Sunday, June 6, 2010

The two profit centers of investments – part I

Whether you invest in real estate or in paper securities, profits come from two sources:
1. Cash flow
2. Capital Appreciation

So risk management is about managing the risk of both. Assets fluctuate in value, however over time they reflect they increase with inflation, economic growth, supply and demand. Because paper securities are easier to trade than a real estate property and because it is followed on a day to day basis with extensive up to the minute market news, these securities are more volatile or at least seem to be more volatile than real estate.

That volatility represents market risks to many, in particular day-traders and option traders whose profits and losses stem from this volatility. They use tools such as technical analysis or sheer intuition to make money from monthly, weekly, daily and even hourly price fluctuations. For the long term investor this is often a zero sum activity. But even a long term investor may use market volatility to buy investments at an optimum price – this is especially the domain of the ‘value’ investor.

Over the long term, stocks and real estate increase at approximately 6 to 8% per year. As pointed out in earlier posts, the longer the time horizon, the lower the chance of losses and as such, both real estate and stocks can be considered low risk. Also as shown in an earlier post, leverage amplifies the volatility and the return on investment (ROI) on your investment assets. Fixed income investments behave somewhat different, these investments seem not to appreciate over time, it is strictly considered ‘money rental’. However, the money-rental income is subdivided in an income and an inflation protection component. Also, when tradable, such securities can add capital gains made from the sale and purchase of these debt instruments. In fact, if it wasn’t for taxation investing in debt could be very attractive since the build in inflation protection should protect against loss of purchase power. That is why investment vehicles such as RRSPs and TFSAs are ideal for fixed income; in particular the TFSAs since there are no taxes upon withdrawal as discussed in an earlier post.

So investment assets fluctuate in value, and risk stems from losses incurred when one is forced to sell at a time of low asset valuation. Thus true risk management should focus on this issue, i.e. preventing forced sales often stemming from lack of cash and cash flow. You may have noticed that we don’t worry about the performance of individual business or assets this because in a diversified portfolio, failure of individual investments is offset by success in others. Unless an investor is very knowledgeable about a particular investment, overweighting one’s portfolio in one or only a few investments is a sure recipe for disaster.

When investing in an investment class, asset value fluctuations should not be the focus of risk management – value fluctuations are a fact of life. When an investor is aware of those fluctuations and their temporary nature, he/she is truly capable of ‘buying low and selling high’. Thus the key of successful investing lies in cash and cash flow management. Asset value fluctuations are like having the flue – flues can be deadly especially for those who are in poor physical form, but if one has the constitution to get past these few days of flue, a person can live happily and prosperous for many years to come. The same is true about surviving value declines in bad markets you need the financial health to survive them and once you recover, you’ll be in better shape than ever before. But when financially unhealthy you could go broke or incur financial scars which may haunt you for years to come. Your financial health is your cash and cash flow.

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