mostly themselves to blame. It's easy to cry "foul" and engage the lawyers when the market has plunged 40% or more and wiped out your investment portfolio, leaving you with massive loans secured against you home. But I suspect that a lot of these people were only too happy to sign off on dodgy loan applications (some with overstated income figures) and skim-read the fine print of the terms and conditions, when their "financial plan" projected massive gains if the market had returned another year of two of double digit performance. Those who play with fire get burnt - the tricky bit will be sorting out those Storm clients who eagerly grabbed the match box and lit their matches knowing the risks, and those "babes in the woods" would were handed a box of "safety matches" and told that there was nothing to fear.
It's interesting to compare how a Storm client who invested at the market peak in late 2007 would have fared if the market had gone up 15% in 2008, rather than dropping 45%:
Assume: Retiree/investor borrows 50% ($500,000) against mortgage-free home valued at $1,000,000, interest 8% ($40,000 pa interest)
Pays Storm 7% up-front fee on funds invested (ie. leaves $465,000 "capital" to invest after $35,000 in fees up front)
Invests in a stock portfolio using max 70% gearing, interest 10% (capitalised)
Dividend rate 3%
Margin loan amount = $1,085,000 (total invested in market = $1.55m)
If market had gone up 15%, at end of 2008 situation would be:
Debt: $500,000 (home loan) + $1.085m (margin loan) + $108,500 (interest) = $1.6935m
Int paid: $40,000 (home loan int only payments)
Income: $46,500 (dividends)
Cash flow: $6,500 "tax free" income (due to tax deduction for capitalised margin loan interest)
Portfolio value: $1.7825m (15% rise)
Unrealised capital gain: $89,000
I doubt that any of Storm Financial clients would have been complaining in that situation!
In reality, a 45% market plunge occurred, with losses only being realised in late 2008 when portfolios were liquidated to meet margin calls (where clients tapped into their remaining home equity to borrow to meet earlier margin calls - say up to the maximum 80% LVR for owner occupied home loans):
Debt: $800,000 (home loan) + $1.085m (margin loan) +$108,500 (interest) = $1.9935m
Int paid: $52,000 (home loan int only payments, assuming extra $300,000 borrowed during 2008)
Income: $46,500 (dividends)
Cash flow: -$5,500
Portfolio value: $852,500 (45% drop)
Debt remaining after portfolio liquidated: $1.9935m - $0.8525m = $1.141m
Since this is slightly more than the family home is worth, bankruptcy results!
The worst part of the advice provided by Storm (aside from the investment strategy not matching the clients real risk tolerance or level of understanding) appears to have been to continue borrowing against other assets (the family home or other real estate) in order to meet margin calls while the market dropped during 2008. If the investors had simply liquidated their stock portfolio to meet margin calls as they arose, they would have ended up taking a big loss, but not being bankrupted and losing the family home. However, it was all too easy in March 2008 to imagine that the market had bottomed out after a "normal" 20%-30% correction, and try to hang in there, rather than turn paper losses into real ones.
I wonder if there are any Storm clients who started investing in 2003 and liquidated their portfolios in late 2007 when Storm began their IPO process? They're probably sitting on their yachts sipping champagne.
Meanwhile, it will be interesting to see how the court cases against Storm Financial and the banks turn out. (Not to mention ASIC's role in all this)
It's interesting to compare how a Storm client who invested at the market peak in late 2007 would have fared if the market had gone up 15% in 2008, rather than dropping 45%:
Assume: Retiree/investor borrows 50% ($500,000) against mortgage-free home valued at $1,000,000, interest 8% ($40,000 pa interest)
Pays Storm 7% up-front fee on funds invested (ie. leaves $465,000 "capital" to invest after $35,000 in fees up front)
Invests in a stock portfolio using max 70% gearing, interest 10% (capitalised)
Dividend rate 3%
Margin loan amount = $1,085,000 (total invested in market = $1.55m)
If market had gone up 15%, at end of 2008 situation would be:
Debt: $500,000 (home loan) + $1.085m (margin loan) + $108,500 (interest) = $1.6935m
Int paid: $40,000 (home loan int only payments)
Income: $46,500 (dividends)
Cash flow: $6,500 "tax free" income (due to tax deduction for capitalised margin loan interest)
Portfolio value: $1.7825m (15% rise)
Unrealised capital gain: $89,000
I doubt that any of Storm Financial clients would have been complaining in that situation!
In reality, a 45% market plunge occurred, with losses only being realised in late 2008 when portfolios were liquidated to meet margin calls (where clients tapped into their remaining home equity to borrow to meet earlier margin calls - say up to the maximum 80% LVR for owner occupied home loans):
Debt: $800,000 (home loan) + $1.085m (margin loan) +$108,500 (interest) = $1.9935m
Int paid: $52,000 (home loan int only payments, assuming extra $300,000 borrowed during 2008)
Income: $46,500 (dividends)
Cash flow: -$5,500
Portfolio value: $852,500 (45% drop)
Debt remaining after portfolio liquidated: $1.9935m - $0.8525m = $1.141m
Since this is slightly more than the family home is worth, bankruptcy results!
The worst part of the advice provided by Storm (aside from the investment strategy not matching the clients real risk tolerance or level of understanding) appears to have been to continue borrowing against other assets (the family home or other real estate) in order to meet margin calls while the market dropped during 2008. If the investors had simply liquidated their stock portfolio to meet margin calls as they arose, they would have ended up taking a big loss, but not being bankrupted and losing the family home. However, it was all too easy in March 2008 to imagine that the market had bottomed out after a "normal" 20%-30% correction, and try to hang in there, rather than turn paper losses into real ones.
I wonder if there are any Storm clients who started investing in 2003 and liquidated their portfolios in late 2007 when Storm began their IPO process? They're probably sitting on their yachts sipping champagne.
Meanwhile, it will be interesting to see how the court cases against Storm Financial and the banks turn out. (Not to mention ASIC's role in all this)
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Friday, 27 June 2008
The Fat Tail bit me - again.
January '08 was a terrible month for my net worth - declining 7.78% from 25 Dec - 24 Jan. If one assumes a normal distribution of monthly returns, the figures since May 2002 would indicate this has an estimated frequency of just 0.09% IE. I'd expect such a bad month to occur once every ninety years or so. However, my June monthly measurement (from 27 May - 26 Jun) just produced a second abysmal monthly result within six months, down 7.10%, which has an expected frequency of around 0.16%, or roughly once every fifty years. As can be seen from the plot of actual monthly returns vs. the fitted normal distribution, my monthly returns don't follow a classic normal distribution - with a large percentage of my portfolio invested in growth assets it suffers from the "Fat tail" effect, whereby "outlier" events occur more frequently than would be expected for a normally distributed, random variation. Once possible explanation of such results is behavioural economics, or the "madness of crowds". Given the relatively robust state of the Australian economy, excessive fear seems to have afflicted the local stock market. If I wasn't already fully invested (and geared!) into stocks I'd be looking at investing in stocks at this time. As it is, all I can do is hold on, and hope this is close to the bottom of this particular roller-coaster dip.
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Sunday, 18 May 2008
Is Savings Rate or Total Return more important in reaching your investment target?
I've recently read a couple of posts discussing whether your investment returns or amount of savings has a bigger impact on your final portfolio value. The analyses provided showed that for periods up to 20 years or so, having a large savings rate ($10K pa instead of $5K pa) had a bigger impact than doubling the ROR from 4% to 8%. My initial response was that this was true looking at a 20 year time frame, but over longer periods the ROR ended up being much more important - especially since your savings become a less and less significant part of your total annual NW increase once your portfolio value grows to 3-4 times your annual salary.
I was looking at a comparison of Moomin's monthly net worth figures since 2003 compared to mine, and found that although his NW had increased eight-fold in the past 5 years while mine had only grown slightly more than two-fold in the same period, our NW had moved almost in parallel over this period:
However, the same monthly dollar change in NW represents a much better performance when you're starting out from $60K than it does starting from $480K ! I then did some quick calculations to compare what average total ROI would be needed to model Moomin's result and mine. It turned out that with the same annual savings rate of $30K my portfolio result can be explained with an average annual ROR of 12% and that of Moomin with the same savings rate and a much higher ROR of 23%!
However, although Moomin appears to be a better investor than I (he definitely takes a more professional approach) the ROR seemed a bit high. So I then had a look at what would be the result of a lower ROR but higher annual savings rate. Using the same $30K annual savings rate and 12% ROR for me, but higher savings rate ($45K) and more modest ROR (15%) for Moomin, I get a chart that appears to model the actual results just as closely (I haven't bothered doing any statistical analysis though):
While I think my annual savings rate averages around $30K pa during this period, I have no idea what Moomin's average savings rate has been - although I'm sure Moom knows exactly what his ROR and savings rate are ;) - so I can't tell which model is more realistic. But the point is that the same results can be obtained (over this short time frame) by EITHER getting a higher ROR OR by boosting the savings rate.
As risk is directly related to ROR, it would appear that boosting your savings rate is a more prudent method for achieving your investment goals. That is, trying to cut expenses and increase income in order to boost your savings is a much more certain route to wealth than shooting for amazing investment returns. However, as your NW becomes much larger than your annual salary it becomes more and more important to attain the maximum investment return commensurate with the level of risk you are comfortable with, and to minimise fees and charges.
I was looking at a comparison of Moomin's monthly net worth figures since 2003 compared to mine, and found that although his NW had increased eight-fold in the past 5 years while mine had only grown slightly more than two-fold in the same period, our NW had moved almost in parallel over this period:
However, the same monthly dollar change in NW represents a much better performance when you're starting out from $60K than it does starting from $480K ! I then did some quick calculations to compare what average total ROI would be needed to model Moomin's result and mine. It turned out that with the same annual savings rate of $30K my portfolio result can be explained with an average annual ROR of 12% and that of Moomin with the same savings rate and a much higher ROR of 23%!
However, although Moomin appears to be a better investor than I (he definitely takes a more professional approach) the ROR seemed a bit high. So I then had a look at what would be the result of a lower ROR but higher annual savings rate. Using the same $30K annual savings rate and 12% ROR for me, but higher savings rate ($45K) and more modest ROR (15%) for Moomin, I get a chart that appears to model the actual results just as closely (I haven't bothered doing any statistical analysis though):
While I think my annual savings rate averages around $30K pa during this period, I have no idea what Moomin's average savings rate has been - although I'm sure Moom knows exactly what his ROR and savings rate are ;) - so I can't tell which model is more realistic. But the point is that the same results can be obtained (over this short time frame) by EITHER getting a higher ROR OR by boosting the savings rate.
As risk is directly related to ROR, it would appear that boosting your savings rate is a more prudent method for achieving your investment goals. That is, trying to cut expenses and increase income in order to boost your savings is a much more certain route to wealth than shooting for amazing investment returns. However, as your NW becomes much larger than your annual salary it becomes more and more important to attain the maximum investment return commensurate with the level of risk you are comfortable with, and to minimise fees and charges.
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Tuesday, 6 May 2008
How I gave my personal financial risk management plan a check-up
A personal financial risk management plan is an important tool to help assure that I've adequate protection in place to look after myself and my family in the event that my assets or earning ability are impaired. Most people never develop a plan for managing financial risks, but it's actually not too difficult or time consuming to put a basic plan into place. Without a plan, you might:
I spent about 30 minutes using a free, online tool from the university of Illinois to sketch out a rough financial risk management plan.
The tool helps you to:
This risk matrix will vary depending on your personal situation. The website gives the example of the risk of death - low probability but high impact for a young breadwinner with a dependant family, compared to high probability but fairly low financial impact for a 90-year-old with no dependants.
The next step looks at the various ways you can choose to handle risks. The website uses the example of an event (totalling your car) to illustrate the four general approaches to handle the risk:
1. Bear the risk: You drop the collision insurance on your ten year old car. You continue to drive it regularly.
2. Transfer the risk: You buy collision insurance on your car so that the insurance company bears the risk of having to replace or repair your car.
3. Reduce or control the risk: You wear seat belts, which would reduce your injury in the event of an accident, and you do not speed, which reduces the likelihood of an accident.
4. Remove the risk: You sell the car and use public transportation.
The website provides nine simple examples of risk handling decisions for you to check that you understand the four approaches.
Step three then goes on to help you identify which of the four approaches you are currently using to handle your financial risks. It then explains how the different techniques for handling risks will be appropriate depending on the probability and degree of financial severity, and puts this into the same sort of matrix that you previously developed for your risk assessment:
The website tool then goes on to tabulate the most appropriate methods for handling each of your risks, based on the way you rated them on financial severity and probability. "You may be surprised by some of the recommendations. For example, you may have believed that everyone needs life insurance. But if your death would have a low financial impact or if the probability of your death is high, you will see that techniques other than transferring (insuring) are recommended. Under this framework, only someone whose death would pose a financial hardship (such as someone who has dependent children) and for whom death is unlikely should insure his or her life. Others should be using different techniques, such as setting aside enough money to pay for your burial (bearing the risk) and seeking ways to reduce the size of the financial risk, such as structuring your estate so that a family business won't have to be sold to pay estate taxes."
Hopefully, this tool will provide a useful check-up of your existing financial risk management plan.
Copyright Enough Wealth 2008
- be over-insured in some areas and under insured in others.
- be unaware of the risks to which you are exposed.
- be insuring risks that are more emotional than financial in nature.
I spent about 30 minutes using a free, online tool from the university of Illinois to sketch out a rough financial risk management plan.
The tool helps you to:
- identify those events which pose a financial risk to you or your family.
- learn the four basic methods of managing risk.
- determine which methods you are currently using to manage your risks.
- identify gaps in your current risk management strategies.
This risk matrix will vary depending on your personal situation. The website gives the example of the risk of death - low probability but high impact for a young breadwinner with a dependant family, compared to high probability but fairly low financial impact for a 90-year-old with no dependants.
The next step looks at the various ways you can choose to handle risks. The website uses the example of an event (totalling your car) to illustrate the four general approaches to handle the risk:
1. Bear the risk: You drop the collision insurance on your ten year old car. You continue to drive it regularly.
2. Transfer the risk: You buy collision insurance on your car so that the insurance company bears the risk of having to replace or repair your car.
3. Reduce or control the risk: You wear seat belts, which would reduce your injury in the event of an accident, and you do not speed, which reduces the likelihood of an accident.
4. Remove the risk: You sell the car and use public transportation.
The website provides nine simple examples of risk handling decisions for you to check that you understand the four approaches.
Step three then goes on to help you identify which of the four approaches you are currently using to handle your financial risks. It then explains how the different techniques for handling risks will be appropriate depending on the probability and degree of financial severity, and puts this into the same sort of matrix that you previously developed for your risk assessment:
The website tool then goes on to tabulate the most appropriate methods for handling each of your risks, based on the way you rated them on financial severity and probability. "You may be surprised by some of the recommendations. For example, you may have believed that everyone needs life insurance. But if your death would have a low financial impact or if the probability of your death is high, you will see that techniques other than transferring (insuring) are recommended. Under this framework, only someone whose death would pose a financial hardship (such as someone who has dependent children) and for whom death is unlikely should insure his or her life. Others should be using different techniques, such as setting aside enough money to pay for your burial (bearing the risk) and seeking ways to reduce the size of the financial risk, such as structuring your estate so that a family business won't have to be sold to pay estate taxes."
Hopefully, this tool will provide a useful check-up of your existing financial risk management plan.
Copyright Enough Wealth 2008
Friday, 21 March 2008
It's your money, look after it
In another example of the dangers of "outsourcing" management of your wealth, Australian artist Ken Done is suing his financial advisers for $53 million, claiming he lost three-quarters of his personal fortune through bad advice. The 67-year-old's money was apparently invested in risky loans and investments in little-known companies that failed - including stakes in two soccer teams, a beauty spa and an obscure Maltese biotechnology company.
If, as he claims, he gave instructions specifying that only 20 per cent of his money was to be put into speculative ventures, he may be able to recover some of his lost fortune through legal action. Done alleges he was misled by false accounting entries and that he paid nearly $2 million in fees over six years.
However, it appears unclear how much of the loss was due to advice from his financial advisers and how much could be due to the actions of the accountancy firm and the principal accountant responsible for Mr Done's financial affairs. In any case, it again highlights the fact that you are ultimately responsible for managing your own financial affairs, and you should keep a close eye on the actions taken on your behalf by "hired help".
Copyright Enough Wealth 2007
If, as he claims, he gave instructions specifying that only 20 per cent of his money was to be put into speculative ventures, he may be able to recover some of his lost fortune through legal action. Done alleges he was misled by false accounting entries and that he paid nearly $2 million in fees over six years.
However, it appears unclear how much of the loss was due to advice from his financial advisers and how much could be due to the actions of the accountancy firm and the principal accountant responsible for Mr Done's financial affairs. In any case, it again highlights the fact that you are ultimately responsible for managing your own financial affairs, and you should keep a close eye on the actions taken on your behalf by "hired help".
Copyright Enough Wealth 2007
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