Thursday, September 9, 2010

How to use your main investment scenario


As part of risk management, the prudent investor looks at a number of possible investment scenarios or forecasts. These are 'what if' cases and you don't have to make them all yourself. You can use books or news paper articles as your scenario. For example, as your worst case scenario you could use Harry S. Dent's book "The Great Depression Ahead' or Nouriel Roubini's double dip news paper predictions. Just add to that your estimate as to how your investment portfolio would perform under those conditions and what you should do to protect yourself against such a scenario.

The best case scenario can also be found in news and book; for that I use authors like Jeremy Siegel. My favorite is his book: 'The future for Investors'. Jeremy's is not truly the sunniest scenario around, but if his long term scenario becomes true, I would be very happy. Yet his views (in my opinion) are quite realistic. So then I have to decide what is the most likely investment scenario for the coming year or five? This will set my ultimate investment course keeping the other scenarios in mind. My 'Main Theme Scenario' is not static and adjusts on a nearly daily basis.

So how do I build this Main Theme Scenario? Well, it is by reading the news paper, watching BNN, reading books and surfing the internet. Obviously, you cannot take all you read seriously. In fact, the opposite is more likely the case – there is a lot of cr.p or more politely stated 'noise' out there. That is why REIN's Don Campbell always talks about 'looking behind the curtain'. You also have to include an optimistic attitude when you read all this. If you're a pessimist, why invest at all? You're trying to make money (income and appreciation) from what you're investing in – so you hope for better things to come. O yeah, there are those who short sell and hope to make money from doom and gloom. Reality though is that the future is bright and pessimists over long haul always miss the boat. The doers make this world, not the naysayers. Bill Gates and Steve Jobs have an unshakeable vision of the future and they build big empires. I never heard of a perpetual pessimist who did create a large successful business. I am not saying that you have to put on rose colored glasses because they may not make you see the stumbling blocks on your path! But overall the successful investor has a long term view of societal progress.

Combine your MTS - I am such a geek and use this abbreviation for Main Theme Scenario :) – with your Asset Allocation Spreadsheet (see earlier posts) to map out the near term road to you personal Belize. My last MTS was formulated October last year. Since then I have posted an update in April ('Godfried's 10th forecast of the year'). Reading the news and following economic numbers (just a few, such as consumer confidence, unemployment, interest rates, durable goods index, etc.) helps me to define our current economic state. I often look for good news during bad times (looking for light at the end of the tunnel) and for consistent bad news during the good times (clouds building at the horizon). So right now, I am looking for evidence that we won't have a double dip and that the world is not coming to an end. When times are good it is easy to make money; when times are bad it is your priority is to protect your net worth while seeding the investments that make you money when the good times return. He, even Berkshire Hathaway has down days!

So after a while, you get your moment(s) that the pieces of the puzzle come together and the old MTS plus many pieces of daily information create a new snapshot of where we are and where we are likely to go in the investment world. This is the time when I sit down and write down my new MTS and use it to guide me in my investment decisions over the coming months. Jeremy Siegel is my long term investment optimistic scenario (my investment portfolio goal) and Harry S. Dent and Nouriel Roubini frame the downside and help me formulate the things I have to do in order not to lose my shirt if things turn sour, my MTS sets the near term investment direction.

Right now, my MTS paints a modestly rosy picture. We are coming out of a large downturn and stand at the beginning of a 3 to 5 year bull market. The TSX is likely to peak over the next years around 18000 (see some earlier posts). Real estate will appreciate between 3 to 6% percent per year and with homeownership declining there will be increased rental demand and higher rents. With higher interest rates (unavoidable in an improving economy) houses become less affordable; also home buyers may be a bit more conservative compared to the early 2000s. Baby boomers reach maximum savings years but will also keep on spending at levels much higher than previous generations. They also will keep on working to well into their seventies, despite their dreams of 'freedom 55'. As said 'freedom 55' was only a dream and certainly not the one baby-boomers worked for to achieve. If there is one thing I learned about my generation than it is that they say one thing and do something else entirely.

Everyone knows about the potential of China and other BRIC countries. The outcome will be likely as predicted but those markets are so fully priced based on those expectations that stock market profits are likely to be mediocre. My guess is that profits lay in Canada, the U.S. and W. Europe excluding the Mediterranean. Growth in these areas will be moderate but many 'gurus' will underestimate the economic vigor of the old world and the old new world. Thus the pricing of their stock markets and other investment assets will remain reasonable and the combination of high dividend yields, improved rents, modest interest rates and low expectations will create a good and stable investment climate for the next 5 to 10 years. A true 'Goldilocks' investment setting! The initial worries of double dip and other scares will gradually decrease and after climbing a long and slow wall of worry. Five years from now the TSX will reach 18,000 and real estate values will have increased by some 30 to 40% (from current Calgary levels). Vancouver real estate will be not as strong but still do well, with many Asian immigrants preferring the less hectic but prosperous lifestyle of Western Canada over the hectic growth and 'ups and downs' of their home economy.

Canada overall will become the multicultural poster-child of the world – this will be our Golden age! But for now we're climbing a slowly rising wall of worry. Focus should be on cash and cash flow. Investment opportunities will be plenty, but our forward looking view is obscured with potential stumbling blocks. Preservation of capital is number one; adding cash flow from good rental properties and dividend paying stocks is number two; buying only investments at the right price and reducing risk to a minimum is number three. Playing call options is just that, playing. It may come in handy from time to time but it is definitely not a priority. Don't be in a hurry to buy; the current environment will offer plenty of opportunities so don't shoot all your powder right now. And when everybody is shouting "Buy, buy, buy!", you sell, sell and … sell."

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