Sunday, November 27, 2011

Some Ken Fisher vitamins for long term investors

Ken Fisher is one of the more successful money managers in today’s world and he has written 8 bestsellers on investing. He is now 40 years in the money management business and his investment results and longevity attest to his investment acumen. An avid researcher of history and financial history, Ken has always a long term view on investing and the title of his latest book speaks for itself: MARKETS NEVER FORGET (BUT PEOPLE DO): HOW YOUR MEMORY IS COSTING YOU MONEY AND WHY THIS TIME ISN’T DIFFERENT.

The book’s title is its message but if you think that you can skip reading it, you’ve got it all wrong. I’ve quoted from Ken’s previous books ‘The Only Three Questions That Count’ and in spite of several good concepts that I picked up from it, I just couldn’t finish it. But ‘Markets Never Forget’ is different, not only is it chock full of valuable investment concepts, even more so, I cannot put it down, it is a great read. Lately with my playbook on my side at every step in my daily life, so is my Kobo e-book reader. After a number of bug crippling weeks, Kobo was literally bugged down. But now with the new update it is once again hunky-dory and Ken is on my side in the livingroom, before falling asleep and at my daily stop: ‘Starbucks’.

I love digital books, lately I threw out every hardcover and paperback I owned, de-cluttering my house. Wow, the empty space it creates along with my kids moving on to more independent life. Not that I don’t read books anymore, to the contrary, but it is now all in the cloud and on Kobo. I digress… Ken Fisher combined with Kobo lets me make easy screen captures of relevant text and graphs. I have shown a similar graph on this blog before, but here is Ken’s table regarding positive and negative stock returns shown below:

Click on the picture to enlarge.
The table shows that on a daily basis, stocks are more up than down. That is why over the long run stocks provide you a positive return especially when you include… dividend return. Even if you consider the 1970’s a period (more precisely 1965-1981 according to Ken) of no stock appreciation the dividends would have added to your profits and even the imperfect Dow Index would have resulted in a positive annual return of 4.5% annually or 111% cumulatively over that 17 year period of ‘flat returns’. It is one of the reasons Ken claims that there are no 'secular bear' markets and he confirms a view expressed on this blog before, we are currently NOT in a Japan style ‘lost decade’ we’re probably in a long bull market that started in 2008 and we’re experiencing a nasty correction from which we will, as usual, recover.

You may look at the above table also differently and conclude that day traders have a 47% chance of making a loss. When you hold a stock one month, your chance of losing is down to 37.7%; after a year your chance of losing is 27.1%. After five years there is still a 13.1% chance you are down but after 20 years you are ahead for sure. There is no guarantee anyone knows or can predict the future accurately; we can only extrapolate and guess. However, Ken’s latest book should help you convince that stock market investment is not dead and that probably there are many profitable years to come. Ken provides some surely needed vitamins for the long term investor in the current nastiness.

Saturday, November 26, 2011


Please, note the posting order of the ROI and COI series has been changed.

If there is one thing that I have learned over the past 5 years then it is about the relation between ROI and cousin COI. COI is not well known because when dealing with COI we think usually in terms of cash flow, dividend, interest and net operating income. When fractionated, we’re talking about the cash (earned) on cash (invested) ratio or the dividend yield, or the interest rate . COI stands for Cash-On-Investment and ROI most of us know already: Return-on-Investment.

ROI measures how fast our investment portfolio, our net worth increases. When working with compound investments we say that at a ROI of 10% and a 41 year investment time horizon, a one dollar investment growths in value to $64. Wow! But in what form comes that investment return? Is it appreciation; is it income or a combination of both? You may consider someone rich when such a person has a $1million dollar net worth. However, what you should really consider is whether that net worth is tied up in a single home and the fact that it never threw of a single penny of cash. So how would that person live off such a home? In fact, the home still requires cash every year and not just for property taxes. If you own shares in RIM and bought 10 years ago at $1 dollar per share, yes even after its recent decline it may still be worth 18 dollars but how much cash did it provide you to live off or to invest in other opportunities? Not a penny in dividends - cash flow from this investment (COI) was nada, zip, nothing unless you sold the shares.

COI is the cash an investment generates – Cash-on-Investment. It will pay the mortgage, it will pay for your groceries and it is much more dependable than cousin ROI. ROI is market valuation; COI is money in your hand.

In fact, if COI and ROI were really cousins, then for the remainder of this posting we have to get transcendental. Not that a successful investor has to be good at yoga, but COI is an intricate part of ROI. They are two yet they are one :). Cash on investment is a component of your overall return on investment; the other part is the aforementioned appreciation. Whether you invest in stocks or in real estate, appreciation or value increase has not been exactly inspiring over the last five years. Yep, if you invested in gold, appreciation would have been tremendous, but then COI would have been absent (until you sell).

The absence of COI is the reason many investors don’t like gold and they consider it speculative. This is true for most investments; appreciation is unpredictable – it may happen today, next week or five years from now. Nobody knows when a stock will go up in value. However, we all know they typically do. There are long term statistics that show that stock markets appreciate ON AVERAGE around 6 – 8% per year. But, as we lately have experienced, there may be years of depreciation or no appreciation. We don’t know when the goose will lay the golden egg. In the meantime, we have to live of some income. When we neglect COI then usually at the worst possible moment, we may be forced to sell the goose against our will and at a loss.

In real estate, net operating Income pays for financing the debt, for paying down debt and the remainder (usually just a bit) ends up in the investor’s pocket. The less financing (leverage) the more ends up in your pocket. However, higher cash-on-cash also often results in a lower ROI. The stock market phrase for dividend paying stocks is ‘getting paid while you wait’. This is incorrect! What are you waiting for? Appreciation or are you waiting for a high ROI? I would suggest that you invest for ROI of which your cash-on-investment is part. Often COI is the very reliable part of your return that is paid to you typically monthly or quarterly.

Since we’re using expressions, what about: “Better a bird in the hand than ten in the air”? Hmmm! The last five or so years have shown us how important COI (the one bird in the hand) is as part of investment return since appreciation has been all but absent. Cash flow from investment allows us to live; to buy other investments and it helps us to better hold onto our investments during tough times.

So let’s look at diversification in terms of sources of cash flow or COI rather than in terms of asset allocation. How much cash income do you want or do you need? That should be your first portfolio design question. What is the dividend yield on my portfolio? How much interest and how much rental income do I get? Multiple income streams that pay your cost of living and provide cash for reinvestment will protect your portfolio from losing purchasing power (inflation) and possibly helps it to grow into somewhat more. Time for a spreadsheet! Let’s do that in one of the next posts. In the meantime, why not evaluate your own investment portfolio in terms of COI and ROI?

COI and ROI – Creating Multiple Income Streams

Robert G. Allen wrote the book Multiple Streams of Income. In it he states that rather than depending on a single income stream, e.g. a salary it would be much more prudent to live on multiple sources of income. This idea stuck with me for a long time. For more details on this book visit Robert’s website:

If you are a growth stock investor, your investment return comes mainly in the form of capital gains. If the growth stocks stop rising so does your income. In fact worse, you will make no further gains and  ALL your income disappears. If you had invested in both dividend paying stocks and growth stocks, you would have had two sources of income: capital gains from appreciation and dividends. So with capital gains disappearing, you at least would make money from dividends.

In the 1980s you could make a lot of interest income just from cash and GICs so there is another income stream. Today that income stream is all but gone. Over time, the source of your income varies. Having multiple sources of income appears a lot more prudent on the day your pay cheque stops coming in or your employer’s pension plan goes bust.

So when looking at creating a portfolio, rather than worrying about what asset classes to invest in, why not take care instead of a diverse source of income or better cash flow?  COI is cash on investment and it is a lot more predictable form of return on investment than waiting for the time that you investment has appreciated to its full potential. Using the idea of creating a diverse source of income streams I created a new spreadsheet to help design a more reliable portfolio. At the end of the 'COI and ROI' series, we should have discussed most aspects of this spreadsheet and if you’re interested to have a copy of the spreadsheet just e-mail me.

We start the spreadsheet by taking inventory of our multiple income streams as shown in the figure below. The yellow fields are for you to enter data, the blue fields are calculated by the spreadsheet using my nifty equations of higher elementary school math.

Figure 1 Cashflow allocation for a 25 year old.
The beauty of this scheme is that you no longer have to worry about whether you need 70% or 40% of stocks in your portfolio. The types of income streams and how much income each stream generates will take care of that. When you’re 20 years old, you probably have most of your revenue from salary and you likely would be aiming for capital gains from real estate and stocks (e.g. figure 1), while when you’re 60 you may be less interested in employment income and more in dividends and interest. When you’re sixty-five you likely have little employment income, but your Canada Pension is starting to kick in along with more dividends and rental income (figure 2). So by determining where you want to get most income to come from or where you plan to get most income from at a certain stage in your life, the spreadsheet will create the appropriate portfolio composition (allocation) to achieve that. Cool eh?

For Now, why don’t you determine what your current income streams are and in what form you would like to receive your income 5 years from now, or when you retire. So we’re carefully designing COI and appreciation will come when it may.

Figure 2. Income stream for a 65 year old of moderate means

Oh, while you're at it, also make an estimate of your current cost of living and what it is when retired.

COI and ROI – Refined Cash Flow Allocation

We have decided how much interest and how much dividend income we want. But there are many ways of generating these income streams. We don’t have to stick to one income source and we can set the proportion that such an income source should contribute. Thus we may have interest income from cash, interest from long term bonds or income generated from investing in a Mortgage Investment Corporation (MIC). This is what we do in the section of the Income Stream Allocation spreadsheet shown below.

To remind you, yellow fields are for the user to set, the blue fields are calculated based on user input.

The spreadsheet allows for 5 types of interest income and 3 types of dividend income. What proportion is generated by each type depends on the investor; his/her risk tolerance and the existing economic conditions. Right now for example, interest from long term bonds may be risky because the chance of capital losses on long term bonds in a low interest environment is quite high. It also depends on how you buy the long term bonds; e.g. through an ETF or directly. In an ETF the bonds do likely not reach expiry and you could incur capital losses; when you hold the bond outright, you could let the bond mature and recover all principal without capital gain or loss. However in that latter case, you still would likely incur a loss of purchasing power (inflation) which is not tax deductible. Etc.

So you must think carefully about how to allocate these types of income. The good news is in doing so, you diversify your income streams even further. The current spreadsheet shows my current preferences

COI and ROI – Assumptions help you design your portfolio

Now that you have defined in some detail the kinds of income you need, we will have to find the appropriate investments to deliver. For that we have to make certain assumptions about the various investment types regarding what they deliver in today’s market. If your portfolio has to keep its purchasing power, the portfolio value needs to grow at least as much as the inflation rate. Also, how is this growth achieved? Through savings from your revenue streams that remain after your costs of living? Through appreciation or a combination of appreciation and savings?
Designing such a portfolio requires all kinds of assumptions which you guess based on your experience and based on current market conditions. What is the current inflation rate or what do you guess is the inflation at the time of your retirement? What is the prime rate? Or what is the prime rate excluding inflation? In other words what is the Real Prime Rate? What is the typical real rate of real estate appreciation in your market? At what real rate do stocks typical grow?
You also need to do an educated guess as to what the current nominal (including inflation) dividend yield  of the S&P/TSX300 is and of high dividend paying stocks such as pipelines, utilities or banks? Etc. All these assumptions affect your expectations regarding cash flow (COI), appreciation and when combined your total return on investment (ROI).

Click on the picture to enlarge
These assumptions are entered by you the investor into the spreadsheet or you can use the numbers as I currently see them and as shown above.
The assumptions for real estate investments tend to interact. For example, your level of leverage (LTV is loan to value ratio) combined with the down payment and...  combined with rental income determine your gross rent ratio (annual rent/ property value) while your cap rate is the ratio of net operating income (NOI) divided by your property value. Elsewhere in this blog we discuss these parameters in more detail so don’t worry if you don’t understand this right now.
Here is the reasoning – an investor wants a rental income stream of $6000 and expects that a typical well priced property purchased in Calgary would throw of 2.6% cash on cash invested (COI). Cash invested is your down payment, which then would have to be $6000/2.6% or $230,769.Since your leverage (LTV) is set at 60%, that requires the total property value to be $230,769/(1-60%) = $576.293. This, assuming a mortgage rate of 4% and assuming that you pay your principal down at 3.3% per year, results in annual financing costs of $25,269.23. That in turn combined with your required net cash flow of $6000 sets your net operating income (NOI) at $31,269.23. NOI divided by property value is the cap rate of 31,269/576,293 or 3.07%.
 If 35% of your total rent typically comprises your rental expense, then the resulting annual effective rent (NOI plus rental expense) divided by the property value of $576,293 results in a Gross Rent ratio of 4.72%. Now, from your market you may know that a gross rent ratio of 4.72% or $6000 per month for a $576,293 property is not unreasonable and neither is the calculated cap rate of 3.07%. If these parameters are not achievable in your market you may have to adjust your real estate assumptions until the numbers come out more reasonable.
The assumption numbers included with the spreadsheet are my current assumptions. When doing your own research you can enter numbers that may be more reasonable for your circumstances or for the economy you live in. The combination of assumptions and your required income streams determine the ultimate composition of your portfolio. This will be shown in the next blog posting.

COI and ROI – The dream portfolio

With all this information entered in your spreadsheet, the computer goes to work and voila! 4.3 milliseconds later the portfolio that generates the lifestyle you want is displayed. You can run this spreadsheet for your current situation to get an idea where you stand,  or for your ideal situation, or for what you feel you need as retirement income.

The resulting portfolio will then set the goal you wish to achieve in order to live your personal Belize. It also determines what your level of diversification ought to be at various stages in your live. The portfolio below is based on the previously used income stream numbers and assumptions.

Click on the image to enlarge

Finally, the spreadsheet also shows you the performance ratios such a portfolio should produce (over the longer term). It shows your COI on total portfolio investment and your total return on investment (ROI). It further shows, the amount of annual savings as a percentage of your portfolio value available for reinvestment. The savings/portfolio ratio plus your portfolio appreciation is the total annual portfolio growth which should be higher than inflation. If it is lower than inflation, your portfolio, in terms of purchase power, would decline over time.

Now you know how much cash flow comes in and whether you have the means to hold on to your portfolio while waiting for appreciation to take place whenever that exactly may be. This approach should get you through today’s volatile markets. If you want to try out the spreadsheet for yourself, send me an e-mail. Of course, I provide no guarantees about the spreadsheet – in using it, you accept the responsibilities of the results (good or bad).

Saturday, November 19, 2011

Live long and prosper

The initial idea of writing this blog was to help starting investors to find their way. It was also to support these investors to get through the tough times and to give them the perspective and strength to hold on to their investment strategies.

Retail investor portfolios do often underperform NOT because the mutual funds that many invest in are poor. Rather because retail investors don’t stick with them, thus incurring commissions, taxes and the disastrous results of market timing. Mentally, humans are not set up for stock market investing because many of our decisions in the real world are emotional made in split seconds when our survival is endangered. What is good for the goose is not necessarily good for the gander. Investing is supposed to be unemotional, analytical and boring. You put your investments in a box rather than trading them continuously responding to each market temper tantrum.

So if this blog is such an essential tool demanded by millions of young investors, why is the number of blog followers so modest? The typical post is read some twenty times. With 188 posts as of today, you would think that people buying 1000s of investment books for big dollars; and people subscribing to expensive investment letters would flood this blog that is free. But no, statistics show only a small number of followers. Yet it adds up, since inception in February 2010, we’ve had over 11,000 page views (not counting my own). Nearly 35% of visitors are from Canada; 25% from the U.S, another 5% from Russia, 4% from the U.K, some from Germany, Holland and even Japan. I am flattered but this does not come even close to the traffic of Google or Facebook. I can even see which posts are of most interest to the blog readers (see below).

But just like when I teach my geology courses to the oil industry, there is one other beneficiary which is even more important to me than my course participants and blog readers. Yes that is the teacher or here the blog writer, i.e. Godfried Wasser – Me. I realize that by formulating the investment process, by trying to step back from the noise of BNN, the newspapers and the stock markets, I become more aware of investment issues and of the back ground stories that are really important to me the investor.

It is not that my advice is always dead on and 100% correct. Far from it. I write here as I see things in today’s light not as they actually evolve in the real world. I show in these posts the emotions and thoughts I go through every day. I often review my own posts to see how good my guesses were or what I said about investment strategies and compare it with what I actually do. I notice that most of the time I do try to be consistent to my ideas presented on this blog and that it somehow works. The blog does also show how I fretted about selling off the riskier stocks in my portfolio in late September. Was this an act of panic or was it well thought out but late in implementation?

I share these thoughts so that you the reader may notice that even after 30plus years of retail investing, I still have doubts and fears every day in the market. It is part of the investment game and it is crucial that you are honest to yourself. Even if you like to brag to your friends about how successful you portfolio is and how smart a guy or gal you are, you have to be able to admit to yourself that you make losses and mistakes as well. It is often that you learn most from your losses and mistakes. With that may come the attitude than nothing is really for nothing. Oh, and I do make the same mistake more than once – stubborn like a donkey and on top of it, utterly foolish.

Reading over the old posts, I realize also that many of the ideas posted here are indeed valuable and worth adhering too. I revisit other posts than the top ten listed above. Lately I revisited the post: What-stock-market-environment-do-you think we're in as many other blog readers have done. Another post I often return to is: Update on natural gas prices. Also ‘2011 outlook as guessed by GW’ is often revisited just to see how my thinking has evolved and how much was right and wrong. That is why I updated my outlook for 2012 in a recent post. It lists the scenarios that I think will most like shape the investment world in 2012. Remember though, you need several scenarios for your portfolio risk management. A few days ago, BNN broadcasted the Munk Debates – a truly outstanding source for potential economic scenarios.

So, as much as I am concerned about helping beginning investors start on the path to their personal Belize, this blog helps me to define and stick to my own investment strategies as well. Thank you for following this blog and, quoting the most logical being in the known universe – Spock: may you” live long and prosper”.

Tuesday, November 15, 2011

What I see for 2012

We’re getting close to year's end. So what is going to happen after the 2011 Santa Claus Rally - if it materializes? To be honest your guess is as good as mine. I have seen some trends and patterns shaping up last year and it may be worthwhile to extrapolate these.

Europe? Europe will have to decide how far their monetary union will integrate and how much sovereignty the member states are willing to give up to create a true monetary union with a powerful central bank and the capability of issuing Euro Bonds. I expect these member states to decide to get stronger intertwined, which probably is the only viable course other than calling the European experiment a failure as so many seem intent on doing. Even then it will take time to sort out the details of the debt mess. Probably we will keep on hearing about this debt crisis for some years to come. Like a seismic shock where its ripples over time flatten. Europe will for some years have to apply austerity and debt reduction and that means reduced growth.

The U.S. is not far behind or ahead of Europe depending on whom you talk to. Yes, we’re now in the fourth year of a banking crisis which resulted in the ballooning of the federal debt and the total debt of the public sector. As if this sector did not have enough loan trouble without the banks. Reinhart and Rogoff released this year a tedious but valuable review of all kinds of financial crises. Banking crises are often related to real estate and falling real estate prices can persist for at least three years after a crisis while government debt balloons dramatically (on average by 186%) due to bail outs, reduced government revenue (taxes) and economic stimulus. This time it seems not much different. As mentioned in earlier posts, I foresee also a revival of the housing market in 2012-2013 and this may give the U.S. an additional economic boost.

Corporate numbers in the U.S. are improving; surprising consistently to the upside. Also stock markets rarely decline in the year of a presidential election. It is possible that we are in a slowly rising bull market rather than a volatile trading range such as in the 1970s. In the 1970s the Dow Jones seemed to be capped at 1000; but the current market may swing between slightly higher highs and higher lows. Not that different from the seventies but just enough to add some appreciation to our dividend and other investment income. Whether the U.S. political climate supports it or not, the U.S. economy will likely improve, but at a snail’s pace. I suspect combined stock market and dividend returns in the 8 to10% range. This together with a slightly strengthening U.S. dollar visa vie Canada’s loonie. I would not be surprised to see a U.S. stock total return in the 10 to 15% range.

Canada will grow as well along with the BRIC countries' demand for commodities and that of the sluggishly growing U.S. economy. Obama’s Keystone blunder will result in Canada looking for other trading partners. As learned over many generations, our U.S. neighbor is only reliable when it feels like it. If Canada ever wants to truly be a commodity superpower then it will have to develop markets away from the U.S. Pipelines towards the Pacific Coast will become a national focus regardless of the ultimate Keystone outcome. The Canadian stock market is in a pretty foul mood. Our banks are cheaply valued around a modest P/E of 10 but still expensive compared to U.S. banks such as BAC (Bank of America). That our banks are more solid seems once again to be a moot point. Investors treat oil companies as if the oil price hovers around $50 dollar a barrel rather than today’s $100. This cannot last much longer. Dividend paying stocks other than the financials are expensive and may be under performing next year’s market somewhat. Overall, I foresee 2012 stock market returns in a similar range (10-15%) as that of the U.S. stock market but without the benefit of a rising U.S. dollar.

China and the other emerging economies may start to turn around the fight against inflation. They also may benefit from improving North American and European markets as well as increased domestic demand. But rising labor costs, higher energy and commodity prices and a shaky banking system may counteract these trends. Thus, I don’t foresee these markets to be stellar outperformers. For Canadian investors it may become increasingly attractive to invest in North American multi-nationals with exposure to these emerging markets and that adhere to Canadian and U.S. stock market regulation with transparent books and governance rather than investing in local BRIC stock markets or worse in individual BRIC companies. This is also supported by the earlier posted notion that it is better to build diversification by market sector rather than by region.

Government debt is often reduced by inflating the currency. This combined with falling currencies to create more competitive pricing will likely result in a higher inflationary setting. With an improving economy both  in North America and worldwide, I foresee inflation returning sooner rather than later and so will rising interest rates. If history repeats itself then I see us standing at the beginning of an era of rising inflation and interest rates. Even with improved savings rates and aging wealth accumulating baby boomers, I see a lot of inflationary pressure at the horizon. So do not invest in long term bonds or GICs. If you invest in debt, invest in short term debt (1-3 year) or in debt instruments linked to the inflation rate (reset bonds or reset preferred shares for example). Locked in long term debt may result not only in declining bond prices but also in declining purchase power of loan principal.

Remember that even in a slow growth climate, undervalued stocks may still result in above average stock market returns or at least returns better than most expect. That is in a nutshell my view for 2012. Real Estate should be a good place to be as well in the upcoming inflationary economy. Well, there you have it – my 2012 outlook ready for the waste basket.

What I learned in Europe

Last week I spend time in my native Holland - a family visit. But when you turn on the tv, you hear the battle noises of Europe's debt crisis. So is Europe coming to an end? Is the EU dead? Is the Euro gone forever? Not likely. Since World War II have European politicians dreamed and worked towards a united Europe and the Euro is not the only achievement, so are open borders, absence of tariffs and much more. When you see Germans and Dutch buy residences nearly ignoring their national border you realize how far the European dream has been realized. At Dutch Realtor brokerages you see houses listed at either side of the Dutch-German border. Try have a Calgary Realtor sell Saskatchewan real estate!

If you compare Greece to the Maritimes; Ontario and Alberta to France and Germany you get the picture. A lot of the European debt crises lies in the hysterical imaginations of the financial press. I am confident that Europe will handle this nasty crisis withou falling apart. Just like Quebec is too integrated with he rest of Canada so is it difficult to imagine Italy and Spain, or even Greece separating from the European Union. Yes, Greece is troubled by large government debt and thus a temporary burden to Germany, France and its other siblings states. He, lets compare the debt of European countries with that of U.S. states such as California and top that off with the U.S. national debt.  Who is now deepest in hock?

There is always bickering in a family that needs change. But this European family had enough 'in-fighting' over the last century or two that it does appreciate the advantages of being one.  The real issue in Europe is how far the integration of the various member states should go. Are these countries and nationalities willing to forego a bit of their sovereignty for the benefit of a fiscally and monetary better integrated Europe?

Also playing a role are the hysterics and double standards of the socalled investment community. But who is setting the tone here? Individual investors such as you and me or overleveraged hedge funds and other financial institutions? Speculators on the bond markets of problematic countries to get that extra bit of high risk ROI.

A BBC article wondered why the UK with a debt/GDP ratio of 90% and a larger deficit than Italy or even Spain has less trouble in today's financial markets than Greece or France. Remember the Royal Bank of Scotland and others?. It is not that the British banking system is so much better than that of France! Remember our politically paralyzed southern neighbors who cut off their Keystone AND their debt ceiling nose rather than giving their political opponents a hairwidth?

The only difference between the 'bonds' of the UK and those of Italy, according to the earlier quoted BBC article seems to be the amount of debt up for refinancing next year. Italy needs a bit over 300 billion Euros while the UK needs 'only' 200 billion. WOW.

We're dealing once again with sentiment and perception. I don't suggest that Italy, Greece and Spain don't need a bit of austerity but these countries are also the focus of a lot of speculation. The speculators made their profits in Greece and now they try it in Italy and possibly France.

Europe will survive the greed of this speculating vulture crowd, which make out only a small portion of the world's investors. But their overleveraged speculations (MF Global comes to mind) create so much fear and uncertainty that they scare the rest of the investors into paralysis. Thus amplifying speculator moves even further. European governments are now trying to regulate some of the big debt rating agencies that have contributed so much to the European debt crisis panics. What though about those speculators that with leveraged money, i.e. borrowed money or other people's money, contributed so much to the damage?

Anyone amongst you who dared buying European government bonds lately? But cowering in 'secure' U.S. Treasuries is the rage these days! Thank G that we are now getting out of what, despite all media hysteria, turns out to be nothing more than a nasty correction in a slowly climbing bull market. The Dow and S&P seem to be back on track and even the underperforming TSX is showing signs of live.

Keep your heads cool and have an open eye for some well priced, quality investment opportunities. For the rest enjoy the ride; well enjoy...  In a recent interview, investor extraordinaire Jim Rogers was quoted as saying that in this market it could prove quite profitable to do nothing.

Sunday, November 6, 2011

How would you feel if you lost $1 billion?

Investors have to take many decisions: What to buy? At what price? When to buy? When to sell and at what price? How much risk is involved? What is your risk tolerance? When buying individual stocks in the stock market you can lose it all! Or you can lose a big chunk of your investment; losing 40 to 80% is not uncommon. If you own only one stock, losing it all means losing all your investment funds and you’re dead in the water until you have acquired (saved) new investment funds.

When you buy a stock index ETF, you buy an instant diversified investment portfolio. If you buy it during a bull market you may loose up 49% in the next down turn - significant but a lot less that 100%! Add to that a subsequent recovery that may result in up to 142% appreciation; i.e. making it back plus somewhat more! Obviously, it is a lot less risky to invest in a stock index ETF than in an individual stock. But then such a stock has the potential to increase 10-fold while a doubling of your ETF over a decade would be considered quite a feat.

Risk and reward! How much is your risk tolerance. You may estimate it in rational terms on a spreadsheet but when push comes to shove, you learn only about your real tolerance living through an actual market down turn. Because your risk tolerance is much more an emotional matter than that it is a matter of numerical analysis.

So ask yourself how would you feel if you lost a billion? Probably not so great; but then if you could lose a billion you’d probably be someone like Bill Gates or Warren Buffett. If you own 50 billion in stock market investments, a billion is a 2% market move. Gosh, those guys must have done that lately on a daily basis! Just imagine!

So let’s go back to our scale of investing. How would you feel about losing $40,000? Ouch! Warren Buffett drove an old car and still lives in his family home located in Omaha, Nebraska. He used to see every dollar spend in terms of future value. If your investment ROI is 10% per year then that dollar would be worth $2 in about seven years; in 14 years it would be $4 and after 28 years it would be $16 dollars. When you’re saving 1 dollar at age 20, that dollar would be worth $64 when you reach age 61. So how do you feel about spending $64 on some chewing gum or $10,000 x 64 = $640,000 on your first used car?

How do you feel about losing $40,000 at age 20 that could be worth $2.4 million when your reach freedom 61? Risk tolerance lies all in the eyes of the beholder! It is a very personal matter. It also depends on the size of your portfolio, a $40,000 loss on a $40,000 portfolio is a lot more serious than that loss on a $400,000 portfolio. Investor age is important as well.

Say you had saved $20,000 at age 20 and invested it at 10% per year in a stock market ETF with a 40 year time horizon. How much risk would you take on your next $20,000? Would you risk it all on that single start-up stock with a chance of a ten bagger? Would you go for a simple double?

If your portfolio was $20,000 at age 60; would you risk the total loss of the next $20,000 for a ten bagger chance? Less likely than if you were 20, but it still depends on who you are! Self-knowledge is essential for each investor and you are most likely to find out how risk tolerant you really are when things go wrong. So ask yourself and test yourself, how you would feel about losing $1 billion dollars. Are you a Donald Trump or a Warren Buffett?

Your life is about your choices

When the market corrected savagely last September, I made a major strategic shift in my portfolio. As mentioned on this blog, I advised older investor to reduce risk levels in their portfolio. I also mentioned before, that most stock market risk lies in short term volatility and that over the long term the true fundamentals of your investments will determine its real return on investment.

The choice in September for me was, do I want to risk going through another 2008 and wait yet another three or four years just to recover to the levels of wealth earlier this year OR...

Do I sell off my riskier holdings and sit with a big pile of cash on the sidelines, waiting for matters to clarify? If I sell I may even have the chance to buy back in at much lower prices and realize a tidy profit! Of course, if the potential crash does not materialize, but instead there is a market upturn, I would have sold at the bottom of a savage correction and lose out on part of the recovery rally to follow.

That is the trade-off. Of course, this sounds awfully similar to market timing or even worse, panic selling. The pure ‘buy-and-hold’ investor may have grimaced at my move, but for me it was a re-allocation of my assets at an unfortunate time.

I finally realized that I was having a too high risk level in my portfolio that ‘prevented me for sleeping at night’. As a semi-retiree, I need cash flow to live from and my portfolio was throwing off only modest amounts cash flow and I was counting too much on possible future appreciation. There was not enough income to build up a cash position for buying new investment opportunities and too lead the lifestyle I like.

This summer, we had a family vacation in a nice resort Whistler; last week I spend moseying around in Canmore and next week I’ll be visiting my father, brothers and sisters in Holland. I helped my kids to buy their first cars this month and my wife and I are considering a vacation trip to Europe next spring, not to mention a cruise to the Caribbean around Christmas 2012 with family and friends. Oh, and my car lease is about to expire and I may need (better said – I want) a new one.

These things cost money – cash! Not to mention the cash my portfolio requires. So it is important at this stage of my life to forego rapid appreciation and focus on capital preservation and cash flow. Even more than ever before! 

It is my lifestyle combined with my peace of mind that in September made me decide to not wait out a potential market crash, but rather readjust my portfolio to reflect my needs rather than fulfilling the desire of a potentially higher ROI. Had I realized this 6 months earlier, I would have locked in less losses from the peak (or better larger profits on investments bought many years ago) than when I finally acted in September.

Why the slow response, if I already knew in May that my portfolio did no longer fit my lifestyle?

The answer: I chose to procrastinate; I was greedy and I didn’t want to give up on even more potential profits. I was a pig who got slaughtered! Well, I was a piglet and I did lose a limb instead of my investor life. But nevertheless, I paid the price for my choice.

There always will be risk in any investment. It is just a matter of choosing how much risk is right for you. A good way to figure that out is first of all, a rational assessment of how much cash flow and what total return on investment you wish to pursue and with what time horizon. But the real fire test regarding your current risk tolerance shows up during the next down turn like it did for me this September when I started to get that nasty feeling in my stomach and had trouble 'sleeping'. My and your investment results are not to be blamed on macroeconomics or on how corrupt management is, the results stem directly from our investment choices.

Whatever we harvest in our lives is a result of the choices we make. Consciously or unconsciously! Do you save or spend? Do you party or study? Do you buy that new car or a GIC? Do you swim or smoke? Choices big and small, made early or late in your life combine in your ultimate lifestyle.

Governments choose to promote home ownership amongst low income citizens by encouraging banks to lend out subprime loans. The greed of the bankers led them to choose to issue subprime mortgages and package these mortgages into structured investment vehicles and collateral debt swaps. Insurers like AIG choose to be counter party for the swaps. And then there were the low income earners who decided to take on the subprime mortgages and home owners who decided to take on more debt to finance their vacations and other lifestyle choices. It all led to a major event of reckoning, the culminated result of our poor choices – the 2008 financial crises!

Life is about choices and we benefit from or pay for our choices both in our personal lives but also in society. The choice by many Europeans to elect governments that advocated extensive social networks creating a culture of self-entitlement combined with the vicious fall out of the financial crisis and the imbalanced trade accounts of the BRIC countries with the rest of the world led to the misery of the European debt crisis. So next time when you make a choice, think about how it may affect your life not only short term but also long term.