Sunday 30 November 2014

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.


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:

Sunday 23 November 2014

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.

Sunday 16 November 2014

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!

Wednesday 12 November 2014

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.

Sunday 2 November 2014

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.