Preference for Regular Payout Insurance

I have a couple of insurance policies; these can roughly be grouped into 2 categories -- those that I didn't opt out and those that I voluntarily bought. Insurance policies that fall in the former group are CPF's Dependents' Protection Scheme and Home Protection Scheme (HPS) while insurance policies that fall in the latter group are the "as-charged" Medishield plan and disability income insurance. The key difference between the 2 groups is the former has lump-sum, one-time payouts while the latter have variable or regular payouts over a period of time. As shown in the title of this blog post, my preference is always for regular payouts over lump-sum payouts.

For insurance to be effective, the asset (from insurance payout) must match the liability. Not only must the value of the asset and liability match, the timing of these cashflows must match as well. An asset that is realised one year after the liability falls due is no help at all. The reverse is also true, as will be shown later, but it is always better to have the asset earlier than the liability. Thus, when buying insurance, one must estimate the nature of the liability and find the appropriate insurance to match both the value and timing of the liability. 

When an unfortunate incident happens, it is likely to have 2 components, an initial period when there is high cash outlay such as due to surgery, and an recuperation period when the cash outlay is lower than that during the initial period but is regular, such as due to follow-up consultations, medication or loss of employment. Depending on the nature of the incident, the initial period will dominate for some incidents (e.g. accidents) while the recuperation period will dominate for other incidents (e.g. disability). Insurance with lump-sum, one-time payouts will be useful for the first type while insurance with regular payouts will be useful for the second type.

It is not wise to use a lump-sum insurance to cover a liability with regular expenses, as there is no certainty that the one-time payout is sufficient to cover the regular expenses even if the value of the payout and expenses roughly match. Take for example, a one-time $100K insurance payout and a liability that requires $3K in expenses a month over 3 years. The payout only needs to be invested at a rate of 3.1% to support the required cash outflow. It looks simple enough and does not require a bull market to achieve this rate of return. However, how can one be certain that there will not be a bear market that ruins the investment? Hence, there are challenges in trying to convert a lump-sum payout to a regular payout. Moreover, considering that the person is no longer as healthy as before, would he still be able to invest as well as he is when he is healthy? Thus, it is best to leave the risk of investing to the insurer and look for a regular-payout insurance to cover such a liability.

Notwithstanding the above, it may be possible to modify the cashflow of the original liability such that the asset and liability now match. For example, a loan obligation may require regular monthly repayments. It is possible to make a lump-sum repayment to either extinguish or reduce the amount of monthly repayment required in the future. A lump-sum insurance will work well in such cases. CPF's HPS plan falls into this category by extinguishing the loan when an unfortunate incident happens. 

In conclusion, it is important to match the asset to the liability. Buying the right insurance matters.

See related blog posts:

• There is Really a Regular-Payout Term Insurance
• The Ideal Insurance Payouts
• Doing Your Own Insurance Planning

Unforeseen Risk in My Medical Insurance

Insurance should always be the first "investment" in any investment plan, because any major medical expenses could easily wipe out years of hard-earned savings and investment gains. However, insurance is usually not discussed as much as investments because it is a boring and taboo subject. A common thinking among investors is to try to grow one's wealth through investment quickly enough so that one does not need insurance. However, how many of us could ensure that we could grow wealthy before we grow old? A well thought through insurance plan would go towards ensuring that we are well covered during the period when we're still growing our wealth and are most vulnerable to any major expenses. However, sometimes, even the best laid plans can go awry when one is not in the best of health.

I have a private "as-charged" Medishield plan (Plan B) that covers me for hospitalisation in a Class B ward. When I was healthier and bought the insurance, I thought I would stay in a Class B2 ward if I were to be hospitalised. I did not buy any rider to cover the deductible and co-insurance portions of the medical bill, as I believe that medical insurance should be to cover large medical expenses. Hence, the coverage of a Medishield Plan B was adequate -- stay in B2 ward, covered up till B1 ward. I could not imagine myself staying in a Class A or even a private hospital ward. The money saved from not staying in these more expensive wards could be spent on a nice little holiday later. In fact, I have occasionally thought about staying in a Class C ward to save more on the deductible and co-insurance portions.

Unfortunately, Man proposes, Heaven disposes. I have not been in the best of health in the last few years. This has exposed gaps in my thinking and a major risk in my medical insurance coverage. I have seen specialists as a subsidised patient in a public hospital, private patient in a public hospital and private patient in a private hospital. Needlessly to say, seeing the specialist as a subsidised patient is the cheapest, but it can take 1-2 months to make an appointment. Seeing as a private patient costs more than as a subsidised patient, but the cost differential between a public and private hospital is not major. The lead time for an appointment as a private patient in a public hospital can range from 1/2 week to 3 weeks, while a private patient in a private hospital can see the specialist on the same day. Hence, in my haste to seek medical attention, I have seen a private specialist in a private hospital on a few occasions. This then exposes me to the risk of being hospitalised in a private hospital ward. The Medishield Plan B that I have only covers 50% of the insurable expenses in a private hospital ward, which is as good as not having any insurance.

Is it a case of being penny-wise and pound-foolish in not buying the most expensive Medishield plan? I don't think so, because if that is the case, I would not have upgraded to an "as-charged" Medishield plan. It is a case of not being able to foresee how I would act when I am not well. 

What will I do now? One option is to upgrade to a Medishield Plan P that covers private hospital wards, provided I am still insurable. But frankly speaking, the annual premiums of Plan P are not cheap. If this option is chosen, at some point in time, I might downgrade to Plans A or B to manage the premiums. Anyway, there are going to be changes to the plans with the introduction of Medishield Life. I will wait and see the benefits and premiums of each Medishield plan before deciding.

If I am no longer insurable, I could only continue on Plan B, and if the specialist in the private hospital diagnoses that I need to be hospitalised, I would go to the Accident & Emergency Department of a public hospital to seek hospitalisation. That probably seems the best way to manage this risk. 

The moral of the story is, always plan for the unexpected.


See related blog posts:

• Buying the Most Expensive IP When Young and Downgrading When Old
• Doing Your Own Insurance Planning
• How Much Does One's Financial Independence Depend on One's Health?

Why Unit Trust Expense Ratio Matters

Many investors would have the familiar experience of finding it difficult to make money from unit trusts. My own experience with the few unit trusts that my family and myself bought is the same. In my last post, I charted the price performance of the 2 unit trusts in my Supplementary Retirement Scheme (SRS) account since my first investment 6 years ago. They have not recovered to the initial price which I made my entry even though the Dow Jones Industrial Average is reaching new highs. Why is it so difficult to make money from unit trusts?

There are several reasons for it. Firstly, studies have shown that it is very difficult for fund managers to beat the market indices. So, most actively managed funds actually fare poorer than the market indices. This poorer performance is even before deducting the sales charges and annual expenses of the funds. Secondly, the annual expenses of the funds is a huge drag on the fund performance. The typical equity fund charges approximately 2% of the fund's net asset value (NAV) annually. This goes towards paying the fund manager and trustee and for other expenses such as administration and audits.

At first glance, 2% of NAV might not seem a lot to pay for professional management of the funds. However, what is the annual returns that investors could realistically expect from equity investments? Approximately 10%. So, a 2% expense ratio out of 10% typical annual returns is equal to 20% of the annual profits that investors could expect. That is a lot of money! In poorer years, the equity returns would be lower than 10% or even become negative, but a 2% expense ratio is still charged. So, in poorer years, the fund managers get more than 20% of the profits that investors could earn in that year.

In comparison, hedge funds' fees comprises 2 components, namely, a management fee based on NAV of the fund (same as non hedge funds), at around 1-2% of NAV and a performance fee based on excess returns, at around 20% of returns above a pre-determined hurdle rate. Take for example, a hedge fund that has a fee structure of 1% of NAV and 20% of excess returns, hurdle rate of 2% and the underlying investments return 10% in a particular year. The total fee that the fund manager gets is 1% of NAV + 20% of (10% - 2%) or 2.6% of NAV in total. Although this is higher than the 2% expense ratio that non hedge fund managers charge, a majority of hedge funds have a high-water mark. If the returns of the hedge fund do not exceed the highest value achieved to-date, no performance fee is charged. So, for the same hedge fund, if the return of the underlying investments is 0% or negative in the subsequent year, the hedge fund manager will only receive the management fee of 1%. On the other hand, the non hedge fund manager will continue to receive the 2% expense ratio regardless of the performance of the underlying investments. From this perspective, the variable performance fee component of hedge funds is more palatable than the fixed management fee of both hedge and non hedge fund.

As a final note, the 2% expense ratio can make a huge difference in the total wealth after a long holding period due to the effects of compounding. Assuming the underlying investments earn 10% annually, a $1,000 investment in a typical fund with 2% expense ratio would become $10,063 while the same investment without the expense fee would become $17,449 in 30 years' time. The 2% difference in expense ratio causes a 73% difference in the total wealth.

Thus, do not underestimate the expense ratio of a fund. As far as possible, always select one with a low expense ratio. Index funds are a good choice, with low expense ratios and performance that are better than most actively managed funds.


See related blog posts:

• Different Mentality in Stock and Unit Trust Investing
• Dollar Cost Averaging Works Best with Volatile Stocks/ Unit Trusts
• Experience with Lifecycle Unit Trusts

Dollar Cost Averaging Works Best with Volatile Stocks/ Unit Trusts

I have 2 unit trusts in my Supplementary Retirement Scheme account. One is an equity unit trust (LionGlobal Infinity Global Stock Index Fund) while the other is a balanced unit trust (UOBAM Growth Path 2040). They are invested regularly on a monthly basis for the past 6 years. The relative performance of the 2 unit trusts since my first investment 6 years ago is shown in the chart below.

Relative Performance of Unit Trusts Since 1st Investment

From the chart, we can see that the performance of the balanced unit trust is more stable than that of the equity unit trust. During the Global Financial Crisis, it dropped to 60% of the initial investment price while the equity unit trust dropped even lower to around 45%. Subsequently, the balanced unit trust recovered to the 80% - 90% level and remained there for 3.5 years until February this year. In contrast, the equity unit trust recovered only to the 60% - 70% level during the same period and rising to the 80% - 90% level only recently. Throughout this period, the performance of the equity unit trust is worse that that of the balanced unit trust.

Yet, guess which of the unit trusts performed better in my portfolio? Surprising, it is the more volatile equity unit trust that performed better. It has returned 26% over the 6-year period compared to only 8% for the balanced unit trust.

The main reason for the better portfolio performance of the equity unit trust is because through regular monthly investment, the plan performs Dollar Cost Averaging (DCA). DCA buys more units when the price is lower and less when the price is higher. Since the equity unit trust has dropped more than the balanced unit trust, more units were accumulated. Hence, when the price recovers, the equity unit trust performs better, even though its price is consistently lower than that of the balanced unit trust throughout this period.

To conclude, Dollar Cost Averaging performs better with volatile stocks/ unit trusts than more stable ones.


See related blog posts:

• Review of My SRS Investments
• Experimenting with Investment Strategies
• All I Want Is To Invest Wisely

The Best & Worst Months for Shares

In Jeremy Siegel's book "Stocks for the Long Run", it was mentioned that the best month for stocks is January while the worst month for stocks is September. October, although not the worst month, is the most volatile, having witnessed the stock market crashes of 1929, 1987 and more recently 2008. Let's review the case for Singapore to see if Singapore's stocks follow the same pattern.

The table below shows the average monthly return for the Straits Times Index based on data for the past 24 years since 1988 (2013 is excluded as there are still 2 more months to go).

Calendar Month	Average Return	Standard Deviation	No. of Best Months	No. of Worst Months	No. of Best - Worst Months
Jan	0.8%	7.3%	5	2	3
Feb	0.9%	7.0%	2	1	1
Mar	0.5%	5.1%	0	1	-1
Apr	2.7%	6.5%	3	0	3
May	-0.3%	7.6%	2	5	-3
Jun	0.2%	6.4%	2	1	1
Jul	1.6%	4.3%	3	1	2
Aug	-2.9%	6.5%	0	5	-5
Sep	-1.1%	7.1%	2	4	-2
Oct	1.0%	9.2%	1	4	-3
Nov	1.6%	5.6%	1	1	0
Dec	2.8%	4.9%	4	0	4

Based on the average monthly return, the best month is actually December at 2.8% while the worst month is August at -2.9%. However, if based on the no. of times that month has the best return in a calendar year, the best month is January with December not far behind. August remains the worst month. It is interesting to note that August was never the best month in any year. Similarly, December was never the worst month in any year. Based on the standard deviation of the monthly returns, October is the most volatile at 9.2% while July is the least volatile at 4.3%.

Hence, from the above analysis, Singapore stocks exhibit similar trends to US stocks, with December/ January being the best month while August/ September being the worst and October being the most volatile. The similarity in patterns should not be surprising, since stocks between US and Singapore are closely correlated.

From the last column of the table, it can also be seen that there is a sequence of positive returns from December to February. Similarly, there is a sequence of negative returns from August to October. Hence, there appears to be some sense in the adage "sell in May and go away".

Personally, do I follow calendar months when buying or selling shares? Actually not really. It is only a secondary consideration. The key consideration is still asset allocation and individual share performance. For example, if I intend to sell shares and January is around the corner with shares rising, I would wait till the end of January before selling. Sometimes, I might even wait till the end of February. Similarly, if I intend to buy shares and September/ October is around the corner and shares are falling, I would wait till the end of October before buying.

However, calendar effects do not always happen. Take this year for example. At end August, shares were falling due to widespread concerns that Fed might start to taper their Quantitative Easing (QE) programme. Shares dropped by 6.0% in that month. Given this backdrop, I would assume that the selling trend would continue into September and October. However, Fed did not taper QE against all expectations. Shares rose by 4.6% in September. Till yesterday, shares are up by 1.2% for October. So, calendar effects do not always happen.

In conclusion, there are certain months and quarters when shares are likely to perform better and certain months and quarters when shares are likely to perform worse. It is useful to know this information when buying or selling shares, but don't bet on it.


See related blog posts:

• Stock Market Performance During World Cups

Do REITs Overpay for Their Acquisitions?

REITs have been active in acquiring properties to add to their portfolios. They do this to increase the rental income and distribution to shareholders as well as diversify the sources of rental income. In addition, there is also the potential for capital gains when the properties are sold. In the process of acquiring properties, they might also raise new capital from the market and increase the liquidity of the shares. However, do REITs overpay for their acquisitions in their attempts to expand? As industrial REITs are most active in acquisitions, we look at a list of acquisitions that industrial REITs have entered into with other companies.

Below is a table listing the acquisitions industrial REITs have carried out with other companies listed on the SGX, showing the acquisition price, valuation price and premium above the valuation price.

Property	Date	Price	Buyer's Valuation	Price - Valuation	% Premium
65 Ubi Ave 1	May 2003	$35.0	$35.0	-	-
1 Changi Business Park Ave 1	Sep 2003	$18.0	$18.0	-	-
TT Int Tradepark	Nov 2003	$92.0	$92.0	-	-
12 Woodlands Loop	May 2004	$24.8	$24.8	-	-
9 Changi South St 3	Oct 2004	$32.0	$32.0	-	-
5 Toh Guan Rd East	Oct 2004	$36.4	$36.4	-	-
52 Serangoon North Ave 4	Feb 2005	$14.0	$14.0	-	-
84 Genting Lane	Jul 2005	$10.0	$10.0	-	-
20 Old Toh Tuck Rd	Nov 2005	$11.6	$11.6	-	-
50 Kallang Ave	Dec 2005	$28.6	$28.6	-	-
2 Serangoon North Ave 5	Dec 2005	$45.0	$45.2	-$0.2	0%
31 Ubi Rd 1	Dec 2005	$23.0	$23.0	-	-
2 Senoko South Rd 26 Senoko Way	Oct 2006	$49.0	$49.0	-	-
30 Woodlands Loop	Nov 2006	$10.3	$10.4	-$0.1	-1%
20 Tampines St 92	Dec 2006	$10.0	$11.2	-$1.2	-11%
134 Joo Seng Rd	Dec 2006	$10.7	$10.9	-$0.2	-2%
3 Changi South Lane	Dec 2006	$13.9	$14.4	-$0.5	-3%
521 Bukit Batok St 23	Dec 2006	$24.1	$24.9	-$0.8	-3%
9 Tampines St 92	Dec 2006	$11.0	$11.0	-	-
31/33 Pioneer Rd North 119 Neythal Rd 30 Tuas Ave 8 8 Tuas View Square	Aug 2007	$36.8	$37.6	-$0.8	-2%
31 Int Business Park	May 2008	$246.8	$246.8	-	-
1/2 Changi North St 2	Aug 2010	$22.1	$22.2	-$0.1	0%
25 Tai Seng Ave	Sep 2010	$21.1	$21.5	-$0.4	-2%
4/6 Clementi Loop	Mar 2011	$40.0	$40.0	-	-
3C Toh Guan Rd East	Nov 2011	$35.5	$35.5	-	-
16 Tai Seng St	Mar 2012	$59.3	$59.3	-	-
15 Jurong Port Rd	Dec 2012	$43.0	$43.0	-	-
Average		$37.2	$37.3		-1%

From the table above, we can see that most of the transactions are carried out at the valuation price. A minority of the transactions are at a slight discount, ranging from 1% to 11%. The average discount of all transactions is 1%. On this basis, REITs do not overpay for their acquisitions.

As the counter-parties to these transactions are also listed companies, the sellers might also announce the transactions on SGX. Some of the sellers would disclose their valuations of the properties, thus allowing us to see both sides of the transactions. The list of transactions with sellers' valuations is shown in the table below.

Property	Date	Price	Seller's Valuation	Price - Valuation	% Premium
65 Ubi Ave 1	May 2003	$35.0	$35.0	-	-
TT Int Tradepark	Nov 2003	$92.0	$92.0	-	-
20 Old Toh Tuck Rd	Nov 2005	$11.6	$9.3	$2.3	25%
31 Ubi Rd 1	Dec 2005	$23.0	$23.0	-	-
28 Senoko Dr	Apr 2007	$12.0	$12.0	-	-
31/33 Pioneer Rd North 119 Neythal Rd 30 Tuas Ave 8 8 Tuas View Square	Aug 2007	$36.8	$22.6	$14.2	63%
1 Kallang Way 2A	Jan 2008	$14.0	$12.0	$2.0	17%
31 Int Business Park	May 2008	$246.8	$246.5	$0.3	0%
29 Tai Seng Ave	May 2010	$53.0	$40.0	$13.0	33%
1/2 Changi North St 2	Aug 2010	$22.1	$14.3	$7.8	55%
25 Tai Seng Ave	Sep 2010	$21.1	$16.6	$4.5	27%
44 & 46 Changi South Rd	Dec 2010	$16.8	$12.5	$4.3	34%
4/6 Clementi Loop	Mar 2011	$40.0	$22.0	$18.0	82%
3C Toh Guan Rd East	Nov 2011	$35.5	$31.0	$4.5	15%
16 Tai Seng St	Mar 2012	$59.3	$59.0	$0.2	0%
15 Jurong Port Rd	Dec 2012	$43.0	$33.0	$10.0	30%
Average		$47.6	$42.6		24%

From the table above, it is interesting to see that most of the transactions are carried out above the seller's valuation price, with premiums ranging from 0% to 82%. The average premium of all transactions is 24%. Note that these valuation prices are not historical costs at book value; they are obtained from recent valuations commissioned by the sellers.

So, we are back to the original question: do REITs overpay for their acquisitions? To answer this question, we need to address 2 other questions, i.e. why do buyer's and seller's valuations differ, and the relative bargaining powers of buyers and sellers.

It is not uncommon for valuations of the same property to differ. Based on the disclosure in the SGX announcements by both buyers and sellers, 2 key reasons could be distilled:

• Buyer's valuations are more rigorous than seller's valuations. Buyer's valuations are generally based on 3 or more valuation approaches, some of which include direct comparison of recent transactions, discounted cashflow of income stream, capitalisation of income stream and replacement cost of the property. In contrast, seller's valuations (note: there are only 5 sellers that disclosed the valuation approaches used) are based on less approaches, including desktop valuation. Furthermore, some of the acquisitions need to be funded by bank loans. If the properties are overvalued, banks would run the risk of loss. On this basis, the "correct" value of the property probably lies closer to the buyer's valuation.
• Basis used in valuations. The basis used in valuations play a key role in the eventual value of the property. In one of the sellers' announcements, it mentioned about valuations on a sale-and-leaseback basis and on a vacant possession basis. Needless to say, the valuation on a sale-and-leaseback basis should be higher than on a vacant possession basis given that the leaseback agreement provides a rental guarantee for several years.

On the relative bargaining powers of buyers and sellers, even though the seller might have a valuation price, it does not necessarily mean that the seller would be willing to sell at that price. The seller probably had been operating from the property for several years already and enjoying continual appreciation in property values. Some premium above the seller's valuation price is required to entice the seller to sell the property and give up future capital gains as well as converting from being a property owner to a property lessee.

Lastly, of all the properties mentioned above with the latest valuation, only 2 properties have seen their valuations fall below the original purchase price.

In conclusion, on the basis that (1) the acquisition price does not differ much from the buyer's valuation price, (2) the "correct" value of the property probably lies closer to the buyer's valuation than the seller's valuation, (3) a premium is likely required to entice the seller to sell the property, and (4) the current valuation of most properties mentioned above is equal to or above the original purchase price, REITs do not overpay for their acquisitions.

See related blog posts:

• The Hidden Risks of Buy-and-Leasebacks for Industrial REITs
• Cash Over Valuation for REITs 
• REITs Are Not Forever Attractive

Managing Expenditure

Saving is usually the first step towards achieving your financial objectives. One approach of building up savings is to have additional sources of income. The other approach is to defer consumption to a later date. To manage my expenditure, I have tried several ways over the last 2 decades; some work and some don't quite work. Let's discuss the ways that don't quite work before discussing the ways that work.

Ways That Don't Quite Work

The conventional way to manage expenditure is to set a budget for the various categories of expenditure. After trying for several years, I have come to the conclusion that budgets don't work. It works well for expenditure that are regular, such as utilities, taxes, etc. But when it comes to discretionary expenditure such as recreation, social events, etc., the budget is sometimes exceeded. The main reason is that the budget does not come to mind at the time of spending money. By the time I remember about the budget, money is already spent.

Related to setting a budget is to record all the expenses made. By recording and compiling all the expenses, you can analyse at the end of the day/ week/ month whether the money has been spent wisely and if not, to remind yourself to spend wisely the next time. Again, it does not quite work. Regret only lasts for as long as I'm looking at the expenses. It does not last until the time of spending money.

Perhaps the only time that budget setting and expense recording work is near the end of the month. If the budget is almost exceeded, I would try to defer some expenses to the next month.Conversely, if I spend less in this month, I would bring forward some expenses from the next month so that more money is available for spending next month. This is usually done by topping some stored value cards that are regularly used.

Ways That Work

The ways that work in managing expenditure (at least for me) has to do with how we think about expenditure. There are 2 ways of thinking about expenditure. The first way is to think of it in terms of opportunity cost. When you spend money on certain items, it means that you can't spend on some other items. As investors, it also means that the money cannot be invested and grown. Hence, the opportunity cost to investors is usually very high. The higher the rate of return and the younger the investor is, the higher is the opportunity cost. As an illustration, I have a target rate of return of 10% per year. At this rate of return, money will double every 7.2 years. I have 27 years before reaching the retirement age of 65. So, every $1 today will become $14.81, say, $15, when I retire. That means that for every $1 I spend today, I will have $15 less when I retire. Hence, the price tag of every item today is multiplied by 15. A mid-level digital camera that costs $2,000 to most people will actually cost $30,000 to me. That is a lot of money! From this perspective, I would think very hard about spending money on big-ticket items.

The second way of thinking about expenditure is to think about the amount of hours you need to put in at work to pay for the item. Let's say the expenditure is equivalent to 2 weeks of salary. Instead of the company paying you a monthly salary and using part of the salary to pay for the item, would you be willing to work for FREE for 2 weeks and at the end of the 2 weeks, the company gives you the item? Bear in mind that during these 2 weeks, you will need to endure the usual scolding from the bosses, tight deadlines, office politics, etc. Very likely, you will think a little longer about spending the money.

Conclusion

Generally, my experience is that if you manage the big-ticket expenditures well, you do not really need to worry too much about the small-ticket expenditures. You might overspend on the small-ticket items, but they will not blow a big hole in your pocket. Managing expenditure is not about being a miser; it is about knowing when to spend.


See related blog posts:

• The Philosophy of Spending Money
• Living a Frugal Life
• How Many Months Do You Have to Work This Year?