Fishing for Future Generations

This is a follow-up post from last week's post on Building A Lasting Portfolio for Future Generations. As rightly pointed out by some of the readers, creating and maintaining such a portfolio across generations is not going to be easy. But when you think about it, how many skill sets are easy to transfer to the next generation? You might be the best engineer/ doctor/ lawyer etc. and make lots of money based on your skills, but how easy is it to transfer those skills to your children so that they too are going to be the best engineers/ doctors/ lawyers, etc. That is assuming that they wish to follow your footsteps and become an engineer/ doctor/ lawyer, etc.

The conventional way parents "transfer" skills to their children is to get the best education money can buy and leave behind as much assets as possible for them. The latter is about giving them fish so that they could feed themselves for a couple of years, while the former is about teaching them how to fish so that they could feed themselves for a lifetime. This is a good way, because after all, new technologies and knowledge emerge and old technologies and knowledge become obsolete. Beyond the conventional way mentioned above, can you further enhance the chance that your children (and future generations) will do well in life? 

The key lies in the fish (i.e. the assets) that we leave behind. Besides just being food, can the fish be used as baits to catch even more fish? Some of the descendents will be able to use their acquired fishing skills in their preferred professions to turn those fish into even more fish. Some of the descendents, however, might need some help in this aspect. Possible ways on how to achieve this are discussed in the previous blog post.

While not everybody will be an engineer/ doctor/ lawyer, etc., we are all money managers, for as long as money is used for all transactions. Being trained in money management will go a long way towards safeguarding our financial security and that of future generations.

Post-script

I managed to find Warren Buffett's advice on how his estate (after making all the donations pledged) should be managed. Below is extracted from Berkshire Hathaway's 2013 annual letter to shareholders:

"What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers."

See related blog posts:

• Building A Lasting Portfolio for Future Generations
• The Passive Portfolio
• How Much Does One's Financial Independence Depend on One's Health?

Building A Lasting Portfolio for Future Generations

It is often said that the earlier you start investing, the more you have for retirement. This is because you have a longer time-span for compounding to take effect. A typical investment life-span is about 30 years, so for a portfolio that can provide 4% real returns (or 7% nominal returns) annually, $1 at the start of 30 years will become $3.24 at the end of 30 years. However, if you can pass down the portfolio intact to your children who can continue to invest for another 30 years, $1 will become $10.52 at the end of 60 years. If they too can pass down the portfolio to their children and grandchildren, the portfolio will continue to compound further.

Although you might have more than 1 child and you wish to split the inheritance evenly between your children, this portfolio may still provide more money for each generation that the preceding one. For example, assuming you have 2 children and each of them will have another 2 children, each child will receive $1.62 and each grandchild will receive $2.63 when the portfolio is passed down to them. While these figures may appear small, these are after accounting for inflation. In nominal terms, each grandchild will receive $14.49.

Before you get too excited, you have to note that this portfolio is meant to be passed down to your children, i.e. it is not meant to support your retirement. If you need to draw down the money for retirement, the portfolio that you can pass down to your children will correspondingly reduce and compound to a smaller value.

How do you build such a portfolio for future generations? Active investment strategies will probably not work. While you might be the best fundamental analyst or technical analyst and make a lot of money from them, how do you ensure that your children and grandchildren are equally good at it? Assuming that you can pass down your analytical skills, how do you teach the mental strength to be greedy when others are fearful and fearful when others are greedy? And this is already assuming that they too are financially inclined and willing to invest the time to pour through financial statements and/or technical charts. So, a portfolio based on active investment strategy will probably not last through the generations.

Among passive investment strategies, there are two -- dollar cost averaging (DCA) and portfolio rebalancing. DCA requires a constant amount of money to be invested at regular intervals in the portfolio. There are 2 issues with this strategy. Firstly, over time, the same amount of money will reduce in value due to inflation. At an inflation rate of 3%, $100 will reduce to $41.20 after 30 years and $16.97 after 60 years. So, progressively, you (and future generations) will need to increase the amount invested over time. To maintain a constant $100 investment at today's value, you (and future generations) will need to increase the amount to $243 after 30 years and $589 after 60 years. The second issue is that DCA is meant to be used to build up the portfolio to a terminal value before you start withdrawing money from it. However, if this portfolio is meant to be passed down to future generations, then there is actually no withdrawal. This means asking future generations to invest an increasing amount of money over time into a "black hole" that they cannot expect to touch in their life-time. This might be too much to ask of them. Although the portfolio could be invested in funds that provide dividends at regular intervals, what they put in in regular investments might be more than what they could get out from dividends. This strategy is probably not sustainable.

The other passive investment strategy -- portfolio rebalancing, requires no further investments to be made. You just need to monitor the asset allocation to ensure that it does not deviate too much from the original allocation. If it does, you just need to sell the assets that have risen in value and reinvest the proceeds into assets that have dropped (relatively) in value. You just need to do this once every quarter or 6 months. If the portfolio is invested in funds that pay dividends at regular intervals, you get an additional source of passive income as well. In essence, this strategy does not require future generations to make any investments, but pays them regularly for maintaining the portfolio with minimal efforts! They are then more likely to maintain the portfolio and pass it down to their children. Also, when they recognise the beauty of this strategy, they could decide to make further investments into the portfolio and enhance it for their children. 

There is still 1 other factor to consider, which is the ability of future generations to make prudent financial decisions. Some of the descendants might be investment experts while others might just squander it away. The vast majority are likely not financially inclined. My current thinking is to split the inheritance so that each has its own portfolio to manage. If one of them were to squander his own portfolio away, there is nothing much we can do, but at least it does not affect the portfolios of others in his generation. For the vast majority who are not financially inclined, the above strategy will work well for them, as it does not require an investment expert to maintain the portfolio. And for the investment experts in future generations, they will be able to grow their portfolios without any help. 

There is a saying that if you give a man a fish, you feed him for a day. But if you teach a man to fish, you feed him for a lifetime. We always strive to earn more and invest prudently so as to leave as much assets as possible for our children so that they can live a better life than us. Yet, are the assets that we pass down to them fish that last a couple of years or fishing instructions that they can benefit for life? Ironically, fish costs money to build up but fishing instructions cost almost nothing but are worth a lot more!

Lastly, please also pass down an instruction to help those in need when your future generations become rich, for their fathers/ grandfathers/ etc. (i.e. us and our fathers), were once poor before.

See related blog posts:

• Fishing for Future Generations
• Experimenting with Investment Strategies
• The Passive Portfolio

You Don't Need To Be Good In Investing To Be Rich

I first read about this chart from Investment Moats. Still, it took me a good couple of months before I realised its implications. In essence, the chart means that you do not need to be good in investing in order to be rich! Pushing the envelop further, it can also mean that everyone could be rich, provided you follow the advice in the chart. The chart is extracted from Vanguard's Principles for Investing Success.

Effects of Savings Growth & Returns

Take a look at the chart above. It plots the value of several portfolios with different savings growth and annual returns. The interesting part of the chart shows that a portfolio with 10% savings growth and 4% returns (dotted red line) could actually outperform a portfolio with 5% savings growth and 8% returns (brown full line)! Before coming into contact with the chart, I thought that the returns rate was the most important factor in growing your wealth. This chart proved me wrong. It also proves that you do not need to be good in investing and achieve double-digit returns in order to be rich. In fact, you do not even need to take on much risk to achieve a 4% return. Several preference shares and bonds could give returns of 4% or more. A list of such preference shares and bonds can be found here. Although Singapore Government Securities (SGS) bonds are currently yielding slightly less than 3%, with interest rates returning to normal in the next couple of years, the yields on these government bonds would also trend higher. The current yields of SGS bonds can be found here.

Are there any catch in this? There is a small one. Assuming a person starts off saving 10% of his monthly starting salary of $3,000, the initial monthly savings is only $300. But at 10% growth rate, the monthly savings would quickly grow to $4,750 by Year 30. It is probably very difficult for anyone to save such a huge amount monthly. However, even if you are unable to follow the 10% savings growth for the entire 30 years, a large amount of savings would have already been accumulated and invested by that time. Assuming the maximum amount that could be set aside every month is $2,500, this ceiling would be reached by Year 24. The value of the portfolio would be $779K at the end of 30 years, compared to $886K if you had followed the 10% savings growth throughout. This value is still higher than the portfolio with 5% savings growth and 8% returns ($744K). The chart below plots the value of the 3 portfolios.

Portfolio Value with Different Savings Growth & Returns

In conclusion, you do not need to be good in investing to be rich! Just like AirAsia's slogon, Everyone Can Be Rich!

See related blog posts:

• All I Want Is To Invest Wisely
• The Lost Art of Bond Investment
• Government Bonds - A Primer

Be Cautious While Being Greedy

The roller-coaster ride of the stock market this past month has brought back memories of the events 6 years ago. Whenever I write about the Global Financial Crisis (GFC), it invariably comes with a tinge of pride. After all, it was a major crash and we managed to recover from it. However, was victory assured right from the beginning, that all we had to do was, in the words of Warren Buffett, to be greedy when others were fearful, or was it a narrow victory snatched from the jaws of defeat? In other words, was buying at the depth of GFC a wise decision or was it a reckless decision that turned out to be lucky? Does this question still matter, since the outcome was positive? My opinion is that it matters, because Lady Luck would not always stand on your side. Although Man proposes, Heaven disposes, we still need to make wise decisions.  

What prompted me to pull the trigger at the depth of GFC in Oct 2008? It was a combination of game plan, indicators, news and history. Info on my game plan and indicators that I consulted are described in Have a Plan, Knowing When Others Are Fearful and Structured Warrant Statistics. The news that caught my attention was the European governments coming together to work out a plan to save the economy (see Declaration on Concerted European Action Plan). As you know, Europeans usually do not readily agree with each other, but the fact that they were ready to put aside their differences and work together signalled that we could begin to see light at the end of the tunnel. And a review of the history of the stock market shows that in the long run, stock market crashes are usually temporary bumps in the long march upwards.

There are, however, 2 problems with history. Firstly, history is written by those who survive the event or those who just watch the event from the sidelines. History is usually not written by those who do not survive the event. And if they were to tell their version of history, the history that they tell could be very different from the history that we know. I once had a colleague who refused to touch stocks again and never spoke about his experience. I guessed he lost heavily in the stock market before. His history will never be known. But could his history not befall on us? 

The second problem with history is that you do not really know which history is playing out when you are in the thick of the action. Was it going to be the history of the Asian Financial Crisis, when stocks rebounded about 15 months after the start of the event, or was it going to be the history of the Great Depression, when stocks found their bottom only 3 long years after the onset? If it was the latter, it was going to be a long road down.

Overall, do I think the decision to invest during the depth of GFC was a wise decision or a reckless decision that just turned out to be lucky? In truth, I believe I have quite seriously underestimated the potential consequences of GFC due to a lack of knowledge of how the economy and the financial world works even till today. So, it certainly wasn't a wise decision that considered all risks. It was at best a decision that was calculated, but had not understood all risks. 

It is particularly instructive to understand what Warren Buffett, the owner of the famous quote "Be fearful when others are greedy and greedy when others are fearful" did during the same period. True to his words, he invested a total of US$20.2 billion in some fixed-income securities with equity participation between Sep 2008 and Apr 2009 (see Buffett's Crisis-Lending Haul Reaches $10 Billion). These securities have both downside protection as well as upside potential. If the stock market dropped further, he could count on receiving dividends from the securities. Conversely, if the stock market recovered, he could convert some of the warrants into equities and profit from the rise in equity prices. His largest equity investment during that period, a US$34 billion acquisition of a railroad, which he described as an "all-in wager on the economic future of the United States", occurred in Nov 2009, when events were more stable (compare Berkshire Hathaway's equity holdings in 2007, 2008 and 2009 in their annual shareholder letters).

What can we learn from this greatest investor in the world? It is that it is not good enough just to be greedy when others are fearful. We also need to be cautious when being greedy. Sometimes, it might just be better to wait until the coast is clearer before making your moves.

In conclusion, while being greedy when others are fearful could help one to make money during "normal" stock market crashes, being cautious regardless of whether others are fearful could save one's skin in an extraordinary stock market crash. Hence, the main reason why I could still be blogging is because the crash did not turn out to be a Great Depression type of crash. For this, we have Ben Benanke, the former Federal Reserves chairman, to thank for. Thanks for saving the whole world from another Great Depression.

See related blog posts:

• Different Types of Bears
• Bye Bye, OSIM!
• Have a Plan

Knowing When Others Are Fearful

The correction in this past month has been fairly amazing. Stocks had been falling faster than I could juggle and yet, the Straits Times Index actually ended the month basically unchanged. The Dow Jones Industrial Average (DJIA) even closed at a record high, as if no correction had happened. Whenever the stock market goes on a nosedive, I would be reminded to check an indicator, which is the Chicago Board Options Exchange Market Volatility Index, or VIX in short. VIX is used by some investors as a fear indicator, spiking up whenever there is great volatility in the market and staying low when the market is peaceful. As Warren Buffett said, “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”. It is useful to have an indicator to know when others are fearful.

Relationship between VIX and DJIA

The chart above shows the relationship between VIX and DJIA. As you can see from the chart, whenever VIX spikes up, a bottom tends to form around these spikes. However, note that this bottom might just be a temporary one, as the market might bounce back up before declining further. Also during the Global Financial Crisis (GFC), VIX actually hit a high of 81 in Nov 2008 but the market continued to crash through before finally bottoming out in Mar 2009. If you had entered the market at the first instance VIX hit 40 and above on 29 Sep 2008, where DJIA was at 10,365 points, you would be nursing a loss of 37% when the DJIA finally bottomed out at 6,547 points on 9 Mar 2009. So, is it still a useful indicator for timing your market entry?

Firstly, I don't rely solely on this indicator to determine my entry point. In times of great market stress, gut feel invariably plays a big part despite all the game plans and indicators. You need to be really comfortable and mentally prepared to catch and hold a falling knife that shows no sign of stopping. It is no use buying and then selling out a few days later at lower prices because of rapidly mounting losses. Secondly, VIX itself can be very volatile whenever there is great volatility in the market. One day, it could be 35 while the next day, it could spike up to 47, before falling back to 39 the following day. So, VIX on individual days might not be very reliable. But if VIX continues to stay consistently high for several weeks, then it shows there is a lot of fear in the market. The longer the panic selling continues, the closer we are to the bottom. Thirdly, even though VIX is not useful in predicting where the bottom is, I use it to gauge roughly when the bottom is. Using the GFC example above, while you would be nursing a heavy loss of 37% if you had entered the market at the first instance VIX hit 40 and above, you would miss the bottom by a little over 5 months, which to me, is actually not that bad. And if you had waited a little longer to see if VIX had stayed consistently high, you would be even closer to the bottom and entered the market at an even lower entry point. Nobody can predict where the bottom is with certainty. I would be sufficiently satisfied if it could gauge when the bottom is with a error margin of a few months.

In conclusion, VIX can be a useful indicator to know when others are fearful, but understand its limitations and ultimately, you must be really comfortable and fully prepared to accept losses which could mount rapidly if you choose to catch the falling knife. It is also important to note that it helps a lot if you have sufficient cash reserves to cushion the fall. And it is also not necessary to catch the falling knife all at one go. It is normal to get hurt from it, but make sure the wounds are not fatal.

See related blog posts:

• Be Cautious While Being Greedy
• Different Types of Bears
• The Big Picture During Bear Markets

Experimenting with Investment Strategies

When I first started investing my Supplementary Retirement Scheme (SRS) funds 7 years ago, I wondered how should I invest the money. Should I invest in the same way as my cash account, i.e. adopting market timing and buying individual stocks, or should I keep it as a cash reserve to be used during severe market crashes like my CPF funds? If I invest like my cash account, I wondered what if my investment strategy had been wrong all this while? Would I then still have sufficient funds to retire? Since the SRS account is small compared to my cash account, I decided to invest it in a different way from my cash account, as a form of hedging in case my investment strategy turns out to be wrong. It also serves as a test lab to try out different investment strategies. After 7 years of experimenting, I think it is time to conclude some of the lessons learnt from these investment experiments. 

Active Investing vs Passive Investing

The first major difference between my cash and SRS accounts is that the former adopts active investing while the latter adopts passive investing. In active investing, you have to do everything by yourself, from setting up a valuation model, analysing hundreds of stocks based on the model, updating the data in the model based on the latest financial statements, deciding what stocks to buy and when to buy them, monitoring the stocks in your portfolio and deciding whether to buy some more or to sell them off. A lot of time is required in this approach. In passive investing, things are a lot simpler. You just need to decide which stocks or unit trusts you believe will appreciate in the long term. Once you have decided that, you just need to invest a constant amount of money in that particular stocks or unit trusts on a regular basis, regardless of whether the markets are going up or down. Of course, you do need to review these stocks and units trusts occasionally, to make sure that they do not stray off-course from your investment objectives and criteria. However, the time spent in passive investing is a lot less compared to active investing.

From personal experience, both active and passive investing can be profitable. Passive investing has achieved an annualised return ranging from 3.11% to 7.04%, depending on the unit trusts bought. Coincidently and very importantly, this is also the annualised return for one market cycle (peak-to-peak), as the unit trust prices have roughly returned to where they originally were 7 years ago.  You may wish to read Review of My SRS Investments for more info. Active investing, on the other hand, has achieved a few more percentage points in returns compared to passive investing, based on rough calculations. It should be highlighted that it is difficult to determine the exact investment returns for my cash account as the investing and non-investing cashflows are not segregated, similar to my CPF account which has monthly contributions coming in and housing loan repayments going out in addition to investing cashflows.

Is the extra few percentage points in returns worth the huge amount of time spent in analysing stocks? From a time-value of money perspective, the extra few percentage points will translate to fairly large differences in wealth when compounded over many years. However, from a lifestyle perspective, time spent on analysing stocks means that you have less time for other things in life. Furthermore, do you really need the extra wealth from the few percentage points in returns to retire or to pass down to the next generation? I guess the choice between active and passive investing boils down to personal preference, whether you like the bolts-and-nuts of investing like a personal hobby or you prefer to spend the time on other more important things in life.

Individual Stocks vs Indices

For the cash account, individual stocks are bought and sold. Some stocks can turn out to be multi-baggers that multiply your investment many times over while others can turn out to be salted fishes that wipe out your investment. You can refer to How to Get a Multi-Bagger? and The Salted Fishes for the list of multi-baggers and salted fishes that I have accumulated in the past 16 years of investing with my own money. Generally, a lot of emotions are involved with individual stocks, with joy for multi-baggers and despair for salted fishes. Even when your stock is a multi-bagger, you are constantly in a struggle over whether to continue holding on to it or sell it off before it declines. With unit trusts, however, the emotions are a lot less as unit trusts are less volatile than stocks. The emotions involved can have an impact on whether you can be a long-term investor and consequently, whether you can achieve the returns stocks can potentially provide in the long run. You may wish to read Different Mentality in Stock and Unit Trust Investing for more info.

Because the price of individual stocks can go down to zero, I usually have a limit on the amount of investment in each individual stock. Furthermore, due to privatisation over the past few years, there are not many stocks on the Singapore Exchange that meet my investment criteria. This has resulted in a limit on the amount of money that could be invested in stocks. In contrast, the price of index funds do not go down to zero and hence, there is no limit on the amount of investment. Even though index funds could lose half their value in a severe market crash, historical evidence shows that they usually recover, so there is nothing much to worry about for long-term investors.

Index Funds vs Lifecycle Funds

Within the SRS account, I also split the funds into 2 and invested in equal portion in an index fund and a lifecycle fund. The benefit of a lifecycle fund is that the asset allocation will gradually change from aggressive to conservative over time. This saves an investor the need to regularly and consciously adjust his asset allocation as he ages and is less able to take risk. However, my experience with lifecycle funds is that the asset allocation may not fit the investment objectives of all investors who invest in the same fund. Furthermore, the asset allocation may change from the initial asset allocation model in unexpected ways over time. You may wish to read Experience with Lifecycle Unit Trusts for more info.

Conclusion

When I started the investment experiments with my SRS account 7 years ago, I never expected to learn so much from it. These lessons have come in useful even for my cash account. Also, you do not always need to choose between active and passive investing, or between individual stocks and indices. They can be complementary to each other. For Singapore stocks, I will continue to adopt active investing, but for overseas stocks, I will be adopting passive investing to save the time required to analyse overseas stocks. Similarly, I will invest in index funds whenever there are limited opportunities in individual stocks to maintain an optimal exposure to stocks. I will continue to experiment with investment strategies using my SRS funds. The next experiment will be to compare between a global stock index and a US stock index.


See relate blog posts:

• Review of My SRS Investments
• Different Mentality in Stock and Unit Trust Investing
• Experience with Lifecycle Unit Trusts

Not All Market Indices Are Equal

One of the most popular and time-tested investment strategies is to invest passively in an index fund. I too have adopted this strategy for my Supplementary Retirement Scheme (SRS) account. However, not all markets are equal. If you pick a market index that is performing well, you are well on your way to financial independence. Conversely, if you pick a market index that is underperforming, you will take a longer time to reach there. The chart below shows the performance of 5 more familar stock market indices, namely, Singapore's Straits Times Index (STI), US' Dow Jones Industrial Average (DJIA), UK's FTSE 100, Hong Kong's Hang Seng Index (HSI) and Japan's Nikkei 225.

Performance of Different Market Indices

From the chart above, if you had invested $10,000 in each of the 5 market indices at the start of 1988, the investment would have grown to $95,169 for HSI, $87,033 for DJIA, $36,982 for FTSE100, $36,052 for STI and only $6,847 for Nikkei 225 as at end Sep 2014. These figures represent a compounded annual growth rate of 8.8%, 8.5%, 5.0%, 4.9% and -1.4% respectively, excluding dividends. Thus, not all market indices are the same and it is important to select the right market index for your passive investment strategy.

For unit trust investments, there are 3 indices to choose from, namely, LionGlobal's Infinity Global Stock Index, US 500 Stock Index and European Stock Index. Their performance for the past 10 years are shown in the table below.

Performance of LionGlobal Global/ US/ European Stock Index Funds

For all the holding periods, the best performer is the US Stock Index, followed by the Global Stock Index and the European Stock Index. This is not surprising, given that the US economy has shown signs of recovery while the European economies are still mired in recession.

As mentioned in my previous blog posts, I will be switching from an underperforming unit trust to an index fund in my SRS account. Since I already have the Global Stock Index fund, the target of my switch will be the US Stock Index fund, notwithstanding the fact that DJIA might have peaked and could be going downhill from now on. You may wish to read Possibly The Worst Time to Invest on why I am not worried about a bear market for my SRS investments.

Will I be committing the mistake of chasing the hottest index only to see it underperform its peers in the foreseeable future? It's probable, but 26 years of market history could not be wrong. I still remember around 1995 when DJIA was about 4,200 points, I thought it was dangerously high and might crash like it did in 1987. In late 1996, when DJIA was around 6,500 points, the former Federal Reserves Chairman Alan Greenspan first used the words "irrational exuberance" to describe the US stock market. Yet today, the DJIA is around 16,400 points! And despite the rise of China in the past decade, it has been the US companies that have been the most innovative, introducing us to smartphones and tablets, social media, e-commerce, etc. If there is the next game-changing innovation, it will probably be coming from US. Even Warren Buffett has kept faith with the US "Old Economy" when he bought a railroad in late 2009 for US$44 billion including debt. He personally described the transaction as "an all-in wager on the economic future of the United States". You can read this article on whether the acquisition has been a good one after 4 years. Despite all the talk about the China economy replacing the US economy as the largest one in the world in the next few years, there is something resilient about the US economy that I have missed. So, while the switch to the LionGlobal US 500 Stock Index fund is not an all-in wager on the US economy, I too would not want to miss the train.

See related blog posts:

• Review of My SRS Investments
• Globalisation, Technology and the Home Bias
• Possibly The Worst Time to Invest