Saturday, June 2, 2018

Investing like a Pro - Being hawkish on making money on your cash

You know that ad on tv about how much your broker pays on the cash in your account?.  Often zip or nada… absolutely nothing!  We all worry about management fees and MER. These things are affecting your return. But anyone who examines his or her return on assets realizes that it is nearly impossible for the entire portfolio to out perform most market indexes (except for the TSX 😊). Reality is that if you have 10% or 30% cash in your portfolio then that cash does not earn a return.  So say you invested 70% of your money in the S&P500 which returns 6% plus inflation or around 8% per annum right now. Then your entire portfolio returns 0.7x8% plus 0.3 (cash) x 0% = 5.6%   Boooboooboo! I made ‘only 5.6%’ and under performed the S&P500.

What if the market crashed like during a bear market and you had no cash and you were forced to sell your S&P500 ETF at rock bottom?  Then you would have a  real loss!  A typical bear market fall is 25-30% thus to get cash you sell say 20% of your portfolio which was 100% invested in said S&P ETF.  Then at the bottom of the market you made -25% and if you sold off 20% then you locked in 20% at -25% or 5% of your total portfolio value in losses. Even if the market returned to break-even then your total portfolio is still down by 5%. Unrecoverable!  If you were at 20% cash and after the crash the market returned to break even but without the forced sale then your return would have been 0%! That is a full 5% outperformance versus the forced seller!  Even better, if you employed the 20% cash at rock bottom prices and thus you made 20% times 25% (that is when you go back from 80% to break-even) in increased portfolio value.  So 80% broken even plus 20% cash invested at 25% or a total portfolio return of 5% versus -5%. Then you outperformed the forced seller by 10%. All because of asset allocation assuming you  invested in the same index (fund).

Now, you know what banks do?  Canadian banks have 10% of their assets as shareholders equity and then… they use their clients cash(deposited into bank accounts) to invest as much as 10 times their own equity. If they make say a 1.5% return on mortgages then the bank's profits are 10x1.5% = 15% on their equity!  If you earned that much on your 20% cash position that would have been an extra 3%of portfolio value as a return.  Don't you think they couldn't afford paying you at least some of those profits?

These days, you can earn around 1.5% to 2% on a one year GIC and over the coming years those returns will likely improve. If you earned on 20% of your cash 2% that would increase your total portfolio return by 0.4%. That may not sound like a lot but if your total performance performance increased from 5.6 to 6.0% than that is an 10% improvement of your return. 
That is why, even with relative low interest rates, you must insist on making income on your cash. Especially in TSFA and RRSP accounts when the interest income is entirely tax free (TSFA) or tax deferred (RRSP).  So don’t be afraid of locking in some of your cash in short term interest earning investments such as a GIC or an interest earning savings account. Don’t get taken advantage of by the shrewd banks. 
There are three exceptions to consider:
1 - Portfolio hedging by buying gold bullion (some)
2 -  Buy shares in the banks that suck the life out your cash. Make them pay you a fat, tax advantaged divided (3 to 5%).
3 - Invest in inflation adjusted preferred shares of these same banks. That is, when talking Canadian banks, nearly as good as cash!
Now that interest rates are on the rise, be even more hawkish on that interest income on your cash!

There is another way of earning a return on your cash!  Selling put options on stock you would want to own anyway given the right price.  A put option is the obligation to purchase a stock at a fixed price (strike price).  You sell this obligation in the form of a put option on a stock that you wanted to own at that fixed price (strike price) anyway, - then the proceeds from the option sale (called premium) is basically cash for nothing. NOTE: These numbers are not real and were used to illustrate the calculations not reality.  Not many put options of  a $10 stock have a $1 premium.

You have the same risk as when you bought that stock at your desired price. But now you sell the put for say $1 each and that obligation is good for,say the next two months  If this was a $1 put premium for a $10 share you'd make 10% on the cash ($10 per share) you need to hold to cover your obligation for two months or 1/6 of a year. If you did such a transaction 6 times per year, your annualized return would be 6 x 10% or 60% or $6 on each $10 cash held to cover your obligation! 
If the price stock moved up during the 2 months term of the option, you made $1 profit with no cash spend on the purchase of the underlying share. That is an infinite return! If the price of the share dropped below the strike price and you had bought the shares instead of selling the put option then you'd be  down for every share you bought.

Alternatively, if you sold the put for 1 dollar, then you made no loss or you made even a small profit for each share you bought as obliged to do at the lower price. Only if the share price fell more than the $1 collected in premium at the end of the  term of the option then you, the put seller, made a loss. But that loss is less  than if you’d bought the shares outright at the strike price. Selling the put reduced the risk of owning the shares.  When you sell put options ensure that you hold the cash needed to pay in case of a forced purchase of the shares you contracted for.
Options are a powerful tool to improve cash flow on shares you hold (selling covered call options) or to ensure your portfolio against a sudden market fall (buying puts) or reducing the risk of purchasing a stock you wanted to own at a certain price anyway (selling puts). Options provide you with numerous techniques to protect your portfolio in addition to diversification. Now that is what the professionals do.

[Here are the numbers:
sell 1 put option per share with the obligation to buy that share for $10 over the next two months if the share price drops below $10 (strike price).
Premium received: $1   and you need to hold cash to cover the eventual obligation: $10  per share purchase price.

If after 2 months the share price is unchanged or above $10 then you received $1 in cash or $1 over the $10 cash you were required to hold. That is a return of 10% on cash held. Since the transaction lasted only 2 months you might repeat this up to 6 times in a year which would be a 60% return on the $10 cash you are required to hold for the eventuality that you must purchase the share.
Or since you didn't purchase anything, you could say that you made $1 on zero cash invested (not entirely true) with an infinite return. 

IF after 2 months, the share price dropped to, say $9.50 then you would be obliged after two months to buy such a $9.50 share for $10.00 (the strike price).  If you had bought the share for $10 without selling the put option, you would have lost $0,50 when the share price fell to $9.50. But since you also received the $1.00 option premium, the total transaction is valued at $9.50 plus $1.00 and you'd still made a $0,50 profit on the entire deal.

If the share price fell to $9.00 then the put seller would still be breaking even and the buyer of the share at $10 outright would be down by $1.00 - a real loss!

Thus, you can use your cash position to cover the potential forced purchase  of shares that you don't mind owning. That would indeed help improve the total return of your portfolio.

NOTE: option contracts are traded in lots of 100. Thus each contract comprises 100 options and is for 100 corresponding shares]

[Illustration by spreadsheet]
Click to magnify

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