Thursday, August 31, 2006

Principle #13 - Be Open To New Ideas

Investing involves making predictions (or guesses) about the future. Frequently we make our predictions by extrapolating the present and the past. Trend following or momentum investing is a clearly defined investment strategy that does exactly that - take a present price trend and use that trend to predict the future price.

However things change. Anchoring and near term bias are two factors which make investors slow to adapt to change or to accept either new ideas or that the market has changed - unless in a state of panic. Some trading systems recognise that change is inevitable and deal with it with stop loss orders or a trading rule that seeks to identify when a trend has ended. A recent example is the commodities boom. For a long time, twenty years, commodity prices were in a cyclical and apparently terminal state of decline. But things changed. Emerging markets grew and consumers in developed markets spent at an unprecedented pace. Increasing demand met a relatively inelastic supply with soaring prices as the result. Those who identified that there had been a fundamental change would have made a lot of money.

I have no idea what the future will bring, but it will be different. Being alert to change and to new ideas and ways of looking at and evaluating investments is a key attribute of a successful investor.

Refinancing Completed

We have (finally) refinanced one of our properties. The refinancing involves:

1. a reduction in the interest rate of 0.5% (from prime - 2.50% to prime -3.0%);
2. a shift from monthly to fortnightly payments;
3. a cash rebate of 0.4% of loan principle (about 3 times the legal fees involved in discharging the old mortgage and registering the new mortgage);
4. a reduction in term by 16 months.

The principal amount and the payments are about the same.

The penalty period for early repayments is two years.

Monday, August 21, 2006

Emergency Funds Are Wasteful

A lot of financial plans include building up an emergency fund. My view is that, save in respect of one specific circumstance, an emergency fund is wasteful and money put aside in an emergency fund is better deployed elsewhere.

The logic behind emergency funds is that unexpected expenses could be incurred which you are unable to meet from current income or that your income stream could be disrupted so that you cannot be assured of meeting your expenses. The standard advice is to build up an emergency fund sufficient to meet living expenses for a short period (three months is common). The advice usually goes one step further and says that the emergency fund should be in the form of cash or on call bank deposits.

My view is that this is both too simplistic and wasteful.

A financial plan should address the question of how unexpected expenses or loss of income will be covered. But saying that the issue can be addressed by putting aside the equivalent of a fixed number of months salary is too simplistic. For people with a low savings rate it may be too little and for those with a high savings rate it may be too much. Consideration also needs to be given to the possible length of the disruption to income and the size of the unexpected expenses.

In my own case, I concluded that we did not not need any emergency fund at all. Relevant factors in this decision were: a two income household, a good savings rate (with room for improvement), several items of discretionary expenditure which could be cut, three months notice being required under my employment contract and the fact that at least some of our investments are in liquid form.

The second issue is the form of the emergency fund. Cash or call deposits are often recommended. While I appreciate the need to have an emergency fund kept in a form in which it can be readily accessed, cash and call deposits are lousy investments (most of the time). The after tax rate of return is usually less than the rate of inflation and, over the longer term, less than most other asset classes. Bonds, money market accounts, short term CDs and short term deposits all provide better rates of return than call deposits with relatively little additional risk. Many listed shares and many mutual funds are also highly liquid - price may be an issue but the liquidity is there.

Given that, by definition, an emergency fund is for the unexpected, I take the view that the additional return which can be achieved by investing the emergency fund in better performing asset classes more than justifies the additional risk involved. The only situation where I might take a different view is where my monthly income is expected to be both highly variable and uncertain.

Principle #12 - Be Vigilant

Many people have an interest in your money. More specifically, many people have an interest in getting their hands on some of your hard earned money. In contrast, only one person has exclusively your own financial interests at heart - yourself.

The people who want to get their hands on your money can be broken down into three categories:

1. people selling a product or service: brokers, agents, bankers, financial planners, fund sales people, accountants, lawyers etc. These people can be useful (some are essential) but you do need to think hard about whether you actually need what they are selling and, if you do, both the cost and the quality of the product or service being offered;

2. people who think they are entitled to a share of yor money: tax collectors, ex-spouses and the like. Sometimes they are legally or morally (the two are not the same) entitled to a share of your hard earned money - but sometimes a little bit of advance planning can reduce the damage these people cause;

3. the outright dishonest: con artists ranging from people like Charles Ponzi to the authors of the the all too common advance fee letters and phishing e-mails purporting to come from banks. Sometimes the people who fall into this category present themselves as financial planners, seminar presenters, property developers and the like. Some are very clumsy and obvious. Others are very slick. They are all crooks.

The best defences against these attempts to separate you from your money are education, clear thinking and vigilance.

Saturday, August 19, 2006

Could I Be Gazumped?

I mentioned that I had signed a provsional agreement for the purchase of a small residential property. Until the formal sale and purchase agreement is signed by all parties, either party can back out by paying liquidated damages equal to the amount of the preliminary deposit I paid (about 5% of the purchase price) plus agency fees and costs for both parties.

The price I have agreed to pay was, in comparison to a recent sale of a comparable unit in the building, a discount to market price. The size of the discount looks bigger than it is because the comparable unit has been redecorated to a very high standard whereas my unit needs to be completely gutted. I was told last night that the original purchaser of the comparable unit has been gazumped to a new buyer who paid about 6% more. As things stand it would pay the vendors of my unit to gazump me.

The vendors' right to cancel the contract and pay liquidated damages will end once the formal sale and purchase agreement is signed by all parties. I will sign tomorrow. The vendors are required to sign by 24th August. Until they do, I will be sweating on this one.

Friday, August 18, 2006

Principle #11 - Do Your Own Thinking

Every day we are bombarded with advice, either solicited or not, on how we should invest our money. This can be helpful. It can also be dangerous. Information that helps us to think about our investment decisions is helpful. Relying on someone else (even a professional) to do our thinking for us is stupid. By all means listen to what the slick sales person or your friends have to say about investments, but then think it through for yourself.

Monday, August 14, 2006

Principle #10 - Small Things Are Meaningful

When it comes to saving and investing, small things can make a big difference to your longer term returns. The old saying "don't sweat the small stuff" could not be more wrong.

A penny saved is a penny earned is another old saying. It would be more accurate to say that a penny saved is $0.01 * (1+((100-marginal tax rate)/100)) earned. A penny saved and invested each day for 40 years is $457.81. This is a lot more that the $144 actually saved. (Assumptions: $0.30 invested at the end of each month for 40 years at a 5% rate of return.) If we do this with dollars instead of cents, the numbers get very big very quickly. Increase the saving from $0.01 per day to $1.00 per day and the end result after 40 years is $45,780. Somebody once used the example of a poor couple who had smoked a packet of cigarettes a day for most of their adult lives. If the money they had spent on that packet of cigarettes each day had been invested in Phillip Morris they would have been multi millionaires - instead of near broke. Small things add up and are meaningful.

Another example is rates of return. You might think that the difference between earning 6% pa on your money and earning 7% pa is quite trivial. It's not. Over a long enough time period its the difference between out living your money and a comfortable old age.

Do sweat the small stuff.

Principle #9 - Be Passionate

Most of the people I know who do well financially are passionate about investing but not about individual investments.

Building your financial net worth takes time and dedication. You need to have a passion for saving and investing money over a long period of time (usually decades) if you want to become wealthy or simply to avoid poverty in your old age. This does not equate to having a love of money (although I do know plenty of people who I suspect do so). It means making managing your financial affairs a part of your life, a hobby if you like, that you enjoy. It means thinking about ways to increase your savings or to improve your investment return on a regular, if not constant, basis. It means being prepared to sacrifice time and short term gratification in order to achieve a longer term goal. It means reading books on investing and on line resources on a regular basis not because you feel you have to but because you enjoy reading them.

Being passionate about investing does not equate to having a passion for individual investments. Quite the opposite. As investors we cannot afford to fall in love with any of our investments. Falling in love with an investment is an obstacle to correctly managing that investment and, when the time comes, disposing of it. Falling in love with individual investments has the potential to be harmful to your investments as a whole.

As a final point, there is a fine line between passion and obsession. Building wealth is not meaningful if it comes at the expense of other important parts of our lives. I know people who are obsessed with building their wealth. They may end up being truely wealthy. They may also end up with rather bland and empty lives.

Saturday, August 12, 2006

Another property purchase

Early last month I said that the case for investing in real estate was less compelling than earlier this year. One of the facts which influenced this view was teh rise in interest rates and the prospect of further interest rate increases. The subsequent fall in interest rates has changed things and it is once again possible to get positive carry on residential properties.

I still kept looking at properties although less frequently. This week I saw an apartment which was available at slightly below bank valuation (rare in the current market) and at a discount to the market value. Succumbing to temptation, I put in an offer. After a small amount of haggling a slightly higher offer was accepted.

The flat is in a building that is in the process of completing a refurbishment of common areas. It has open but unspectacular outlook, including a limited view of the smog that hangs over Victoria Harbour. The interior of the flat is a dump. It will need to be gutted and completely refurbished.

The good news is that a mirror image flat in the same building which had been refurbished to a high standard just sold at a price which should allow me to achieve a reasonable profit if I decided to refurbish and on sell rather than retain for long term rental income.

The bad news is that while I can complete the purchase with bank funding, I will not have the cash available to undertake the refurbishment until January or February next year unless I either sell something else or use the money I am setting aside for my taxes (due in January). The alternative is to do nothing until January - I would have to hold the flat and meet the mortgage and other outgoings with no rental income. I negotiated a three month settlement which means that it is only the period from mid November until early January that I will not be able to pay for the refurbishment. That six to eight weeks is going to be painful but I am more inclined to do that than to sell something else. Raiding the tax money is not really an option.

Principle #8 - Understanding Influences

As investors we are constantly subject to a number of external and internal factors which influence our decision making. These influences and the way we respond to them can have a powerful effect on the decisions which we make. While it is unlikely that we could make any decisions without external influences, we also need to recognise that both internal and external influences can be detrimental as well as beneficial to our decision making process.

Spending a few minutes considering what has influenced a decision before making an investment can help avoid costly mistakes. Investors who allow themselves to be influenced by the hype and stories of other people making fortunes have usually ended up losing money whether it was on tulips (1635-37), the South Sea Bubble (1711-1722), Japanese equities (late 1980s) or technology companies (late 1990s). It is so often the case that if investors simply asked themselves "does this make sense?" before they part with their hard earned money they would have been a lot better off.

Here's an example. What kind of person buys shares in companies that have no earnings, no established business, no track record and which expects to run out of cash in a few years? The answer is a lot of people who allowed themselves to be influenced by hype, stories of quick and easy wealth and glowing recommendations from "professionals" and brought into the dot com boom. Sure, some people made a lot of money but a lot more people lost out as well.

Thursday, August 10, 2006

Morgtage rates cut

In the latest move in a highly competitive battle for market share, Bank of China has cut its Hong Kong prime lending rate by 25 basis points to 8.0%. Bank of China's new prime rate is the same as HSBC and Hang Seng Bank. Most other lenders have kept their prime lending rates at 8.25%. Mortgage loans are now generally available at prime - 2.9% or prime - 3.0% resulting in effective interest rates of 5.0% or 5.1%.

Older mortgages priced at a smaller discount to the prime lending rate will still benefit from the reduction (including us - we have one mortgage loan with Bank of China).

At the same time, this week has seen a noticable decline in HIBOR rates. When my two HIBOR linked mortgages next roll over in September and October, the combined effect of the lower HIBOR rates and the switch from 3 month fixing to 1 month fixing will cut my funding costs on these loans by about 0.6%.

This has to be positive for the Hong Kong property market.

Wednesday, August 09, 2006

We have cashflow!

The property I purchased last month is now let. While it is disappointing that it took about a month to find a tenant, the good news is that the rent is at the high end of my expectations.

We now have 100% occupancy on our properties. However this will change towards the end of September when one tenant moves out.

Saturday, August 05, 2006

A meaningful saving

I have belatedly realised that I can reduce the interest rate on two of my mortgages at no cost and very little risk by taking advantage of the yield curve.

The mortgages are linked to HIBOR (Hong Kong Interbank Offer Rate). These are floating rate mortgages (as is usual in Hong Kong). The interest rate is periodically fixed to HIBOR (plus a margin of 0.8% or 0.7%). The default option is based on the three month HIBOR rate. Every three months it rolls over at a new rate of interest based on the prevailing three month HIBOR rate. My last fixing resulted in an interest rate of 5.1045% (being three month HIBOR of 4.3045% plus 0.8%).

However, I do not have to accept the default option of using three month HIBOR. I can choose any available HIBOR term that I want. Interest rates in Hong Kong are currently showing a normal yield curve which means that shorter term rates are lower than longer term rates. The shorter the HIBOR option I elect the lower the interest rate. If I elect one month HIBOR instead of three month HIBOR I will end up paying an annualised interest rate which is (currently) about 0.44% less than I am currently paying. On both an annualised basis and over the remaining lives of the mortgages, the savings are meaningful.

The risks of being worse off if I elect one month fixings instead of three month fixings are both small and remote. When these mortgages next come up for fixing (in September and October) I will refix using one month HIBOR and count the savings.

Interest Rates Down

Interest rates in Hong Kong have risen over the last two years. Borrowers are typically paying 5.25-5.6% for new loans at the moment. The days of a positive carry on yield are mostly gone.

Hong Kong has not followed the last two increases in interest rates imposed by the US Federal Reserve. Given that the Hong Kong dollar is pegged to the US dollar this is a little but unsual. Classical economic theory would suggest that if the two currencies are to remain linked interest rates should be similar.

There are a number of reasons why Hong Kong has not followed the Fed. The main reason is liquidity. In very simple terms, Hong Kong banks have excess deposits and those deposits have grown faster than their lending portfolios. This partially explains why deposit rates are lower than the deposit rates in the US and why interest rates have not risen as far.

In fact, interest rates have shown signs of falling in the last two months due to competition amongst the lenders. As an example, the interest rate on one of my mortgages which is linked to three month HIBOR has just dropped from 5.4056% to 5.1045% for the next three months.

Negative Equity Cases Still Declining

Negative equity is a situation that arises when the amount owed on the mortgage(s) is greater than the value of the property against which the mortgage is secured. This can arise either because the amount owed has grown to an amount higher than the property's value due to capitalisation of interest or because the value of the property has declined (or a combination of the two). Occasionally it may be the result of borrowing more than the purchase price but such situations are very unusual.

Negative equity is not a good situation. It means that if you sell the property, not only will all of the sale proceeds go to the lender as partial repayment of the debt, but you will still owe the lender money and have to pay the costs of sale out of your own pocket. Property owners with negative equity who are unwilling or unable to meet the shortfall and costs are usually forced to wait out the downturn until values recover. Whether this is the smartest decision to make is another matter. Although I cannot speak from personal experience, I would expect that being in negative equity is a very worrying situation.

Negative equity cases in Hong Kong are estimated to have peaked in June 2003 (the time of the SARS epidemic) at about 106,000 cases. This figure has declined to 8,777 cases at the end of June 2006. In three years the number of negative equity cases has fallen by 92%. The delinquency rate for those still in negative equity remains an insignificant 1.13%.

Although it was a long, painful six year decline from the 1997 peak until the 2003 low, the massive decline in the number of negative equity cases and the persistently low delinqency rate shows how robust the housing sector can be in times of adversity and how rapid a recovery can be. Contrast Hong Kong's experience with Japan's to see a very different example of how long downturns can last.

Wednesday, August 02, 2006

Principle #7 - Stress Testing Your Investments

Investing means assuming risk. Risk can mean either the possibility of loss or simply the variance of returns from expectations. All investments carry risk - there are no exceptions and, in the real world, there is no such thing as a risk free rate of return. Also, as a general statement, the higher the expected rate of return, the higher the risk (although the relationship is not always a linear one).

Predicting returns on investments is difficult. Measuring the corresponding risks is also difficult. Many extremely intelligent and very experienced investors and academics have been on record as making some spectacularly bad decisions. I have no reason to suppose that my ability to predict the future is any better than average. However, in order to make sensible investing decisions, in order to plan for contingencies, it is necessary to make an attempt. This will give you an indication of the potential for things to go wrong and, if they do, how badly. This analysis is particularly important in situations involving debt financing (e.g. mortgaged property) or where there is a possibility of losses exceeding the amount invested (e.g. futures trading) or where your ability to tolerate a loss is limited (e.g. if you are near retirement).

An example of my approach to stress testing my investments in real estate is here. In reviewing this part of the private portfolio, I listed the things that could go wrong: vacancy, rising interest rates, falling net yields and declining market value being the obvious potential sources of danger. There are of course other potential risks, but I considered these sufficiently remote to be ignored. Looking at the list of risks, I then considered the portfolio's ability to service the mortgage obligations should they eventuate. I concluded that rising interest rates and falling yields would have only a limited effect on debt servicing capability. As an investor looking for long term yield who starts with a positive cash flow and a healthy level of income, I was not overly concerned about the risk of declining market values. It would hurt, but would not ultimately affect the cash flow. The most substantive risk was the risk of vacancy. It is a small portfolio and even a single vacancy would result in negative cash flow.

Having identified the risks and made some attempt to quantify them, I then considered a contingency plan to deal with them should the need arise.

I still need to do the exercise for the rest of the private portfolio.