Sunday 29 March 2015

A Moment of Silence for Mr Lee Kuan Yew

This weekly blog will not be publishing any financial blog post this week as a mark of respect for Mr Lee Kuan Yew. Let's take this moment together to remember the contributions that Mr Lee and countless members of his generation have made to the Singapore we have today.

Sunday 22 March 2015

The Anti-Fragile Portfolios

Most investors will worry about a bear market. However, if you have an anti-fragile portfolio, then you should not need to worry about it. In fact, you should maybe even relish it should one comes along. What is an anti-fragile portfolio?

First of all, let us define what is "anti-fragile". The word "anti-fragile" comes from the book bearing the same name written by Nassim Nicholas Taleb. It is used to describe things that will become stronger from shocks. It is different from "robust", which just means things can withstand shocks but will neither gain nor lose from them. As Taleb himself is a former trader, he gave examples of what instruments are anti-fragile. One such instrument is options, which will rise substantially in price should an unexpected shock (also known as a "Black Swan" event) occurs. Thus, an example of an anti-fragile portfolio is a barbell portfolio comprising mostly of, say, conservative government bonds and a small portion allocated to instruments that would gain substantially from shocks.

Actually, some of the commonly known investment strategies do have some anti-fragile properties. I realised it unintentionally with my unit trust investments which are invested using Dollar Cost Averaging (DCA) strategy. 2 unit trusts -- an index fund and a balanced fund, were invested using DCA. During the Global Financial Crisis, the index fund fell by 55% while the balanced fund fell by 40%. Yet, when they recovered to their original prices, the more volatile index fund returned an annualised gain of 7.0% compared to only 3.1% for the less volatile balanced fund. You can refer to Dollar Cost Averaging Works Best with Volatile Stocks/ Unit Trusts for more info.

Another investment strategy that has some anti-fragile properties is portfolio rebalancing. When setting up my passive portfolio, I had run some simulations and back-testing to see what sort of stocks and bonds would provide the greatest returns in the long run. The results show that stocks and bonds with the greatest volatility actually provide the best returns. You can refer to Volatility is Your Friend for more info.

It should be highlighted that the above 2 investment strategies have some major differences compared to a barbell portfolio. With the latter, you will make small gains during normal times and significant gains when shocks happen. With DCA and portfolio rebalancing, the portfolios will drop in tandem with the stock market but will show large gains when the stock market recovers. I call them "anti-fragile" because they have the ability to bounce back from a market shock and emerge stronger.

When I set up my passive portfolio in Dec 2013, I had not picked the most volatile stocks and bonds. The stock component was a global index fund while the bond component was a global bond fund. Both funds were global in geographical coverage so as to reduce country-specific risks. So far, the returns from this portfolio has been pretty good, at 12% over a 14-month holding period, although the anti-fragile property of it has not been tested yet.

This time round, I'm setting up a more spicy passive portfolio with components that are more volatile. In Oct last year, I blogged about the US stock market being one of the best performing stock markets over a 26-year period in Not All Market Indices Are Equal. So, the stock component is the LionGlobal Infinity US 500 Stock Index fund. The bond component is Fullerton Asian Bond Fund. Like the non-spicy passive portfolio, the mix is 70% stocks and 30% bonds, to be rebalanced whenever the allocation exceeds the original allocation by 8%. Both components are non-global and therefore subject to more risks. So, if my analysis is correct, this spicy passive portfolio should perform better than the non-spicy one over the long run. Let us see if it really is.

P.S. I am currently in the busy phase of my project, so I won't be able to respond to your comments. Hope to seek your understanding on this.

Sunday 15 March 2015

Possibly The Worst Time to Invest – A Year On

About a year ago, I blogged about setting up a passive portfolio comprising of 70% stocks and 30% bonds and discussed whether it could the worst time to invest, considering that the Dow Jones Industrial Average (DJIA) was near an all-time high and the Federal Reserves was planning to raise interest rates from an all-time low. You can read more about it at Possibly The Worst Time to Invest. After a year has passed, how has the portfolio performed?

The portfolio was started in Dec 2013 with a lump sum investment. Since then, an additional investment amounting to around 13% of the intial investment was made in Mar 2014. Dividends received from the bonds were also reinvested back into the bonds. Other than that, the portfolio was left untouched and the market conditions did not trigger any rebalancing. After 14 months of investing, the portfolio has grown by around 12%, which is quite a respectable amount. Thus, if you have a good game plan and a good defence in place, do not let the current market conditions stop you from investing, because nobody can predict accurately when it is a bad time to invest.

You might counter that compared to a year ago, today's conditions are a worse time to invest than last year, with DJIA touching yet new highs and interest rates already starting to move up. But without using hindsight, would you agree with me that this time last year, the risk of a market correction is equally real? In fact, the stock market did encounter some turbulence in Oct last year. Not only that, oil prices crashed by more than 50% in the space of less than 6 months, currencies of oil-exporting countries depreciated, China's growth slowed down and Greece was at risk of exiting the Euro zone. All these are real occurrences, but they did not bring down the stock market, except for a brief period in Oct and for oil-related stocks. In essence, there are always worrisome events that can stop you from investing, but if you do that, you would also miss out on any gains in the stock market during the period you are out of it.

Some of you might be increasing your war chest in preparation of the coming bear market. Shoring up your defences is always a good thing, but too much of a good thing can become a bad thing. Even if a bear market is really coming, does it mean that an investor with 100% war chest will definitely do better than another investor with only 50% war chest? Much will depend on how these 2 investors deploy their war chests, how long and how low they think the market would go, and what stocks they buy. The key issue is, besides having a war chest, do you also have a good game plan to go with it? Besides, you know that inflation will erode the value of your cash if you keep too much of it. One thing I found out after 15 years of investing is that you can actually lose more money to inflation over a long period of time than to a single bear market. See Inflation - The Silent Killer for more info.

For new investors, you might think that the worst thing that can happen to your investments is to have a severe bear market shortly after you started investing. This is actually recoverable. I started investing my Supplementary Retirement Scheme (SRS) account in Nov 2007. Shortly after that, the Global Financial Crisis began and my index fund fell by more than 55% in price. Yet, when the fund recovered to its original price in Oct 2014, it provided an annualised return of 7.0%. You can read more about it in Review of My SRS Investments. The key strategy to this recovery is the use of Dollar Cost Averaging to invest in this index fund.

Actually, having a bear market just after you started investing is not the end of the world. The worst thing that can happen to an investor is to have a severe bear market just before retirement, not just after investing. To a young person who has just started working and investing, the amount of money invested is small. Not only that, he has 30 years of incoming cashflows from his job to fund his investments. But to a person who is just about to retire, he probably has a lot more money invested. To make things worse, he has 20 years of outgoing cashflows from his investments to fund his retirement. The longer you prevent falling down, the more painful your fall is.  

Like Life, investing is not about preventing falls. It is more important to learn how to fall down with minimum hurt and pick yourself up. The first time you fall down, it is going to be very painful, it might even bleed or leave a scar. But if you learn how to pick yourself up after a fall, then no amount of falls will bring you down. Each time the market brings you down, you will pick yourself up and become stronger. Some of the more experienced investors will tell you that one of their proudest things about investing is to survive and thrive in many bear markets! So, do you have a good game plan to thrive in the next bear market?

P.S. I am currently in the busy phase of my project, so I won't be able to respond to your comments. Hope to seek your understanding on this.

See related blog posts:

Sunday 8 March 2015

To Invest Or Not To Invest?

If you have followed my previous 2 blog posts, you might be confused whether investing is easy. On one hand, I mentioned that there are ways to invest wisely. On the other hand, I also mentioned that investing is not a bed of roses. How should you make out of these 2 seemingly contradictory blog posts?

First and foremost, investing is really not easy. You know that the trick to making money is to buy low and sell high. You may also have a plan to ensure that you buy low and sell high. You also know that if you invest at the bottom of a bear market, you will make a lot of money. However, when that bear market happens, your existing portfolio will be showing a lot of losses. Assuming you have a portfolio of 20 stocks, easily 15 of them would be in the red, with a few of them so deeply in the red that it is virtually impossible for them to recover to their original prices. The sea of red can be very frightening. The more you try to save your portfolio by bargain hunting, the deeper in the red your portfolio becomes. You do not know for sure whether the market will sink deeper or when your war chest will be exhausted. When that happens, are you sure you still have the conviction to stick to your plan of buying low and selling high? The worse thing that can happen besides losing money is to lose your confidence. If a stock loses 50% of its value and you still have confidence in it, you would hang on to it. But if you do not have the confidence, even a 5% drop would prompt you to sell it off. Besides losses in the market, other things could happen at the same time, which will further weaken your confidence. La Papillion has written a wonderful blog post on what could happen during a severe market crisis such as the Global Financial Crisis. It is so good that you should read the original.

While active investment strategies are losing confidence, it is business as usual for passive investing strategies such as Dollar Cost Averaging (DCA) and portfolio rebalancing. With DCA, you invest a constant amount of money in the stocks or unit trusts on a regular basis regardless of whether the market is a raging bull market or a rampaging bear market. Every month, you drilled yourself in putting money into the stocks or unit trusts. This drill will continue during the months of a bear market. With portfolio rebalancing, you check whether the allocation to different asset classes have drifted far away from the intended allocation and rebalance the amount allocated if it does. Just like DCA, you drilled yourself to check the allocation every few months and rebalance when needed. Even though actual rebalancing only takes place occasionally, you will not hesitate to rebalance when the time calls for it, even during a bear market. 

One crucial reason why it can be business as usual for passive investment strategies is they usually do not run out of "bullets" for investing. This means that they will outlast any bear market. With active investment strategies, no matter how huge your war chest is, it is actually finite because you do not know how fast you are going to deploy it nor how long the bear market will last. With DCA, the small but steady stream of investment cashflow is comparably more infinite if you have already bought adequate insurance and set aside sufficient funds for emergencies. With portfolio rebalancing, you do not need to add more cash to your portfolio. The war chest is the portion that you allocate to bonds and cash. While the war chest will keep on shrinking as you continue to rebalance out of it as the market drops, every remaining dollar in the war chest buys you more of the same stock or unit trust. You can keep on rebalancing until the bear market bottoms out. When you are still standing when the bear drops off, you are going to recoup all the losses lost to the bear market and make money when the bull market takes over.

To conclude, investing is not a bed of roses. But there are ways to invest wisely.

See related blog posts:

Sunday 1 March 2015

Investing Is Not A Bed Of Roses

Do you walk away with the idea that investing is easy after reading investment blogs? That all you have to do is to invest the money and the returns will roll in on a regular basis in the form of dividends? In a way, I am guilty of this as I subconsciously relegate blog posts on how to survive a bear market to the back. After all, who would be interested to read blog posts such as "How to survive a harsh winter" when the season now is summer?

Investing is not always easy, especially during the depth of a bear market. No matter how vividly we describe the situation, it is difficult for the reader to appreciate it without experiencing one himself. I once have a colleague who remarked that my paper losses in stocks should not be painful, since the losses exist on paper only. One day, he bought into an Investment-Linked Policy (ILP). The ILP dipped 2-3% in value after a couple of weeks. He could not accept the paper loss and sold it off. Paper loss is real for those who experience it. Even when you just watch a crash happening without any money invested, the experience is very different from a crash you are directly involved in. Prior to graduation in 1998, I had watched several market crashes unfolding as I monitored my father's portfolio while he was working. I thought that experience would prepare me well for the crashes I would encounter when I start investing with my own money. Still, when the first crash happened during 2000-2003, I had to stopped monitoring my portfolio as the losses were too great to bear. Investing is not a bed of roses even though it might seem easy at some point in time. You can refer to Behind Every Successful Bear Market Recovery is A Cash-Like Instrument for a brief description of the situation during the Global Financial Crisis in 2008.

Even though bloggers who have experienced a market crash seldom blog about survival techniques in the bear market, a number of us have built in defences in our portfolios. The most common defence is keeping a war chest ready to be deployed when the market crash happens. Other defences include having a regular stream of cash that could be invested, such as an income and/or dividend stream. Yet others include diversification into different asset classes, portfolio rebalancing and Dollar Cost Averaging. I have written about such defences in Possibly The Worst Time to Invest. For a more technical discussion on risk management techniques, you can refer to A Comparison of Risk Management Tools & Strategies. Generally, based on past experience, simple defences such as keeping a war chest works better than more technical ones such as computing Value-at-Risk losses.

Also not always blogged about is the need to have adequate insurance and an emergency fund to cater for emergencies. It is not pleasant to be forced to sell off your investments at depressed prices to raise cash when emergencies happen. While we bloggers might not constantly blog about these things, they are some of the most important things to have before you start investing. To be able to reap the benefits of investing, you must first have a good defence.

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