Archives for category: Investing Series
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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.

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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.”

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.