Sunday, May 22, 2016

Assets and cash flow diversification are essentials for a roadmap to richness

An asset is something that you can own that either makes you money or retains or appreciates in value. A liability is something that results in you owing something to someone else. You could see your lifestyle as a liability while the labor/expertise that you may provide is an asset. If the money that you can produce exceeds the cost of your lifestyle, then you become richer every day and if the situation reverses you are becoming a liability to your estate and you will get poorer by the day. It is all about your balance sheet, your income statement and don’t forget the cash flow statement. After all, as we discussed, your body may depreciate and you are not an infinite resource. Although with immortality on the horizon… who knows. J
Not all assets are created equal and not all assets perform the same and do so at the same time. Stocks of public companies are typically assets but their value may fluctuate greatly. Fluctuations are fine because they allow you to buy when cheap and sell when expensive.  The fluctuations are often called ‘volatility’ and you can measure volatility for example by using the VIX (Volatility index). At high volatility, option premiums tend to be high and so you may add to your income by selling said options. Although many fear volatility, it becomes to me increasingly clear that volatility is an investor’s friend and whether you like it or not, volatility is a fact of life. Right now, Calgary experiences volatility in another asset class:  real estate (both in value and rental income). Gold is yet another asset class and it appears to appreciate right now because of increased demand. But not everything called ‘Gold’ is gold. Many gold ETFs are just derivatives rather than holders of physical gold. It is becoming tricky when an ounce of Gold held at COMEX has 500 owners. In other words, when 500 owners want to exchange their ETF shares for ‘their’ ounce of gold only 1 in 500 will actually get it. That is why owning physical gold in a bank deposit box or even under the mattress may be a lot more desirable than a share in a Gold ETF.
Bonds generally return money, but right now after inflation your bond yield is often negative. Investors may think it is safer than volatile stocks but that is mostly their perception. Stocks right now in the U.S. are becoming less attractive – earnings seem to have peaked and a strong U.S. dollar suppresses the value of the 40-60% of net income earned by S&P companies overseas. So if earnings don’t grow, U.S. stock prices go only up because people value those earnings higher and higher. So, when expressed as a percentage of stock price, earnings yield is falling just like bond yield. Yes dividends are still raised but are they paid at larger and larger proportions out of earnings (rising payout ratio)? 
Canada experienced over the last five years flat to declining stock market performance. In fact, 2015 can be counted as an actual bear market, but now we are turning the corner and our commodity dominated stock market is one of the world’s best performing stock markets. Around 2008 all economies seemed to crash at the same time and regional diversification seemed no longer valid; instead diversification in stock performance was more by sector than by country. Now we see a more diverse performance again by country as illustrated by the divergent performance of Canadian versus U.S. markets. Will it last? Who knows – hindsight is definitely 20/20.
Overall, because of inflation and because of higher GDP (or should I say our ever improving lifestyles) our investment returns will increase over time. A lot is relative – if everyone loses money and becomes poorer, then the one who loses least is ‘richer’.  When the stock market dives and Bill Gates ‘loses’ 10% or $5 billion in the market is he poorer than any other investor in that same market?  Wealth and net worth are relative.  When Bill loses 10% and you lose 5% you got richer in relative terms than Bill. Overtime we will experience bear markets and bull markets in all kinds of asset classes. We can’t be experts in every asset class or in every publicly traded company and we cannot participate in every bull market. But general investment principals remain the same – especially ‘buy low and sell high’ or ‘cash flow is king’!
So, if dividends in financial stocks are cut, wouldn’t you be happy to have rental income? Or capital gains from gold mining stocks?  That is why diversification in different types of assets (or better asset classes) and cash flow sources is so important. You know about the continuous bickering between eastern and western Canada. Well it is not only because of population density but also about a financial and manufacturing dominated economy versus a commodity dominant economy. It is easy to say that the West should move away from a resource based economy and diversify, because we have here a lot less people (labor) and we are far away from the large consumer markets. In the East we have big consumer markets and manufacturing is nearby, how could the west compete with that?  So different styles of economies require different approaches that are dependent on the lands and the people living in it. Alberta’s governments have tried to steer the economy away from resources but after losing serious money they learned that you need more than just money to steer an economy.  Alberta, though, has moved over the decades away from resource dependence. Now 24% of our economy is from energy versus 30% in the 1980s. But to do that took lots of time and population growth as well as technological change – not government subsidies and pet projects.

Luckily, it is a lot easier for individual investors to diversify using some very simple rules. Understanding that ‘real’ physical assets are different and often a lot less volatile and less dependent on government than paper investments. I would think that it is a lot easier to take residence in a real estate property than in a REIT stock certificate. Diversification between ‘real’ assets – the ones you can touch and use – and paper assets is very important. I prefer to hold a bird in the hand over a bird in a bank which one day may go under. Diversity reduces the overall volatility of your portfolio while it allows you to benefit from the volatility within specific asset classes. It is the best of both, or better, of all worlds. In a following post I’ll compare the performance of a portfolio with changing asset allocation and I will show how asset allocation combined with position sizing matters.

2 comments:

  1. Hi, great article. If someone were to buy a house in either Toronto or Vancouver do you still think that is better than stocks. Seems like those markets are higher valued than the stock market.

    Thanks

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    Replies
    1. Thanks for your comment. I don't follow Vancouver and Toronto real estate closely. I understand that condo - apartments are not overvalued but that single family dwellings are severely overpriced and we read everyday warnings about them in the news. Some commentators feel that the overvaluation of the single family dwellings are due to a lack of supply, i.e. not many new places are being built.
      Anyway, I personally, would be reluctant to buy in those cities until it is clear as to what is going on. The risk that Vancouver or Toronto valuations suddenly fall is for me too high. It would be like buying stocks near the peak of a bull market. If you can barely afford to buy at current prices and take on a large mortgage - say 90% of the purchase price and Toronto's house prices fall by 'only' 5% then you lost 50% of your down payment. In my opinion your upside is limited and your downside is huge. I can only tell you how I see this situation; in the end it is your money; your risk tolerance and your decision. I hope this helps.

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