Properties and the Population Picture

I've written a couple of times about the potential impact of demographics changes to the property market in future. However, I'm not sure how many people actually noticed and think of it in the current rage over properties. Since words did not effectively convey the message but a picture can say a thousand words, let's try showing pictures instead.

Below is a picture taken from the Opening Address at the “Our Population, Our Future” Townhall Dialogue in Oct 2012. It shows that with a Total Fertility Rate (TFR) of 1.2, the size of every subsequent generation will be reduced by 40%.

Do take note that the picture below does not reflect the current demographics figures. It is reflective only if the TFR persists at 1.2 for at least 2 generations. So, the discussion in this blog post on the potential impact on the property market applies in the future when we are about to retire and not currently.

Figure 1: Impact of TFR of 1.2 on Generation Size

How will the above picture impact the property market in the future? Each generation does not operate independently in the property market. When Our Generation retires, we will need to find alternative sources of income to support our retirement. Since quite many people are asset-rich but cash-poor (and assuming this trend continues), one possible option is to sell our properties to those who are buying, i.e. the Grandchildren Generation who are setting up their families. Even if some of Our Generation do not need to sell or downgrade their homes, eventually their properties will be passed down to the subsequent generations as inheritance.

Hence, based on the above picture, we are looking at 36 nos. of the Grandchildren Generation buying/ taking over the properties of 100 nos. of Our Generation. I cannot see how 36 persons can absorb the properties of 100 persons. We can only hope that our grandchildren will be 3 times as rich as us.

To be fair, the demographics picture above cannot be directly applied to the inter-generational transfer of assets. People are marrying later nowadays, at a median age of 29. So the inter-generational age gap is about 30 years, i.e. when Our Generation reaches the retirement age of 65, the Grandchildren Generation is only about 5 years old, hardly able to support themselves, much less to take over the assets from us. Readjusting the demographics picture to an inter-generational age gap of 20 years, the relative size of each generation would be as follows:

Generation	Age	Size
Our	65	100
"Children"	45	71
"Grandchildren"	25	51

The age of each generation in the above table looks more reflective of the actual age of the net buyers and sellers in the property market, with Our Generation planning to sell at the retirement age of 65 and the "Grandchildren" Generation (in "quotes" to differentiate it from the actual Grandchildren Generation) planning to buy around the marriage age of 29.

Based on the above table, there will 51 nos. of the "Grandchildren" Generation buying/ taking over the properties of 100 nos. of Our Generation. While the figures are better, it still does not change the overall picture that there will be more net sellers than buyers in the property market when we are ready to retire.

Having said that, there are many other factors affecting the property market besides demographics, such as migration, new housing supply and property regulations. A lot of these factors are unpredictable, especially in the long term. But the one fairly predictable factor that is demographics shows that the property market when we retire will be quite challenging. For a more complete discussion of the impact of migration and new housing supply, you can refer to the post on Properties, the Population White Paper and the Land Use Plan.

Interestingly, how did Our Generation end up in such a situation? The figure below shows the relative size of each generation based on an inter-generational age gap of 20 years:

Figure 2: Relative Size of Each Generation

 
The relative size of the "Grandparent", "Parent" and Our Generations are based on the actual population statistics in Jun 2011 for the age groups 75 - 79, 55 - 59 and 35 - 39 respectively (Note: I am in the 35 - 39 age group, but you can recalculate the relative generational size for your own age group using data shown in the post on Properties, the Population White Paper and the Land Use Plan). However, do note that there is higher mortality among the "Grandparent" and "Parent" Generations, so their sizes are smaller than they should be. The relative size of Our, "Children" and "Grandchildren" Generations are based on the TFR projection mentioned above.

As can be seen in Figure 2 above, when Our Generation is buying properties to set up families, the "Grandparent" Generation is much smaller and buyers outnumber sellers. But when Our Generation is going to sell properties when we retire, the "Grandchildren" Generation is also smaller and sellers outnumber buyers. In short, Our Generation is at the short ends of both sides of the transactions.

Nevertheless, there are actions that Our Generation can take to avoid such a situation. We could either have more babies, or avoid being asset-rich and cash-poor when we are about to retire.

See related blog posts:

• Properties 
• Properties, the Population White Paper and the Land Use Plan
• Properties and the Arrival of Robots and Automation

Why Warren Buffet's Rule No. 1 Is Not "Always Make Money"

Everybody knows that Warren Buffet's famous Rule No. 1 is "Never lose money" and Rule No. 2 is "Never forget Rule No. 1". However, why is it that his Rule No. 1 is not "Always make money" but "Never lose money"? By right, if you aim to always make money, won't the outcome be the same as never lose money?

Since Warren Buffet is heavily influenced by the teachings of Benjamin Graham, we have to bring in Benjamin Graham's concept of "margin of safety" (MOS) in this discussion. Imagine that the intrinsic value of a stock is $1, if the stock trades at $0.90, it would have a MOS of 10%.

Let's now consider 2 investors, one who subscribes to "Never Lose Money" (LNM) and another who subscribes to "Always Make Money" (AMM). Other than this investment principle, let's assume that both investors have the same investment characteristics, e.g. same amount of capital, same rules in selling, etc.. Given this investment principle, the AMM investor will always go for an investment so long as it has, say, a 10% MOS. On the other hand, the NLM investor will never go for an investment unless it has say, a 40% MOS. 

In terms of investment opportunities, there will be more investments with 10% MOS compared to those with 40% MOS. The AMM investor will be more busy investing compared to the NLM investor. However, the AMM investor will quickly find that he has a shortage of capital to take advantage of all the investment opportunities (with 10% MOS) while the NLM investor will always have sufficient capital for an investment opportunity (with 40% MOS).

Assuming that the stock realises its potential and rises to its intrinsic value, the AMM investor's profit margin will be 11.1% ($0.90 to $1). On the other hand, the NLM investor's profit margin will be 66.7% ($0.60 to $1). On profit margin alone, one profitable trade of the NLM investor is equivalent to six profitable trades of the AMM investor. If we include trading costs, the difference in profit margins will be even greater. Now, let's not forget that the AMM investor have spread his capital thinly across many investments with 10% MOS while the NLM investor can only concentrate on a few investments with 40% MOS. The capital outlay on the stock by the NLM investor will be several times that of the AMM investor. In total, the NLM investor's absolute profit will be many times that of the AMM investor. Having said that, it should be noted that it will take a much longer time for a stock to rise from $0.60 to $1 than from $0.90 to $1.

Assuming that the stock continues to be undervalued and trades around $0.80, the AMM investor would suffer a loss while the NLM investor would not be invested yet.

Finally, assuming that the stock is a value trap and falls to say, $0.40. The loss margin of the AMM investor will be 55.5% ($0.90 to $0.40) while that of the NLM investor will be 33.3% ($0.60 to $0.40). Factoring the larger capital outlay, the NLM investor would probably lose more money compared to the AMM investor. However, to watch a stock falls from $0.90 to $0.40 will be a much larger psychological blow to the AMM investor. This psychological blow may have a greater impact to the AMM investor's investment philosophy. He might lose patience with the stock and sell it off. More seriously, he might even lose faith with the concept of value investing which has proven to work so many times.

In conclusion, the rule of "Never lose money" will lead to less frequent losses, less frequent but much larger gains, and less emotional distress and more faith with a proven investment philosophy. It's no wonder that Warren Buffet's Rule No. 1 is "Never lose money" and not "Always make money". It's just 3 words, but a lot of intelligence packed into it.

See related blog posts:

• Different Tastes for Different Folks
• Behind Every Successful Bear Market Recovery is A Cash-Like Instrument 
• A Comparison of Risk Management Tools & Strategies

Cash Over Valuation for REITs

Price-to-Book (P/B) ratio is actually a measure of cash over valuation (COV). Since no buyers like to pay high COV for properties, should REITs be treated the same way? This question has baffled me for some time, and my position has shifted a couple of times. Let us try to tackle this question by understanding why shares can trade above book value and whether the same arguments apply to REITs.

Why Shares Can Have COV

Shares typically trade at a P/B ratio greater than 1. The main reason is because the assets bear very little relation to the earnings power of the company. A company can have very little assets but have considerable earnings power due to its brand value, intellectual properties and/or favourable regulations. As these factors are considered intangible, they cannot be included as assets in the balance sheet (unless they are taken over by another company, after which these intangible assets become reflected as "goodwill" in the new company's balance sheet). However, these intangible assets have real earnings power, which allows the share price to be higher than the book value.

Another reason why shares trade above the book value is because the assets are depreciated annually but seldom revalued. For example, a company might own the land on which it is sited. The land might appreciate in value over time, but the value of the land in the balance sheet is reflected at historical cost, which could be just a fraction of the prevailing land value. Investors who understand this would price the shares higher than the book value.

Since the subject of this topic is REITs, the shares that bear the closest relation to REITs are that of property developer/ holding companies and hotels. Interestingly, property shares generally trade below their book value. Examples of property developers are Capitaland (0.9x), City Dev (1.2x), Keppel Land (0.8x), UOL (0.8x) and Wing Tai (0.6x). Examples of property holding companies are Bonvests (0.6x), GLP (1.3x) and Hong Fok (0.4x).

Why REITs Should Not Have COV

Having understood the reasons why share prices can exceed book value, we can now review whether the same arguments hold for REITs. The assets of REITs are mostly properties. While they are allowed to engage in some property development that might lead to increased future earnings, their core business must be in holding and leasing out properties. Therefore, the earnings power (i.e. rental income) are closely tied to the assets. Unlike shares, REITs value their properties on a regular basis. Any increase in rental income will translate to increased valuation and is reflected in the balance sheet on an almost annual basis. Hence, the book value reflects the prevailing value of the assets.

On brand value, while some properties are more desirable than others, this is reflected in the rental income and eventually the book value. Nevertheless, there could be some premium attached to the sponsor company of the REITs. This will be discussed further in the next section.

On management skills, while REITs have engaged in Asset Enhancement Initiatives (AEIs) to enhance the rental income of their properties, the increase in rental income is relatively small compared to the overall portfolio and should not confer a major premium over the book value.

Why REITs Can Have COV

As mentioned in the earlier section, there is some brand value in having a strong sponsor company for the REIT. Firstly, the sponsor company could have the financial strength to support the REIT during a difficult period. This is evident during the Global Financial Crisis when many REITs faced difficulties in refinancing their loans. REITs with strong sponsors generally fared better than REITs that do not. Secondly, the REIT may have a right-of-first-refusal over the sponsor company's properties, which could generate a pipeline of yield-accretive acquisitions for the REIT. Investors who like the pipeline of potential acquisitions and its impact on future earnings will have to pay a premium for this REIT.

Perhaps the biggest reason why REITs can have COV lies in the differences valuation is carried out for physical properties and financial assets. For properties, valuers would consider the prices of similar properties and/or compute the discounted cashflow of the rental income that the property can bring. The asset value thus computed, minus the debt, becomes the book value. Property valuers are limited to similar properties in this valuation. However, for financial assets, investors can compare across all asset classes (shares, bonds, commodities, etc.). The discount rate that valuers and investors use to value the income stream of the property is thus different and can lead to different asset values.

Conclusion

REITs can have COV because of different discount rates adopted by property valuers and financial asset investors. However, the COV for REITs should never be as high as those for shares, as assets for REITs are mostly tangible properties and the valuations are updated regularly. It is always safe not to pay a high COV for REITs.


See related blog posts:

• REITs Are Not Forever Attractive
• Do REITs Overpay for Their Acquisitions? 
• The Hidden Risks of Buy-and-Leasebacks for Industrial REITs

REITs Are Not Forever Attractive

REITs have been an attractive asset class since their introduction in Singapore in July 2002. They provide regular distributions with opportunities for capital gains. However, unlike shares, REITs are not exactly forever. The main reason is because the assets that REITs hold are mostly leasehold properties with expiry dates. When the leaseholds expire, they will lose the properties and will no longer be able to lease them out for rental income. Of course, REITs can always renew the leaseholds and/or buy new properties to rejuvenate their asset portfolios, but that will mean going back to the shareholders for money. Let us consider the case of a single-property REIT.

The assumptions adopted in this example are as follow:

Leasehold period	100 years
Purchase price	$100M
Equity	$50M
Debt	$50M
Rental yield	6.5%
Interest rate	3.0%
Discount rate	5.0%
Distribution rate	90.0%

Based on the above assumptions, the property will generate annual rental income of $6.5M, incur interest costs of $1.5M in the initial year and generate distributable income of $5.0M. As the REIT will distribute 90% of its distributable income, it will return shareholders with $4.5M in distributions. As for the remaining $0.5M, let's assume that it will be used to reduce the debt, thereby reducing future interest costs and increasing distributions to shareholders.

Based on Discounted Cash Flow (DCF) valuation, the annual distribution stream of $4.5M (gradually increasing to $6.5M as the debt is being paid off) for 100 years will be worth around $95M. The DCF valuation hovers above this initial value for the next 65 years. However, as the property nears its 100-year leasehold expiry, the DCF valuation will drop rapidly. See the figure below.

Figure 1: Valuation of Single-Property REIT over Time

To continue to operate beyond the 100-year leasehold of the property, the REIT will have to raise capital to renew the leasehold or buy a new property. It could do this in 2 ways: conserve cash from the distributable income in subsequent years, or raise fresh capital from new or existing shareholders. The first method will lead to a drop in distribution to shareholders for a prolonged period of time (e.g. if it choose to conserve all of the distributable income of $6.5M, it will need at least 7.7 years to raise $50M in equity). This is not very palatable to investors.

The second method of raising fresh capital could maintain and even raise the distributions to shareholders in the short-term. However, it comes at a cost of dilution of shares and reduced distributions in the future. From the figure above, it can be seen that the closer to the end of the leasehold period of the existing properties, the less the existing shares are worth and the more new shares need to be issued to raise the same amount of capital.

Now consider the case of a REIT that regularly adds a 100-year leasehold property to its portfolio every 20 years by raising fresh capital. For the first 20 years, it will have only 1 property. For Year 21 - 40, it will have 2 properties, so on and so forth. By the 80th year, it will have 5 properties. Beyond that, the no. of properties will remain constant at 5, as every new addition will only replenish another whose leasehold has expired.

Let's assume that the deal for every leasehold property remains the same, i.e. $100M purchase price, 50%-50% funding by equity and debt, 6.5% rental yield, 3% interest cost etc. The DCF valuation of the REIT over a 200-year period is shown below.

Figure 2: Valuation of Multiple-Property REIT over Time

Several observations can be made from the above figure:

• The jump in DCF valuation from every additional property reduces over time. When the property portfolio is small, every additional property represents a large % increase in the portfolio size and distributable income. However, as subsequent properties are added, the increase becomes progressively smaller.
• The DCF valuation increases for the first 5 properties and decreases thereafter. For the first 5 properties, there is increase in the portfolio size and distributable income, leading to increasing DCF valuation. Beyond the first 5 properties, there is no net increase in the portfolio size and distributable income. At the same time, the no. of shares is increased from every capital raising exercise. Hence, the DCF valuation decreases thereafter.
• At some point in time (200 years in this example), the DCF valuation will be below that at initiation and will continue to decrease.

Figure 3 below plots the no. of shares to be issued for each property acquisition. Due to the increasing DCF valuation for the first 5 properties, the no. of new shares to be issued decreases. Beyond the first 5 properties, the DCF valuation decreases, leading to increased no. of shares issued. The key point to note is that although the leasehold properties can expire, the shares issued previously will never expire. So, over time, there will be a lot of shares outstanding.

Figure 3: No. of Shares Issued for Every Additional Property

In conclusion, REITs may have been an attractive asset class to-date. However, it is important to note that the assets that REITs have are mostly leaseholds with expiry dates. As REITs rejuvenate their property portfolios to replace leaseholds that expire, it often means dilution and reduced distribution for shareholders. REITs are not forever attractive.


See related blog posts:

• REIT Asset Expiry Profile
• REIT Debt Maturity Profile
• Can You Count on REITs for Retirement?

The "Prudent Family" Rule in Portfolio Management

In portfolio management, there is a rule known as the "Prudent Man" rule. This rule dictates that an investment professional who is entrusted to invest a trust fund on his clients' behalf has to act as what a prudent man would have done if there were no specific investment instructions. This post is not about the "Prudent Man" rule, but is a light-hearted post introducing a new "Prudent" rule, which is the "Prudent Family" rule. Note that although the Prudent Family also has a Prudent Man as a family member, he is not the same man as in the "Prudent Man" rule. For the rest of this post, "Prudent Man" refers to the Prudent Man in the Prudent Family, not the Prudent Man in the "Prudent Man" rule. 

The "Prudent Family" rule provides a light-hearted way of looking at portfolio allocation among various asset classes. By following the "Prudent Family" rule, you will find that you will end up with a balanced portfolio of stocks, bonds, hybrid securities/ alternative investment and cash. The largest proportion will be stocks, followed by bonds, hybrids/ alternatives and cash. Let me now introduce the various members of the Prudent Family.

Firstly, who in the Prudent Family would find it prudent to hold stocks, which offer high growth but are  more volatile? Needlessly to say, it would be the Prudent Man, who will want to have some adrenaline and capital appreciation in the Prudent Family Portfolio. Also, being the head of the household, he will have the largest say in the portfolio. Following stocks in the Prudent Family Portfolio will be bonds, which are almost the direct opposite of stocks with lower growth but higher stability. So, who in the Prudent Family would think it prudent to hold an opposing view from that of the Prudent Man? That would be the Prudent Woman. As the saying goes, behind every successful man is a woman. Being the woman behind the Prudent Man, she will have the second largest say in the family portfolio.

Next on the Prudent Family Portfolio are hybrids/ alternatives. Hybrid securities, as the name suggest, have characteristics similar to both stocks and bonds. Examples would be convertible bonds, which pay regular coupons (i.e. dividends) like normal bonds but can rise and fall in value with a corresponding rise or fall in the mother shares. Even REITs can be considered to fall into this category. Alternative investments, on the other hand, bear little or no relationship to the traditional asset classes of stocks and bonds. Examples would be commodities, which do not pay regular dividends and are most of the time not correlated to the price movement of traditional asset classes. Coming back to our Prudent Family, who would think it prudent to have characteristics of both the Prudent Man and the Prudent Woman or be totally independent of them (i.e. do not take any sides)? That would be the Prudent Child. Being the youngest member in the family, the Prudent Child has a small say in the family portfolio, especially if he prefers full independence from the Prudent Man and Prudent Woman.

Finally, the last on the Prudent Family Portfolio is cash. As we all know, cash earns very little in interest and is easily eroded by inflation. Given such characteristics, who in the right mind in the Prudent Family would think it prudent to hold cash? That must be the Prudent Mistress, isn't it?

So, in the Prudent Family, the Prudent Man would hold stocks for growth, the Prudent Woman would hedge against the Prudent Man with bonds, the Prudent Child would either hold hybrids or alternatives so as not to take sides with either the Prudent Man or the Prudent Woman, and the Prudent Mistress would embrace cash for safety.

It is worth highlighting that for the Prudent Family Portfolio to work well, every member of the Prudent Family has to be prudent. For example, if the Prudent Mistress becomes imprudent and holds too little cash, the entire portfolio will be subject to the depressions of Mr Market which the Prudent Family cannot fight back against. Conversely, if the Prudent Mistress becomes too prudent and holds too much cash (which means that the rest of the Prudent Family become imprudent), the portfolio will be eroded by inflation. You can work out the outcomes on the portfolio if the other members of the Prudent Family become imprudent. In all cases, the outcomes will be negative. Hence, every member of the Prudent Family has to play his/her respective role well to ensure that the Prudent Family Portfolio can achieve its investment objectives.

If you find the Prudent Family is an interesting family, there's still one more person in the Prudent Family for you to meet. That would be its originator, (The) Boring Investor :)

The Hidden Risks of Buy-and-Leasebacks for Industrial REITs

Buy-and-leaseback arrangements are quite common among some of the industrial REITs. They buy a property and lease it back to the original seller for a no. of years. The advantages of this practice are it increases the distribution to shareholders, diversifies the sources of rental income and has the potential for capital gains when the property is eventually sold. However, there are risks involved in this practice.

While the property is a long-term asset often lasting 50 years or more, the lease agreement is a much shorter one that lasts between 3 to 7 years (with extensions at the options of the tenant). The thinking behind buy-and-leaseback arrangements is that the REIT would be able to find a tenant and maintain or increase the rental income for the intended holding period of the property. However, some of the industrial properties are highly customised ones. The pool of potential tenants would likely be limited to those in the same industry as the original tenant (Of course, there is always the option of pulling down the property and redeveloping it). Given the small pool of potential tenants, would there be sufficient competition for the industrial space to maintain or increase the rental income? This has not even considered the fact that Singapore is reducing the intake of foreign labour that many industries depend on and there are less expensive places overseas to do business. If the rental income is reduced, the value of the property will take a hit. Yet, the loan originally taken to finance the acquisition remains unaffected and still needs to be serviced and eventually paid off. There will be lower distribution for shareholders. In addition, with a lower valuation, the debt-to-asset headroom will be reduced, leading to less property acquisition opportunities in future and moving the REIT closer to the Loan-To-Value (LTV) covenants in its debt obligations. Of course, the extent of the impact will depend on the size of that particular property relative to that of the REIT's property portfolio.

Conservatively, the buy-and-leaseback arrangement should be treated as a financing transaction for the seller with the property as the collateral. However, in this respect, REITs are at a distinct disadvantage compared to banks. Let us compare the case of a company taking a loan from the banks using the property as the collateral versus the case of the company engaging in a buy-and-leaseback arrangement with the REITs. Banks will have the following advantages over REITs:

• Banks can request for other collaterals, whereas the only collateral for REITs is the property.
• Banks can give a lower loan amount than the value of the collateral, whereas REITs usually pay close to the valuation of the property.
• Banks can monitor the valuation of the collateral and ask for margin top-ups if the LTV ratio rise above a certain threshold. REITs will have to absorb the reduction in valuation.
• Banks can demand immediate repayment of the loans and seize the property for sale if the company does not service its loans. REITs can only fall back on the rental security deposits.
• Bank loans usually contain cross-default covenants, i.e. if the company defaults on one loan, it will trigger automatic defaults on all other loans and banks can demand immediate repayment of all these loans. Lease agreements do not have such covenants and cannot ride on the cross-default covenants of bank loans, i.e.a default on a lease agreement does not trigger a default on the loans.

It is worth noting that if the REIT takes on a loan to finance the buy-and-leaseback transaction, it is actually on the short side of both transactions, i.e. it is subject to the protective features of the loan transaction but the lease transaction do not offer comparable protection.

In conclusion, a buy-and-leaseback arrangement provides opportunities for REITs to increase their rental income and distribution to shareholders. However, there are also risks involved. REITs will need to exercise caution before entering into such transactions.

See related blog posts:

• Do REITs Overpay for Their Acquisitions?
• REITs Are Not Forever Attractive
• Cash Over Valuation for REITs

A Comparison of Risk Management Tools & Strategies

In my last 2 posts, I have discussed some of the risk management tools and strategies that can be used to manage investment risks. This post puts together all the risk management tools and strategies and discusses their pros and cons.

Tool #1: Value-at-Risk Analysis

Value-at-Risk (VaR) analysis was discussed at length in the post on Stress Testing Your Portfolio. Essentially, this tool serves to estimate the amount of loss at a given probability of occurrence and in a given holding period based on historical price changes. The advantages of this tool are:

• It provides a sense of the loss expected for a decline. By estimating the amount of loss in advance, an investor is better able to prepare himself psychologically for the decline and make rational decisions at the depth of the bear market.
• It allows adjustments in the portfolio to be made. If the estimated loss is too much to bear, an investor can adjust his portfolio to something more palatable.
• It identifies the stocks that are likely to decline the most. Based on this information, an investor can determine if he should still keep those stocks in his portfolio.

However, VaR analysis is not fool-proof. The estimated amount of loss from VaR analysis may or may not be the same as that actually experienced, as the actual decline may have a different probability of occurrence or duration of decline. The disadvantages of this tool are:

• It relies heavily on historical price changes. When the financial conditions are different, the historical price changes may not mirror the actual price changes. For example, the Global Financial Crisis (GFC) was of a different nature from the Dot.Com Bust. Using price changes from the Dot.Com Bust to estimate the VaR losses during the GFC might underestimate the actual losses.
• New stocks have limited price history. Similarly, VaR estimates for new stocks with limited price history might be understated.
• Duration of a market decline is seldom equal to a year. VaR is usually estimated for a month or a year. However, a market decline is seldom one year long. The longer the duration, the higher is the loss.
• Detached from real market events. Although VaR analysis uses historical price changes, it does not reflect a real event, such as the Dot.Com Bust or GFC. The VaR estimates feel like a "statistics" and not potential losses from a real market decline.

Tool #2: Back-Testing Using Actual Market Events

Back-testing using actual market declines corrects for the detachment of VaR analysis from a real market event. It achieves similar objectives as VaR analysis, which is to estimate the potential losses from a market decline. It works even simpler than VaR. To perform this analysis, just take a real market decline, say, the GFC, measure the total decline from the peak to the trough, and apply to the exposure you have to the stock. For example, if you have a $10,000 exposure to a stock, and it declined 40% during the GFC, the estimated loss from this stock is $4,000. Repeat this for all stocks in the portfolio and you will get the estimated loss for the portfolio. As back-testing also relies heavily on historical price changes, it shares many of the pros and cons of VaR analysis. Specific advantages of back-testing are:

• The loss estimate is based on a real market event. It is able to answer the question, "If your portfolio were to go through the GFC again, what kind of losses would it have?". By linking it with a real market event, investors are better able to relate to and prepare themselves for the potential losses.
• It provides a realistic check on the estimated losses from VaR analysis. Unlike VaR analysis, the estimated losses from back-testing is not just a "statistics". It also corrects for the duration that affects VaR estimates.

Specific disadvantages of back-testing vis-a-vis VaR analysis are:

• It does not show the correlation between different stocks in the portfolio. Back-testing only consider the peak-to-trough decline and does not consider the price changes in-between. Hence, the correlation between different stocks cannot be performed for a deeper analysis.

Nevertheless, VaR analysis and back-testing based on actual market events are not mutually exclusive. They can work hand-in-hand to serve as a cross-check on each other.

Strategy #1: Diversification

Everyone should be familiar with this strategy, so I will not discuss too much about it. Just take note that during market crises like the GFC, most types of investment will go down together.

To share my experience during the GFC, I had a fairly diversified portfolio at the start of the GFC. The table below shows the portfolio allocation among different asset classes in Jan 08. Also shown is the % change in value (ignoring dividends) in Oct 08, at the depth of the crisis. (Note: The % change assumed that the portfolio remained constant throughout the period).

	Shares	REITs	Biz Trusts	Preference Shares	SGS Bonds	Cash	Total
% Allocation	18%	7%	11%	18%	12%	33%	100%
% Change	-64%	-66%	-65%	-22%	3%	0%	-27%

As shown in the table, diversification worked to some extent, but not as well as expected prior to the crisis. Both REITs and Business Trusts (BTs) fell as much as shares and served no diversification benefits. Preference shares fell by a less extent, but they were expected to hold steady. Only the Singapore Government Securities (SGS) bonds and cash held steady as expected.


Strategy #2: Never Run Out of Cash

Cash is ammunition. When market prices are severely depressed, having cash on hand allows you to buy on the cheap. Without cash, you will be at the mercy of the market. Psychologically, cash provides a form of security and allows you to be in control. Having said that, buying further might lead to further losses, but at least you have a choice and are not dependent on the market or on others to bail you out.

Although cash is a great friend in times of crisis, holding too much cash might erode their value in times of high inflation like the past 5 years. So, holding them in cash-like instruments such as preference shares and SGS bonds would help to minimise inflation losses. See the post on Behind Every Successful Bear Market Recovery is A Cash-Like Instrument for the experience with preference shares.

Conclusion

The above are some of the risk management tools and strategies that can be useful in managing investment risks. They work to some extent, but they have some shortcomings as well.

See related blog posts:

• Stress Testing Your Portfolio 
• Behind Every Successful Bear Market Recovery is A Cash-Like Instrument
• Different Types of Bears