Investing Demystified
Page 12
7 By adding other safe bonds to your minimal risk bonds you are also diversifying your interest rate risk away from that of just one currency (you have exposure to a couple of different yield curves), but for the purposes of keeping the portfolio simple I don’t think this diversification is worth the added complexity and currency risk of those bonds.
8 We have left out the large and broad market of financial institution debt. This includes interbank debt, but also various obligations issued by financial institutions. This is less of a transparent market for the rational investor and someone with the broad exposures discussed in this book already have a lot of the same exposures via the existing bond and equity positions in their portfolio.
9 Occasionally the yield curve is inverted (long-term yields are lower than short-term ones). This is when the market is expecting the interest rate to drop in the future.
10 The straight line between minimal risk, point T, and up to the right assumes that the investor can borrow at the same rate as the minimal risk bond. In reality the borrowing rate for the investor would be higher and the curve to the right of point T would be flatter to reflect the lower expected return (higher borrowing costs) as risk increases.
chapter 8
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Incorporating other assets
This book is about making portfolio management straightforward and efficient. The overall message is simple:
Recognise that you are a rational investor.
Create a very simple investment portfolio consisting of minimal risk assets and the broadest possible equity index, perhaps adding other government and corporate bonds.
Think about your risk profile and how it may change over time and as the world around you changes. Adjust your portfolio accordingly.
Implement the portfolio in a way that is tax efficient. The suggested portfolio will already be extremely liquid, which is great. Get help on taxes if you need it.
Make sure you purchase the portfolio in the most cost-efficient way. This is worth a bit of time up front.
Don’t get impatient. The rational portfolio will be much better for you over time, but you will probably not see the cost and portfolio construction benefits immediately.
In my view, at this point you are doing better than 95% of the investing community. The remaining 5% have an edge and you can’t compete with that. Nor should you try.
Your investment portfolio is obviously not the whole story; you have other assets and potentially liabilities. For an individual this could be a house, private investments, stake in a family business, a plot of land, and perhaps even less tangible elements like a future inheritance, your education or skillset. For an institution the asset base could be future business prospects, your people, etc. Likewise your liabilities could be manifold, other than just the mortgage on your house.
What else do you have?
Many investors think of their investment portfolio as separate from the rest of their lives. While that is probably convenient, an investment portfolio should be seen in the context of, or at least be influenced by, the other assets or liabilities a person or institution has.
Most investors tend to take quite concentrated risks, often without giving it too much thought. As an example, if you work in the property sector in the UK, own a house in London and stand to inherit a share of the family property business one day, you already have significant exposure to the UK economy and particularly the property sector. You may have a diversified rational portfolio with your investments, but you are still taking a large concentration risk in your overall economic life. If the UK property market went down the drain you would be in a rough spot, despite having done the right things in your investment portfolio. It could well be that the diversification benefits you gained from having a broadly diversified portfolio were dwarfed by the fact that the rest of your assets were so concentrated. You might be losing your job and any potential future job prospects, your house may decline in value and your inheritance be worth less, all for the same reason.
As unpleasant as the plight of the UK investor would be in the above scenario, compare it to the situation of an investment portfolio composed exclusively of UK property stocks. In that case all the assets would be falling at the same time and there would be no respite anywhere. The investor would have failed to take advantage of the opportunity to diversify and paid the price for it.
Similarly, consider if you owned a lot of shares in the company you work for. While companies are interested in aligning the interest of shareholders and employees, you would be taking a great concentration risk if something went wrong in the company. Not only would your investment in company shares probably be a far greater portion of your portfolio than if you did not work there, but you would have your job prospects and investment assets tied up in the same company. This is great if you were one of the first to join Microsoft, but horrible if your employer was Enron. Of course in many cases company shares or options are a part of compensation packages and obviously better to have than forego, but I would caution you against blindly adding to the concentration.
While it is of course possible that the UK property market or the company you worked for collapse for the same reason as the wider world economy, and therefore stock and bond markets also collapse, by having an international investment portfolio at least you guard against localised risks. Someone from Greece today, Argentina around the turn of the century, Thailand/Indonesia/South Korea during the Asian crisis in the late 1990s or any of the other countries that have defaulted over the past decades would perhaps better appreciate the advantages of avoiding local concentration risk. This was doubly true if they had mistakenly deemed local government bonds free of risk and to their horror found that they were not. The graveyard of financial history is filled with investors who claimed things to be different this time around or thought their country or area of expertise was immune to various risks.
Taking the argument a step further you could actively de-select your market in your investment portfolio. Instead of buying the world equities market, you could buy the world, ex-UK. The trouble with this of course is that most countries with the notable exception of the US only represent a small fraction of the overall world equity markets, and the advantages of this kind of diversification are therefore negligible. As the US markets represent over a third of the wider world equity market, de-selecting the US from the world equity portfolio may make sense for US investors who are worried about significant existing US exposure in their overall assets. Non-US investors will benefit less from this de-selection and at any additional costs it would probably not be worth the additional diversification benefits.
Other assets
Individual investors often tend to think too narrowly about incorporating all their assets when thinking about their personal portfolio. Your personal assets include everything, including intangible assets, and even potential liabilities. Here are a few ideas, some of which may seem far-fetched:
Tangible assets:
Investment portfolio
Future pension (who guarantees it?)
Security and generosity of government safety net
Insurance policies
Property holdings (do you own a house?)
Private investments
Company shares or options
Future inheritance (morbid perhaps, but do you have a sense of timing and how it is invested?)
Car and other possessions
Intangible assets:
Education and qualifications
Languages you speak
Current job and prospects (if you work in finance you already have a lot of direct and indirect exposure to the financial markets, and may want to temper adding to it through your investment portfolio)
Previous job experience (will affect future earnings potential)
Partner’s education and job
Geographic flexibility
Liabilities:
Flexibility of liabilities – will you certainly incur t
hem?
Future school fees or health bills
Mortgage
Credit cards, car, etc. loans (if you have any liquid assets you should never have loans like this – they are far too expensive)
Tax (including tax you would incur to realise assets)
Are any liabilities not fixed, but move up and down with the economy? How do they correlate with your assets (it’s better if they decrease as asset values decrease)?
Think of everything and think out of the box to compile your lists.
Of course it would be great if the performance of your various assets in no way correlated, but unfortunately that is not very realistic. Most things link to the economy somehow.
If we were presented with perfect data sets regarding the values, risks and correlations of an investor’s other assets we would be able to do some sort of scientific optimisation of asset allocation. That, however, is almost impossible. The idea of taking assets, including intangible ones, and optimising allocations based on them probably sounds like nonsense to most people. But while we don’t have the data or desire to do these calculations in a scientific way it’s still worth nurturing your gut instinct about how this all fits together.
A simple way to start thinking about the non-investment assets is asking yourself if there is something you really don’t want to happen, and go from there. Would you be in trouble if the local property market collapsed, or if you lost your job? Would you be able to adapt if the skillset you had educated yourself to was no longer required? Would the causes of these events trigger problems elsewhere in your overall asset base? Could you adapt?
Imagine the scenario where a major local business ceased trading. The thought processes of someone locally who was affected may look as follows:
In the context of an investment portfolio we want to minimise the probability that these things happen at the same time as a large decline in your investments. It could be that the industry you worked and were trained in all of a sudden shifted to China or India with job losses and bleak prospects for you as a result. This would be bad news for you. But in a case like that you can take solace from the fact that while this hurts you locally your rational portfolio is broadly diversified and perhaps not declining at the same time as everything else in your life is going wrong.
There is no generalised way to reduce the concentration risk outlined above. If you find yourself with too great a concentration risk try to find ways to divest some of the assets that add to this risk and re-invest those in a more diversified portfolio like the rational one. Unfortunately many people only worry about these issues after misfortune has hit.
Not just geography
I had a friend who was a successful internet entrepreneur. He had made some money from selling his internet business and was now launching the next one.
Because of the risk he perceived in his own business he did not invest too much of his money into the new venture. He thought the risk of it going badly was too high for him to risk his life savings. As a result, he invested his savings in various internet firms he respected and thought he understood quite well. It seemed to make sense; he was investing in what he knew.
Of course what happened was the massive internet crash that took everything down with it. His second venture failed – it ran out of cash as nobody wanted to invest more in the internet sector. Unfortunately this happened for the same reason and at the same time that my friend’s internet stocks plummeted in value.
Many people would probably consider my friend’s actions quite reasonable. He was aware of his concentration risk in his second company and diversified away from it, even including investing in other countries with his cash. But in the end the diversification was a false one – he was not diversified because the value of all his assets linked back to the same assumption, namely the internet continuing its meteoric rise.
Currency matching
Before the 2008–09 crash foreign-denominated mortgages were all the rage in certain parts of Europe. In theory it was simple. You could buy a property in Poland in zloty and finance that purchase with a Swiss franc-denominated mortgage. Instead of paying high single-digit interest rates on a Polish mortgage you would pay next to no interest on your Swiss franc-denominated mortgage because of the lower Swiss franc interest rate. Similarly some friends financed the purchase of their expensive London apartment with a mortgage based in Japanese yen and paid little in interest on their mortgage.
In both these cases there was a currency asset/liability mismatch. It may seem tempting to make only small interest payments in a foreign currency, but these set-ups involve foreign currency risk.
The financial markets are obviously aware of the interest rate differential and the forward rate (the rate at which you can trade the currency in the future) should reflect the interest rate differential. So if zloty/Swiss franc is at 3.50 and the nominal interest rate differential is 5%, all else being equal, the one-year forward currency rate is 3.50 × 1.05. If the spot rate moves less than 5% in the following 12 months the mortgage holder will be in profit; the interest differential plus change in principal outstanding would be lower than the payment on a domestic mortgage.
It is perhaps quite instructive that post the 2008–09 crash these mortgages are increasingly rare. The mortgage borrowers essentially took a large currency bet that currency markets were inefficient, which they were probably ill equipped to take. When the crisis hit and investors escaped to ‘safe’ currencies like the Swiss franc, the currency rallied from about 2 to 3 zloty per Swiss franc, and the zloty equivalent amount of mortgage outstanding went up. This happened exactly at the same time as house prices declined in Poland. Someone with a 1 million zloty house and 80% mortgage before the crisis, might have found themselves with a 750,000 zloty house and a 1.2 million zloty equivalent mortgage (0.8million × 3/2). Many investors went bust as a result.
The point is you have to weigh up a potential currency asset/liability mismatch against the benefits of diversification that investing abroad and in other currencies brings. If you have significant and specific liabilities in one currency it makes sense to have at least matching assets in that same currency in minimal risk-type investments (or like keeping the mortgage in the same currency that your house will one day be sold in) before diversifying investments into other currencies.
The institutional investor
Thinking about all your assets and liabilities in a portfolio context is not exclusive to the individual investor. Imagine you run a Florida-based insurance company. Your speciality is insuring beachfront properties in the Miami area against hurricanes. Business is good – so much so that you are in no rush to pass on any of the risks to the reinsurance companies. Like any insurance company you are building a reserve account from the premiums you collect in case a hurricane hits the coast and you have to pay out on lots of insurance policies.
Next you are presented with an excellent investment opportunity for your reserves; a property investment company that primarily invests in the same region of Florida. The project promises great returns, and you feel doubly good since you are already somewhat of an expert on the area. As a result you put a large part of your reserves into the project. After all, what’s not to like? Actually, there is a lot not to like …
The insurance company has taken a massive correlation risk between its assets and liabilities, and exposed itself to the perfect storm (no pun intended). Should a hurricane hit the coast the insurance company would see the size of its liabilities (the insurance policies) increase dramatically at the same time and for the same reason that the value of its assets (the property development) go down in value. On top of this there would probably be fewer buyers of property assets even at a lower price, as liquidity tends to dry up in distressed situations and the company would have a hard time realising the cash value when it was most needed. Bad, bad news.
The example above is fictitious; in reality no reasonable insurance company would put itself in such a situation, or th
e overseeing regulator would stop them (like they did with mortgage banks before 2008!). But the lesson remains: the combination of your assets and liabilities, and the risk you are willing to take, matter a great deal in your investment portfolio.
Other assets rethought
The material in this part of the book on incorporating all assets and liabilities in an ‘all-in’ approach to portfolio management may be seen as an extra or ‘nice to know’ area of portfolio management, but in my view every investor should consider it seriously. It’s an area that is developing as financial firms get better at understanding and incorporating additional information they have about you, hopefully with the result that they can more easily offer cheap products that are tailored specifically to your needs. While it is not central to the theme of the book I would strongly encourage you to think about your broader assets and how things fit together. If your broadly diversified investment portfolio only represents about 10% of your overall asset base and the remaining 90% is highly correlated and dependent on the same factors, the diversification of your investment portfolio may actually give you a false sense of security.
chapter 9
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What is omitted from your rational portfolio and why
Avoid investments that require an edge or those you already have exposure to
It wouldn’t surprise me if the portfolio I have suggested has many sceptics. It probably looks too simple to make much sense, and leaves out several successful asset classes that have dominated not only the financial press, but also our popular culture. I live in London, a city which has seen an incredible rise in property prices over the past decades. Because of this most investors take for granted that any reasonable portfolio consists at least partly of domestic property. London is one of the places in the world that came through the crash relatively unscathed so the fans of property maintain their continuing belief.