BULLy the BEAR

Someone sent me a newsletter that essentially is an advertisement to buy some diversified funds. Attached in the newsletter is this picture which I found it very interesting. This is, of course, not the first time nor the last time I’ll ever see this picture. I’ll like to take some time to think about the myths portrayed in the diagram.




The diagram shows the investment risk pyramid, where the highest and presumably highest returns are placed right at the tip of the pyramid. At the base, and therefore forms the foundation of the whole pyramid structure, lie the no risk and presumably lower returns (in fact, negative returns). You can see that cash is defined as a no risk instrument.

I think everyone should define what they mean by risk. In the academia world, risk is volatility – or how much the price of the instrument varies from its mean price. In that aspect, then the investment risk pyramid would make perfect sense.

However, I find that definition of risk a bit inadequate for my laymen, non-academic purpose and $-minded purpose. Risk, at least for me, is defined by how much you can lose for how much you want to gain, i.e. I risk $10 to bet that this team will win, so that I can get back $15. My risk for earning $15 is $10. It does not really matter to me if the it yo-yo up and down since I know how much I can lose and how much I can win. I suppose in that sense, the pyramid does not make sense to me at all.

I know the risk of holding cash - it will be lower each year after accounting for inflation (which is around 3-5% pa). It's invisible but the effects can truly be felt. In the past, I can go to the food court with $3 and have a full meal. Now, I can barely fill my stomach or even buy anything with $3. So, I'm questioning if it's right to treat cash as 'no risk'. In fact, the risk of holding cash is that you will lose some 3-5% of it every year.

Going by the same argument, if you treat shares as the second highest risk group according to the investment risk pyramid, it doesn't make sense to me too. Yes, shares are highly volatile (actually, have you seen those illiquid stocks that pay high dividends before? Vicom, anyone?) hence it has one of the highest volatility. This means that it's 'risky' since the price fluctuates wildly about its mean. Well, they can go ahead and classify them as risky but I'll do it anyway. Not dabbling in shares intelligently is the most risky thing you'll want to happen to your financial health.

After reading through the newletter, the punchline came. It offers a product that gives a guaranteed annual return of between 2.30% to 2.55%. Sounds good isn't it? Better than fixed deposit - a fact that they never fail to mention.

Thanks but no thanks.

On the subject of diversification, there had been many many articles and books written about it. I'm here to contribute more noise to it and provide another dimension on that subject.

Diversification works very well when the market is in order. We all know that the market is fairly efficient, but not entirely so all the time. To assume that each and every individual is fairly rational when they evaluate their own buy and sell transactions is, in my opinion, a much better one then the assumption that they are always rational. Thus, under usual market condition, we can expect that the market will behave in a fairly rationale manner.

When we diversify, we try to buy into different instruments in different asset classes, different sectors in the same asset class and perhaps different prices in the same counter (aka dollar cost averaging). The key point in diversification is to bet on something, yet with a hedge in case the event you are betting on did not happen. Academics had written at lengths on the optimum portfolio allocation, efficient frontier, blah blah blah. Basically, the idea is to buy non-correlated assets in a optimum mix so as to increase the returns of the portfolio without increasing its volatility.

However, there is something that needs to be thought about, and that forms the gist of this article.

In this new world where information flows fast and furious, the non-correlated asset classes - so carefully chosen in order to optimise your returns - are not so un-related anymore, especially so when the market goes into its moment of madness. What I'm trying to say is that the correlation between asset class is not a constant - it changes according to times, sometimes even direction. Take for example the usually un-questioned assumption that bonds and stocks goes in opposite direction.

The following are charts taken from yahoo! finance website. I compared the blue SP500 (^GSPC) and the red 10 yr treasury bond (^TNX) over a period of years.





You can see that there are periods of time where the bonds and stocks go in the same direction, despite the market truism that bonds and stocks are negatively correlated. So imagine, a person who blindly follows the oft repeated 'fact' that bonds are safer than stocks and that when stocks go up, bonds go down. Things are just not that simple.

But do not get me wrong - I'm not trying to say that portfolio allocation or even the idea of diversification is bullshit. It is important. However, blindly following market truism without having a thought in it can be dangerous to your financial health. Be very very careful of those one liner advice like "Buy low sell high" or "It's not about timing the market, it's about time in the market".

There are a lot of missing things not said in such truism, and don't they say "What is not said is more important than what is said"? Oops....that is also another truism for you to think about.

Let's say you have reit A with 10% dividend yield at $0.40, then another reit B with 10% dividend yield at $1.00, which would you buy?

Reit A, because it's cheaper so with the same capital I can own more so I'll get more dividend? That's what I thought till I calculated it out. Here it goes:

Supposedly I have $4000 to invest. For reit A, I can buy a total of 10 lots (4000/0.4 = 10,000). Thus, at the end of the year, I'll have a total of $400 in dividends. (0.40 x 0.1 x 10,000)

For reit B, I can buy a total of 4 lots (4000/1 = 4,000). For this reit, I'll have a total of.... ahem...$400 at the end of the year too (1 x 0.1 x 4000).

I was a little caught by this result. Haha, newbie mistake...tsk tsk... Conclusion - dividend yield depends on the dividend amt declared and the price of the stock you bought. If both stocks have the same dividend but one is cheaper in price than the other, it will not affect the amt of dividends you have if you have a fixed amt of capital to invest.

Ever talked to taxi drivers?

There is a disparity between what I see and what the people in power are saying to us. It seems like we're in the midst of a major recession not seen since the great depression. The major economies are in trouble, banks had collapsed, inflation and worse - stagflation is looming, GDP is contracting, unemployment is rising, wage freeze wage cut...these are headlines of what I read in the newspaper. However, the reality seems to be far from the picture.

I see people queuing up for property so as not to miss the opportunity to invest during 'recessionary' times. I see many people buying cars. I see penny stocks occupying the top volume of sgx charts and those ultra pennies are in fashion once again. I see people who are not interested in stocks suddenly becoming interested in it and scolding others for being 'old-fashioned' by putting money in savings accounts.

What do I make of this? I don't know.

As usual, I'm skeptical of the whole cheery outlook. It's just a few months ago that we seem to be at the brink of global recession and all of a sudden, the clouds had cleared and the sun shines again. If I'm sure of anything, it's just that humans in general have extremely short term memory. I think it's a good thing that we are wired this way, otherwise life might be too unbearable to live through.

I think in uncertain times, it is best that we have a plan in mind. Basically, there are two opposing realities playing out right now - one is that we're out of the gloom and the other is that we're heading from the top to another one. So, I think it's reasonable to think of two scenarios:


1. What if the market rises high, then sinks deeper

I'll be happy because there are certain counters that I need to buy and haven't got enough or any yet. It'll be a good opportunity to scoup up some more bargains when and if that happens. I'm afraid if the bad times do not come earlier, the temptation might be too strong to just join the crowd and raise my buying price.

It's one thing not to make money. It's totally another when one do not make money yet sees others making money. It'll wreck havoc on one's pysche.


2. What if the market moves up further, punctuated by shallow corrections

I'll be happy because I'm already invested along the way. It's actually less stressful because thinking about how much profit to take is better than to think about whether to cut loss or ride it out. Bullish times is good to sit back and relax because everyone is happy.


Happiness is nothing more than good health and a bad memory - Albert Schweitzer

After reading W.E.B's op-ed, I have some thoughts to share. Cash is really not king presently. Look at the returns of the following possible places to park your money:

All returns are quoted in per annum time basis

1. Cash - savings accounts - 0.1% to 0.25% (DBS)
2. Cash - fixed D - 0.1% to 0.7%
3. Money market fund - 1-2%
4. SGD treasury bonds - 15 yr bonds - 3%
5. Stocks dividend - roughly 5% (don't kill me over this figure pls, I know there are higher yield than this)





Considering a rough inflation rate of 3-4%, I think most of the places to park your money will give you negative real returns. Except of stocks that is. But this is not a blog post to ape W.E.B's op-ed cry out to buy buy buy. I'm just showing you how much you stand to lose by holding on to the false security of holding cash.

Some of the older folks are holding dear cash since forever, afraid that the stock market will eat up their money. Oh, that's undeniably true - stock market gives good returns and do note that it is also the ONLY one listed above that your capital can be eaten up too. The rest are more or less risk free and pretty much capital guarantee. It reminds me of the boiled frog parable - if you put a frog in boiling water, it'll jump out to safety. If you put a frog in water and warm the water up to boiling point, the small differences will not be perceived so readily by the frog and it will scorch to death.

This analogy extends to holding cash. It's rather easier to get 'eaten' by inflation at the rate of 3% per year passively than a one shot (possible) 5% loss punting the stock market actively.

Still, don't go out and just BUY BUY BUY. Ask yourself this: what to buy, when to buy and how to buy. The market is not your mother - it will snatch the milk bottle off your mouth, steal your toys, tempt you with poisoned sweets and maybe, there's a chance that it will reward you for taking that risk.

August 19, 2009
Op-Ed Contributor
The Greenback Effect
By WARREN E. BUFFETT

Omaha

IN nature, every action has consequences, a phenomenon called the butterfly effect. These consequences, moreover, are not necessarily proportional. For example, doubling the carbon dioxide we belch into the atmosphere may far more than double the subsequent problems for society. Realizing this, the world properly worries about greenhouse emissions.

The butterfly effect reaches into the financial world as well. Here, the United States is spewing a potentially damaging substance into our economy — greenback emissions.

To be sure, we’ve been doing this for a reason I resoundingly applaud. Last fall, our financial system stood on the brink of a collapse that threatened a depression. The crisis required our government to display wisdom, courage and decisiveness. Fortunately, the Federal Reserve and key economic officials in both the Bush and Obama administrations responded more than ably to the need.

They made mistakes, of course. How could it have been otherwise when supposedly indestructible pillars of our economic structure were tumbling all around them? A meltdown, though, was avoided, with a gusher of federal money playing an essential role in the rescue.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous
as that posed by the financial crisis itself.

To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.

Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

I want to emphasize that there is nothing evil or destructive in an increase in debt that is proportional to an increase in income or assets. As the resources of individuals, corporations and countries grow, each can handle more debt. The United States remains by far the most prosperous country on earth, and its debt-carrying capacity will grow in the future
just as it has in the past.

But it was a wise man who said, “All I want to know is where I’m going to die so I’ll never go there.” We don’t want our country to evolve into the banana-republic economy described by Keynes.

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.