Monday, September 23, 2013

Money Honey's Investment Building

Now, taking a spin on one of my favourite personal financial bloggers, the DIY Income Investor, I have come up with my version of his Income Pyramid.

I'm calling it, Money Honey's Investment Building.It's an investment building because it's shaped like a building, and we are building our investments. Get the pun? Hur hur. Anyway...

Now, while the Income Pyramid is flat based, the Investment Building is a building. Your investment building may come in many shapes and sizes. I won't say if its right or wrong, everyone can choose their own favourite type of building to suit the amount of resources that they have and the type of risk and style they prefer. My preferred model also happens to be my favourite modern structure in the world, the Empire State Building in New York City.

The Empire State Building (ESB), like my ideal Investment Building has a strong, solid and relatively wide base compared to the rest of the building. The middle section is quite uniform, and when it reaches the top, it tapers off and becomes more skinny.

Now, think of the entire mass of the building as your wealth. The higher it is, the more dangerous and the more risky things get. It's pretty much like the Income Pyramid, except with a lot less emphasis on a very broad base. I think the pyramid is perfect for surviving 4000 years and counting. But a solid building like the ESB works just as well, given that we don't live more than 80 years. Plus, to top it off, you get a fantastic monument at the end of the show! So, let's head on to the levels of the Investment Building.

Level 1: Solid Foundation
The most rock solid foundation to investing is to have no net debt. This doesn't mean that you don't borrow. This means that day to day, month to month, year on year, you don't have debt increasing. It's really quite hard to live on no debt. If you have enough money to pay for a house or car in full, then this is obviously not the website for you. You don't need to invest because you already have, or you just have so much money that you don't need to.

But for us normal folks, this means having the ability to reduce debt as we go into the future. That should be your number 1 priority, cutting off your debt. To put it in an example, if your monthly housing loan costs you $800, make sure that you diligently pay off that $800. If not, that shortfall will have interest incurring on it, making your debt cost even more than it originally was supposed to be. If your debt is reducing as planned, it is easy for you to forecast and understand the capital repayments as well as the interest repayments that you still have left. It creates financial certainty.

Secondly, now interest rates for most long term loans are at historical lows. By paying off any loans in full, you are actively making the choice to sacrifice potential gains, because you would have otherwise invested that money, and earn more than your interest repayments. This is not true all the time, but at the current market conditions, they are! Look at this post by the Monevator, he sums it up quite well.

Basically in short, live within your means. Live expecting to be safely provided for by yourself until you're 70. Take note when I said "by yourself". Only hippies and lazy, dumb people expect the government or social welfare to look after and provide for them. Don't expect others to provide for you. Your own well-being, is simply your own damn problem. Isn't that the way it should be?

If you can achieve this, then let's move on to the next level.

Level 2: Easy Access Savings
I think the title explains it all. This level requires you to set aside some cash in an easily accessible place. Basically, this is emergency money. This is the money that you can withdraw at the drop of a hat to quickly fund an emergency or make extraordinary payments. Definitely NOT for anything that you can account for or see in the short term future. The funds in this level is strictly for emergencies, therefore it must be liquid, accessible and above all, sufficient.

I would strongly advise to keep this level funded with between 3-6 months of normal monthly expenditure. If you're ever in a squeeze, cutting back on your lifestyle will probably help extend this fund by a few months, depending how much you tighten your belt. For the extra cautious, or the people with very low levels of job security / income inflows, you might want to consider even up to a year in this. This is highly subjective and depends on each person on a case to case basis.

Although these funds should be quickly accessible, that doesn't mean that you have to spare interests to get it. There are many savings accounts which offer good rates as long as money remains above a certain level, or if you wire in a certain amount every month. Of course, a simple bank account will really do the trick here.

Risk: Bank insolvency risk. Many governments insure a base amount of deposits of banks that are registered in their country. In Singapore, the Deposit Insurance Scheme (DIS) set up by the Monetary Association of Singapore guarantees up to $50,000 per account in these following banks.

Level 3: Cash Savings Account
So, what is different between level 2 and level 3? Level 3 adds an extra layer of buffering before you have to dip into your investments.

This should be where all excess money goes in, which is after paying off level 1 debt and fully funding level 2. This is where you money should sit in if you have to hold any cash at all. Therefore, you should be looking for reasonable yield, yet flexibility to deploy your money into the higher levels when an opportunity arises.

Being the buffer in between your cash and investments, this level treads a very blur line between level 2 and level 4. However, it is very important to have a clear boundary of what cash you can touch, and what cash you cannot touch, and this is what is the most important distinction between level 2 and level 3.

Risk: Bank insolvency risk, same as level 1. Also, depending on the terms and structure of your cash savings account, you may not receive the agreed upon interest rates if you fail to deposit a certain amount monthly, or if your balance drops below a certain point. Also, if you need to withdraw money within a certain period, you may be penalized for doing so. This is not really a risk, but rather things to note that can affect your yield in this account.

As we go to higher levels, things get riskier. If you can't handle the heat, stay out of the kitchen. In investments, it would be: If you can't risk losing any money, don't make any risky investments.

Level 4: Investment Grade Bonds
It cannot be contested that bonds have much lower volatility compared to equities. Therefore, with the lower risk, you are presented with lower rewards.

Bonds are basically a loan, but from you, to a government or corporation. But I think you can think of it as a fixed deposit account, but tradeable. The other difference is that the owner of the account will get bi-annual "interest payouts", which are the bonds coupons. Basically, at the end of the term of the bond, the "borrower" will repay you back your capital, plus the last bi-annual interest payout. Simple enough, isn't it?

The main question here is, do you invest in individual bonds, or do you engage in a bond fund? Should you choose a fund that is actively managed or follows a benchmark? Should the fund be a mutual fund, or an exchange traded fund? All these questions have good merits, with their cons as well.

However, considering that we are building up our Investment Building with stability of the structure in mind, bonds here are the level that we are going for.

Risk. Interest rate risk. All bonds are subject to interest rate risk. To keep things simple, if interest rates go up from the time you bought your bonds, their value goes down. If interest rates drop, their value goes up. Default risk. Investment grade bonds have a very low chance of default, but it is certainly possible. In such a case, your capital is not guaranteed and you may suffer a substantial loss.

Level 5: Junk (High Yield) Bonds
I would like to use the prefix of Junk compared to High Yield because all too many investors get caught up chasing yield that they forget about the risks involved in investing in these sort of bonds.

Junk bonds have a higher credit spread, which means more yield compared to investment grade bonds. As always, there are risks that come with this added reward. The main risk here is the much higher chances of a default. Junk bonds have very equity-like characteristics, which makes them more volatile than investment grade bonds. The risk/rewards curve never lies. So do keep in mind that if equities tank, there is a large correlation to junk bonds as well, as these bonds are actually tied to these equities. Default rates will also increase in such periods, making them much riskier than investment grade bonds.

However, that being said, bonds are not as volatile as stocks when considering their equity-like propertoes. It must be remembered that bonds are a form of debt, regardless of their packaging. Drawdowns peaked in 2008 at 35% if you were in a bond fund.

If you are holding individual junk bonds and the company issuing these junk bonds goes insolvent, its assets will be seized and liquidated, while bond holders are next in line to collect back their money before equity holders. The recovery rate is about 40%, whereas of course equity holders would not get anything in this case. Not much reprieve I must admit, but it is better than nothing.

Risk. Interest rate risk. All bonds are subject to interest rate risk. To keep things simple, if interest rates go up from the time you bought your bonds, their value goes down. If interest rates drop, their value goes up. Default risk. Investment grade bonds have a very low chance of default, but it is certainly possible. In such a case, your capital is not guaranteed and you may suffer a substantial loss.

Level 6: Real Estate Investments
Many people will say that real estate investments are just a fad, however I beg to contest. I will mostly be talking about Real Estate Investment Trusts (REITs), as opposed to an actual physical real estate. Mainly, physical real estate should be part of your physical assets and not part of your financial stocks. However, REITs can play a part in your investment portfolio.

REITs are basically trust funds which own properties and manages them. Being property owners, they collect rent and facilitate the maintenance of these facilities. They can run across various areas of the property market. One of the key main things about REITs though, is that they are firstly asset-backed, and secondly have a payout ratio to meet. REITs own physical property, that means by owning shares of a REIT, you are in fact a partial owner of whatever properties they own. Secondly, REITs are obliged to payout part of their profits to shareholders to receive a tax benefit, which many of them do.

The property market does suffer ups and downs, just like any other market. However, it has been shown by a study in the UK that the property market does appreciate at almost the same rate as other financial assets. Personally, I believe that only 2 variables are always constantly on the rise, labour costs and property costs.

Next, these REITs all have a Net Asset Value (NAV), which is the sum of the value of all the property that it owns if it goes bankrupt. Being back by physical assets means that the value of the company isn't in goodwill, it's branding or efficiency, which are intangible. Currently in Singapore, there are many REITs that are selling below its NAV. That means as an owner, if you sell off all the property and redistribute it, you will immediately profit, without even accounting for the potential gain of income rental!

However, REITs are equities as well, and as such, they do also suffer from drawdowns, which can turn quite massive. The GFC saw REITs plummet 68%. While this can scare most people, I think the most comforting thought is that you still are a shared owner of actual property. As a shareholder of a REIT, your assets are mostly the property, which will still retain value, as opposed to a normal equity shareholder, who may not be left with much of anything at the end.

Risk: REITs have interest rates risk since their recurring dividends give them a very bond like property, so the same risks applies. REITs are also subject to the fluctuations of the equities market, which is why they can have such large drawdowns. However, REITs still can maintain a portion of their value if things go south, which is more that can be said compared to other equities.

Level 7: Globally Diversified Dividend Equity
Dividend stocks are my personal sweet spot favourite. Just like junk bonds have equity-like properties, dividend stocks have bond-like properties. Equities have a much higher up-side compared to bonds, which also equates to a much higher down-side as well. During the GFC, assets in this class tanked down 67% from it's peak. Though most people don't usually buy equities at it's peak, it is certainly a possibility and investors potentially stand to lose that much.

Compared to equities, dividend paying companies tend to be large, well-run, with reputable and favourable status in this geographical influence. They are more shareholder focused, therefore more prudent with the management and governance. These companies usually lag behind equities in the broad economy. This means that they lose less in a downturn, but also gain less in an upturn.

The main case for these equities is that they pay dividends. Dividends allow for young investors to diversify and fortify other positions and allow better allocation of funds. For older investors, it provides a stable source of income when no further investments are needed. In a sideways market, dividend stocks generate the most returns to an investor, while offering lower volatility, and still being able to participate in the upswing, albeit slightly handicapped.

The risks of dividend equities are in the first paragraph of this level. Although they behave like fixed income investments due to their dividends, they are ultimately still equities and should be treated as such. They are also subject to interest rate risks, but to a much less extent that of bonds or REITs. They are still subject to large swings in prices and whatever else that may affect the equity market.

Level 8: Globally Diversified Equity
Stocks are a tough game to play, everyone knows that. Just as much as you can make a fortune, you can just as easily lose a fortune too. The only free lunch that most pros will tell you about is the benefits of diversification. Through diversification you immediately eliminate the unsystematic risks of holding individual stocks or in narrow sectors. This can be done by buying an entire index, through ETFs or mutual funds.

To add another layer of this cake, it would be to look towards diversifying across geographical boundaries. Not every country is going through the economic cycles at the same point of time. While some countries and regions are going through a boom, others may be going through a bust. This therefore reduces the systematic risk of specific markets, because now you are diversified across many markets.

However, a good point to note is that economies are getting more interlinked and dependent on each other. During the great financial crisis on 2008, the whole world felt the effects, though some economies were much less affected by others. Economic crisis of a global scale can still affect a globally diversified equity portfolio.

Risks: Global issues that affects many countries and economies in a similar fashion. What impacts one country negatively will likely do so to many other countries and this creates a worldwide issue where all markets are affected.

Level 9: Country / Region Diversified Equity
When you think that a certain country or region is going to experience a large boom which would be narrow defined to them, you may want to invest there. The benefit is straightforward, that particular country has some sort of advantage that will allow it to grow faster and be more prosperous compared to other countries.

So again, with risks comes rewards. The largest risk here lies within the unsystematic risk and the lack of geographical diversification. From 1929 to 1932, the US stock market tanked 90%. On top of being affected by the global economy, specific issues regarding internal affairs will also affect the progress of the economy. Think of political or social unrest, which ultimately leads to economic uncertainty. Riots, wars, natural disasters, that sort of thing.

Risks: Unsystematic risk. This risk is dependent on the market. Therefore if the entire market is being influenced by the same factors, the market would be affected similarly as most of the stocks in it. A recession or a major boom are things that can negatively and positively affect the entire market.

Level 10: Individual Securities
Investing in individual securities requires one of the highest level of knowledge and experience. There is exposure to multiple risks, like systematic risks, unsystematic risks and global risks.

There are no benefits of diversification, but that means that is no averaging factor to returns as well. For taking a large amount of risks, you are in a position to earn large returns as well.

Risks: Muppet risk, being used by the pros. There are brokers out there that trade individual stocks for a living for years and years, with insider information and teams of analysts and more resources than your annual paycheck. This is really seriously risky business, so tread carefully.

Level 11: Leveraging
The only form of leveraging that I can condone is property loans. Then again, if you bought property at a high, and the value falls, you stuck in as big of a rut if it was any other investment.

Basically, leveraging is increasing your bets with borrowed money. If you leverage factor is X2, that means you earn 20% for every 10% you would have earned. But, this of course runs the other direction as well, your losses also are magnified.

Leveraging offers many sort of products and vehicles. There are leveraged ETFs, mutual funds and CFDs for individual stocks, indices and forex.

The main issue here is about your downside risk. With leverage, your downside risk increases, by a lot. Leveraging is the only level in the entire investment building where you can lose more than what you put in. For every other level, if the investment goes sour, the amount of recovery decreases every level, as the amount of risks increases as well. That means no matter what happens, you can never OWE anyone money. You just simply lost all of yours. Leveraging does not protect you from this. You may be liable to fork out money to repay people, since you were making investments with borrowed money!

Risk: Very risky, definitely not for people who want to preserve capital. This really should only be on very well researched bets with people with very large risk appetite. Of course, this also should be the smallest percentage of your portfolio, depending on the amount of leveraged used. I personally would not recommend anyone to dabble in this, except for those who are completely fine losing their capital invested in these vehicles. Basically, if you choose to invest in these, be prepared to lose your capital. It's the same rule for gambling. Only gamble what you can afford to lose.

With that, I hope that I've outlined a rather simple framework that clearly states the pros and cons for most asset classes, as well as give you a nice gradual path to step your foot in and explore the world of investing without taking too much risks too quickly.

Remember, the higher you go, the more risks involved, the most you stand to lose and the more knowledge is required to remain successful. I would strongly advise people without any financial background and can't bear a large drawdown to stay away from anything above Level 5. I can assure you, by mastering and being knowledgeable in that, you are already making your money work much harder for you than it is compared to people who are not even aware about the many different pros and cons of assets in the world of investing.

[1] Junk Bonds and Dividend Stocks Drawdown
[2] REITs drawdown
[3] Equities Drawdown

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