Investing 101: Start saving before you do anything else

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Wait. Isn’t this supposed to be about investing? So why am I telling you about savings? At the very least, shouldn’t I be telling you about concepts like Time Value of Money (TVM) or Compound Interest? Well, all of those might be important but let me explain why I think savings, at least in the beginning, is the most important step of all.

Compounding will turbo-charge the returns you get on your capital. C the difference between simple interest and compound interest. A simple interest of 10% per annum (p.a.) on a sum of $1,000 brings your total to $2,000 after 10 years while the same $1,000 compounded at 10% p.a. for 10 years gets you $2,593.74. That’s almost 60% returns ($1,593 vs. $1,000) just by letting your returns compound.

So why is savings so important?

Zero compounded by anything is still zero

For starters, no matter how powerful compounding is, if there isn’t anything to compound, your returns are still zero.

That’s just it. You can’t escape the mathematics of the situation.

Naturally, the higher the savings rate also means that compounding has a much bigger number to compound on.

Without savings, it’s going to take a long, long time

In the beginning, you aren’t likely to have much capital to start with. Even if you can produce god-like returns in the realm of 20-30% p.a., the absolute sum is not going to be life-changing.

For example, let’s say you have a financial independence target of $1 million and you expect to compound $1,000 to your financial freedom. Assuming you can achieve the above-mentioned godlike returns of 25% p.a., it will still take you roughly 31 years to reach your target.

But what happens if you start saving an additional $1,000 a year? Then it only takes you about 24 years.

And remember, the above example assumes you are going to some sort of investment genius. I can assure you that more likely than not, you will be as average as I have been.

Let’s try to apply some more realistic numbers and see what that takes us. This example is going to be in the context of someone working in Singapore that has a Central Provident Fund (CPF) account. As of writing and I think (fingers crossed!) for the foreseeable future, the Special Account (SA) pays roughly 4% p.a.

If a Singaporean worker starts working at 25 years old can somehow contribute get $5,000 per year in their SA and it continues to compound at 4% p.a. until he/she reaches 55 years ago where CPF allows that lump-sum withdrawal, this person would have $280,424.69. Assuming that the 4% p.a. is a real rate of return, I think more than a few people would be quite happy with having $280K in their bank.

Savings forces us to live with less

Living with less means that it’s much easier to be financially independent.

Most people don’t realise this but there isn’t a magic number to financial independence. Financial independence depends a whole lot on whether you have enough income to meet your expenses.

A person with an income of $100,000 and expenses of $100,001 per year will never experience financial independence and in fact will be forced to dissave.

Naturally, achieving financial independence means being able to generate the income necessary to cover your expenses at will. There is no dependence on an employer for this income.

How does this relate to savings?

Well, if your savings rate was high, then your expenses would naturally be low. Let’s consider two people, both with an income of $100,000 p.a. Let’s say that A only saves $10,000 while B saves $90,000. The corollary must be that A spends $90,000 while B spend $10,000 per year. This means that each year, A would have saved 1/9 of a year of his expenses while B would save 9 years of expenses.

I also think there’s something to say about how people buy too much crap that they don’t need due to excessive advertising or how we end up spending on things that won’t mean much some years down the road and the environment is paying a price for that.

Less is more

If we were to apply the pareto principle of how 80% of all outcomes are determined 20% of actions, I would say being able to save and having a high savings rate is the 80/20 rule of personal finance.

I don’t think I’ve ever read or heard of anyone who has gone broke by saving too much. On the other hand, there are numerous examples of those who have made millions and lost it all and more because they simply couldn’t control their spending.

In short, save more, spend less.

How to Understand Investing (part 2)

In part 1, I detailed the most important takeaways from ‘The Intelligent Investor‘ (although in my haste, I left out the idea of Margin of Safety). In this part, I want to show you the parallels between the act of buying the book and investing.

This is essentially the second reason why I asked my younger brother to buy the book. I wanted to see what his thought and action process was like.

Reason 2: Buying stocks from a value perspective is pretty much like buying anything else

#1: Hardcover or Softcover?

Now, there are various ways to think about the difference but let’s take a look at the first factor that comes to mind — price.

Hardcover books are more expensive than softcover books although the first print comes out earlier than the softcover. In the past, I used to automatically buy the softcover version of the book since I figured that I was getting the same content for a cheaper price.

As the years have passed, I’ve come to realise that hardcover version of the book lasts much longer than the softcopy version of the book. Sadly, my own copy of ‘The Intelligent Investor’ is an example of this.

For things that you genuinely treasure, it never makes sense to consider only the price of the stock. In investing, the parallel to this would be buying stocks just by looking at price. Some people who buy stocks actually think that a stock that costs $10 is a more expensive stock that cost $1.*

The other parallel is to remember that sometimes, cheap stuff is cheap for a reason. Just like the book, a stock that sells for pennies (aptly called “penny stocks”) could reflect the actual fundamentals of the company.

#2: Borrowing before buying

Although I recommended that my brother buy the book, one other thing he could have done is go to the library to borrow the book first. You may say that he trusted me, as his brother and someone who knows a thing or two about the markets and therefore didn’t have to check the book out first.

However, borrowing the book is a smart thing to do if you want to know whether it’s worth spending your money on. In investing, this is akin to fundamental analysis where a would-be investor investigates the earnings, assets and cashflows of the firm in order to know what price to pay for the stock.

This could also be a good step before you decide whether it’s worth buying the hardcopy or just the softcopy, or whether the book is even worth buying at all.

Conclusion

In short, most people know exactly what to do when they buy a product. They check out the reviews, they compare the specifications between one product and another and they also compare where they can buy the good for the best price as well as other factors like delivery and any warranties from the manufacturer.

It’s strange that many people don’t do this when it comes to investing. They don’t compare the returns from one investment to another, whether those investments are guaranteed or the guarantee is merely a probability. They buy high for fear of missing out and sell low for fear of losing everything. Swayed by fluctuations in price, they hold investments for ever shorter periods of time.

It’s just weird.

Investment should be like buying anything else. Thinking of it as such will make you a better investor.

 

Notes:

In case you’re wondering, paying $1 or $10 for a stock doesn’t matter. What matters is how much you pay relative to the earnings per share.

How to Understand Investing (part 1)

Some weeks back, my younger brother wanted to learn about investing. I thought about it long and hard for quite a few weeks and eventually, I told him to go and buy this book – The Intelligent Investor by Benjamin Graham, the version with annotations by Jason Zweig.

Don’t call yourself an investor if you haven’t even read this

Who is Ben Graham?

Benjamin Graham is more famously known as Warren Buffett’s professor and former boss. Graham, together with Dodd, wrote the classic textbook, Security Analysis. Essentially, Graham is the godfather of Value Investing.

Graham biggest contribution was to popularise the idea that buying stocks should be a function of what you get relative to what you pay for. What you pay for is the price but what you get is a share of the profits and assets of the business. In essence, Graham popularised the use of the P/E (price-to-earnings) ratio and, together with Dodd, suggested normalising earnings before comparing with price, which is basically what Shiller’s Cyclically Adjusted Price to Earnings (CAPE) ratio is.

Anyway, I told my brother to buy the book for two reasons and this post is essentially for him.

 

Reason 1: It’s the right way to think about Investing

I don’t mean to offend anyone from what I’ve seen, too many people approach business and investing the wrong way. They learn wrong ideas and end up doing stupid things until they either realise it too late or never at all.

Many people think that investing is all about buying low and selling high and they fail to understand what it really means to buy a stock. From ‘The Intelligent Investor’, there are three important lessons to learn.

#1: Price is what you pay, Value is what you get

Buying a stock means buying a share of the business which is why stocks are also known as ‘equities’ which basically translates into ownership. The essence of Graham, which is at the core of what Buffett and other Value Investors believe, is that an owner of the business cares about the assets of the business and what earnings or cashflows those assets can bring the owner.

Now, the majority of “investors” in Singapore only care about price. They know how much they bought a share of Singtel for. And they know how much they can sell one share of Singtel in the market right now. Why? Because the price is the simplest piece of information to find.

Better investors can cite the earnings, cashflows or dividends that the business can bring in each year. But imagine you’re a business owner. Will those metrics be enough? You’d probably want to know other things: How your competitors are doing? What do customers think of the product? What are the largest components of the cost of production?

The first important lesson from Graham is that being a stockholder means being an owner of the business. If you only buy the stock based on its price and the hope that the price will go higher than the price that you paid for it, that’s speculation. And Graham made it quite clear in the book that therein lies the difference between investing and speculation.

The trick is knowing which activity you’re engaging in.

#2: Price and Value can, and will diverge

The second important idea from Graham is that the stock market is driven by emotion, short-termism, and irrational behaviour. He personified the market as a fellow called Mr. Market who quotes you prices on the stocks each business day.

As Buffett understood, the advantage investors have is that an investor can afford to ignore Mr. Market and take advantage of his over-pessimism or over-optimism. On days where Mr. Market believes that the world is going to end, he ends up quoting prices that are so low that it’s benefit to buy. On days where he thinks markets will keep going up forever, he’ll quote prices that are so high that the business will never be able to provide a decent rate of return for investors*.

#3: Price and Value will converge (eventually)

Of course, for Value Investing to work out, prices and value must converge. In other words, buying at prices that are low relative to value lead to good returns because the market will eventually recognise that the company is worth much more than the current price and therefore bid prices back up to what the company is actually worth.

The problem with this is that this recognition can take time. For example, prices of financial stocks remained fairly depressed following the Global Financial Crisis of ’08-09 and it was only until last year (2017) that bank stocks finally started to gain some favour again.

This is why the great economist, John Maynard Keynes, who was a pretty successful investor as well, said that the markets can remain irrational longer than you can remain solvent. This is why many investors caution against the use of excess leverage. For the majority of retail investors, leverage is something to be VERY careful of. If you choose to proceed, do so with caution.

On the other hand, prices tend to come down fast. So if you’ve bought at a very high price relative to value, don’t expect to hang on to your gains for long. Once again, taking on leverage by shorting the market is also not for the faint-hearted. There are many Value Investors who short Growth and have paid a high price for it. When you short, being early is (almost) the same as being wrong.**

I wanted to do this in one post but it’s gone on for a little too long. In the second part, I’ll show you the parallel between buying “The Intelligent Investor” and investing.

Notes:

*The classic example of knowing how ridiculous the market was when a dot-com CEO told his shareholders that given the company’s share price at the time, he would need to return them 10 years worth of revenues in order for them to just break even. I thought it was Cisco but I can’t seem to find a source for this. Cisco’s price to sales went as high as 37 though.

**For those interested in finance, go watch ‘The Big Short’. It’s accessible and the heroes in the show almost lost everything by being early.

Are you diversifying or deworsifying your portfolio?

Should you have more baskets to store your eggs? Is more always better?

You’ve probably heard the saying “Don’t put all your eggs in one basket”. The wisdom goes that at least if you drop the basket, you won’t have to worry about losing all your eggs.

In the investing world, the same logic can apply. Having a portfolio of many stocks means that if one company fails, bringing the value of its stock down with it, an investor’s portfolio should not be affected to a large degree. In the finance literature, this is known as eliminating non-systemic risk.

In general, portfolios with 10 or more stocks reduce the amount of volatility dramatically relative to the market and once the portfolio reaches 30 or more stocks, volatility is reduced to barely above a percentage point. (see here)

Unfortunately, there are a few problems with just having a larger number of stocks in your portfolio.

 

Industry-specific Risk

It doesn’t matter if you have many stocks if they all belong to the same industry and that industry is currently in the midst of a cyclical decline or the various players in the industry were all engaged in unsavoury practices.

In 2008-2009, the financial industry was hit by the downturn in the U.S. housing market. This led to credit being frozen in the banking sector and once the dominoes fell, even the better-capitalised banks felt some pain.

More recently, many Singapore-listed firms in the oil & gas sector were also hit when oil prices fell from over a hundred US dollars to a low of 30 US dollars. The bigger players such as Keppel Corp and SembCorp saw their share prices fall to multi-year lows and haven’t recovered much despite oil prices climbing up to about 70 US dollars.

Smaller companies that provided services to the offshore gas industry suddenly found demand for their services dry up and those that were up to their eyeballs in debt have been in serious trouble for some years now.

In short, having a large number of stocks doesn’t matter if a large number of them all depend on the same economic factors for profit.

 

Geographic or Location Risk

The same goes for companies that all depend on a certain location for profit. It’s also well-known that investors tend to have a home-bias. This means that investors tend to put a huge chunk of their portfolio in their home country.

If the country has a huge domestic economy and many of the companies are dependent on that country for business, then when the economy goes south, the fortunes of those companies will all be affected.

Similarly for the stock market, having all your stocks in a single market could mean terrible returns. from 1999-2009, investors in the S&P 500 would have made less than 0% returns p.a. This is the “lost decade” that many investment books talk about.

What those books neglect to mention is that the “lost decade” happened for the S&P 500. Other asset classes within the U.S., as well as markets outside the U.S., fared much better. For example, the MSCI EM Emerging Markets (Net) Index returned 9.78% in annual total returns for the same period.

 

Where Conventional Diversification Fails

So, if you diversified across a number of stocks, industries, and markets, you should be fine right?

Not so fast.

Research has shown that when a crisis hits, many asset classes that seem uncorrelated start seeing their correlations move to one:

But it has been well documented that correlations tend to increase in down markets, especially during crashes (i.e., “left-tail events”). Studies have shown this effect to be pervasive for a large variety of financial assets, including individual stocks, country equity markets, global equity industries, hedge funds, currencies, and international bond markets.

To make matters worse, research also finds that:

Not only did correlations increase on the downside, but they also significantly decreased on the upside. This asymmetry is the opposite of what investors want. Indeed, who wants diversification on the upside? Upside unification (or antidiversification) would be preferable. During good times, we should seek to reduce the return drag from diversifiers.

In other words, different asset classes may move out of step in bull markets while they all seem to move in the same direction when the bear bites. This results in diversification that causes a drag on returns in bull markets while offering little protection from the bear.

However, the article also finds that the two asset classes that are useful for diversification are a mix of Stocks and Bonds. Specifically, the study used Treasuries in the bond mix which suggests that Treasuries go up when Stocks go down due to a flight to safety.

 

Main Takeaways

The main lessons from this are to be aware that while diversification is necessary within the asset class, we don’t want to add too many asset classes to the mix thinking that that will be the solution to preventing the entire portfolio from tanking at the same time. The bigger lesson would be to have a sense of whether valuations are rich or cheap as well as to rebalance the portfolio towards the optimal mix.

Alternatively, you can take Andrew Carnegie’s advice to “put all eggs in one basket and watch that basket” but I wouldn’t recommend it; It’s too much work. Furthermore, it’s hubris to think that you are better than many of the people who analyse companies for a living. This may work for investors like Warren Buffett* but unless you think that you’re that good, you should spread your investments.

Just don’t spread them too thin.

 

Notes:

*Actually, even Warren Buffett had his share of mistakes like Dexter’s Shoes so imagine if all he owned was that shoe company.

Market cycles matter

I know I run the risk of being wrong but for what it’s worth, this is my honest opinion. After all, it’s very difficult to spot bubbles except in hindsight.

Recently, I’ve been talking a lot of shit about cyrptocurrencies and I think many people have mistaken my comments about cryptos as a sign that I think they are a total scam.*

I don’t. In fact, with my cursory understanding of the technology, I think they the Blockchain technology that all cryptos are based on could fundamentally change the way some business is done. There seems to be a lot of promise in reducing the fees that many financial intermediaries earn or ensuring the integrity of the supply chain of a product.

The problem I had with cryptos is the fact that almost everyone seemed to be buying into the hype. In fact, my boss asked an innocent question, “Why was there suddenly so much attention on bitcoin when the thing itself is almost 10 years old?”

I thought the answer was simple.

The only reason why 2017 was the year of bitcoin and cryptos was that there was so much money that was made (whether the money was real or illusional is another matter altogether).

That fact in itself made the intended use of cryptos irrelevant. All that was relevant (and still is for some people) was whether the price of cryptos was going to go up or down. Now, that is something interesting to me because it is the same with any other investment. If there are too many people chasing after the same returns, they are going to bid the price up and sooner or later, no one is going to believe that the price will keep going up and that will be the beginning of the end for the inflation in prices.

The people that believe that it could be otherwise just haven’t read enough.

It was the same for financial assets and real estate (‘08/09), internet start-ups (00s), Asian real estate and stocks (‘97), Nifty Fifty stocks (60s), equities (1929), the South Sea Company, tulips and so on and on.

Stage one: nascency

People who invest in anything, in general, need to be more aware of the fact that ALL markets move in cycles. In general, any cycle starts with a small segment of investors in some new or previously unloved asset class. These investors get called all sorts of names- whackos, gamblers, speculators or what-have-you.

Stage two: some people make decent money

Eventually, these guys start making some money and people start to take notice. As more people chase after the same returns that these guys have gotten, the initial group of investors starts to make outsized returns. It doesn’t help that this initial group seem like average Joes and Janes to their neighbours. People start to think that if these people can make 1000% returns, I can too.

Stage three: envy draws everyone

Investors in other asset classes, which have returned nowhere close to the returns from this asset class, then wonder what the hell they’ve been doing, getting tiny returns while these people that they thought were whackos are proving them wrong. It doesn’t help that some “whackos” make all this money that is many multiples of what their full-time job pays in a year. Some of the investors start becoming converts.

Eventually, many people who have no business investing in anything start putting in tiny bets into this new asset class. The bets pay off. They then put their entire nest egg into this ‘sure thing’.

Stage four: beginning of the end

Then, without warning, prices start to collapse.

Entire nest-eggs and paper fortunes worth several lifetimes evaporate. Those with gains start selling furiously, desperate to hold on to whatever gains that they have. This compounds the selling. The die-hards are telling everyone else that this is just a dip. It’s a chance to buy even more they say. What they forget is that some people have already put all they have into this one thing.

Stage five: back to earth

Prices start to stablise and provide some relief. But as corporate bankruptcies due to losses in this asset start to filter, everyone starts to realise that it’s over. All they can now do is lick their wounds.

While it seems like the easy answer is get it at stage one or two, the unfortunate thing is that there’s no way to predict which asset to get into or when it’s going to take off.

Many other experts on investing have written about bubbles, market euphoria and how to spot these things. My favourite person on the topic is Howard Marks of Oaktree Capital and I understand he has a whole book devoted to market cycles coming out later this year. I’ll be sure to read it.

Revisiting the crypto craze

If you cast your mind back cryptos, very few people were talking about it prior to 2017. Only the people who kind of understood or were willing to explore the technology were invested before 2017. I dare say that prior to 2013, the people in it were mostly the people who were working on the technology itself.

Only after a certain group of people had already made outsized returns on their investments did cryptos start to attract the kind of attention it did in 2017. It probably also helped that 2015 and 2016 weren’t exactly good years for stocks. This made the gains in crypto seem all the more attractive. Everybody from South Korean students to Japanese salarymen started buying bitcoin too, thinking that they’re all bonafide investors now. My boss was also asking if we could do a presentation on the economics of bitcoin.

That’s basically when I knew that cryptos were done. I didn’t know if prices would continue to go up or not but I knew cryptos were now a major bubble.** The point here is not about cryptos per se. The point is that if we look back at the Global Financial Crisis (GFC) in ‘08/09, there was a similar story that played out in US real estate (in ‘04-’06) which led to the financial crisis.

Next time, if someone asks you for money to invest in something, you probably want to ask yourself: “Which part of the cycle are we at right now?”

Notes:

*Funny enough, there’s actually one called Super Cool Awesome Money (SCAM).

**After some colleagues and I discussed how ridiculous the price increases in crypto had been, the price of bitcoin more than doubled over the next three weeks. It goes to show how difficult timing markets can be. Crazy can get crazier. Lord Keynes has been quoted to death on this but it bears repeating: “The market can stay irrational longer than you can stay solvent.”

Investing Series: Why invest?

This is a series of posts that I planned to start on some time ago but never got around to doing. So why am I doing so now? Well, someone in the family wanted to know how to get started so here I am writing down my thoughts, basic reading material as well as other things one needs to get started. The entire series is here.

Why should one invest?

This sounds like a simple question but it needs to be answered because without honestly answering this question, one may find that he/she does not have the necessary resolve to see the plan through.

A simple analogy would be dieting. Many people diet because of some shallow motivation like wanting to lose a few kilos or to fit into a pair of jeans that they used to be able to fit into. However, most diets fail simply because many people who start a diet see the diet as something temporary. Once the objective has been met, the diet will stop. Unfortunately, once the diet stops, the weight gain comes back with a vengeance.

It’s the same with investing. Many people start investing thinking that it’s the path to helping them get a new car or to pay for that dream holiday. However, once that goal has been reached, the investment plan is chucked aside and the wealth accumulation stops.

Notice that in the previous paragraph, I used the word “plan”. And the reason I used the word “plan” is that an investment operation (to use Benjamin Graham’s phrase) is not a one-off action. It is a commitment to a process.

The commitment is necessary because markets don’t always go your way. Often, they go against you and test your nerves. You will wonder if you are indeed doing the right thing or if the wisdom passed down through the ages have become obsolete. This becomes especially true when many people around you are making huge gains* from some new-fangled form of investment that they themselves fail to understand.

The commitment is also necessary because unless you use leverage (i.e. borrowed money), buying assets require savings and savings require income, and needless to say, income comes from work. Therefore, there has to be a commitment to save instead of spending your income on present consumption to distract you from the stresses of work. This isn’t something that many people can live with unless one has the epiphany that consumption beyond a certain base level doesn’t bring extra utility.**

For me, investing is a no-brainer.

1. It makes you wealthier and with wealth comes fewer worries and more choices.
2. It’s fun. Investing is like a game where you try to figure out what things are worth. If you can buy it for less than what it’s worth, you’ve got a bargain.
3. I’ve reached the realisation that more things don’t make you happier. Even certain experiences are over-hyped. Many things that make one happy don’t necessarily come at a monetary cost.
4. It’s an exercise that you can do in solitude. In fact, some solitude may be necessary as chatter and other opinions may only add to ‘noise’ instead of being ‘signals’.
5. It’s simple if done right. Notice I said ‘simple’ and not ‘easy’. Simple means that you don’t have to follow complex and arcane rules or necessarily be quicker or smarter than others. However, it’s not easy because one needs to have the right temperament (i.e. discipline and patience), especially when things aren’t going your way.

That’s why I invest. You may not become one of the richest people in the world but if done even semi-right, you will definitely be better off than most people who leave their financial future in the hands of financial planners***.

In short, start thinking about why you really want to invest before even doing any investing. If you find your reasons to be shallow and superficial, you may want to start thinking again before committing to an investment plan.

Notes:

*Unfortunately, many of those gains will eventually prove to be illusionary.

**Taken to the extreme, this is the nirvana reached by monks. The detachment from worldly possessions because all worldly possessions are by their very nature, impermanent.

***The term ‘financial planner’ refers to how it’s used in the Singapore context. I don’t have anything against financial planners but in Singapore, ‘financial planners’ are basically product salespeople for insurance companies. There’s nothing wrong with having insurance but most financial planners are paid on a commission basis and belong to an agency whose targets are sales-driven. The only way to hit these targets is to sell products that have higher commissions and these are typically plans with some sort of investment component where the investments are taken care by the fund management company associated with/outsourced to by the insurance company. These funds charge high fees for basically giving you market returns. Some financial planners may not like it but show me a financial planner who got wealthy through actual financial planning instead of sales commissions and I’ll retract what I said.