Investing Demystified
Page 15
There is unfortunately not a great amount of good and reliable data on private investments (outside the more institutional methods like venture capital, etc.). Many involved with private investments are notoriously bad at sharing performance data with the wider world. This is probably because many high-net-worth investors are reluctant to share information about their private portfolios, although exposure to the tax authorities may also play a role.
Poor information non-withstanding, according to a recent survey of studies on angel investing6 the average annual return to angel investors was 27.3%, which is obviously phenomenal. I would, however, suggest that there is an extremely heavy selection bias (only good results get reported, or people start reporting only after getting good results), and that if you had blindly invested in all angel deals the returns would have been substantially lower and perhaps fairly unimpressive. The report also states that 5–10% of the investments make most of the profits and the majority fail.
We all live in hope of being the first investor into the next Google or Facebook, but reality is probably far less glamorous. For most investors, making that investment has the probability of a lottery ticket even as many recount their near misses. But of course some people have become rich buying lottery tickets. I was president of the Harvard Club featured in the movie about Facebook (The Social Network) and knew people close to the founders. The endless ‘could have/would have/should have’ stories have inevitably followed.
Generally, and beyond the scope of this book, here are a few things to think about if you are considering potential private investments:
Edge Are you in the analytical or informational position where you are the right person to be making this investment? A private investment may be a bit like buying a lottery ticket – a bad idea if you have average odds, but potentially interesting if you can better your odds somehow. But someone who is without an edge or advantage who blindly invested in every private deal that came her way would see a queue of people trying to take her money and would soon run out.
Portfolio How does the investment fit in with your other assets? Would it tend to go wrong at the same time as everything else? Is it related to your job or area you live in? If you have several of them do they represent a substantial portion of your assets that may act similarly to each other?
What do you invest? A lot of private investments become very time consuming in addition to the money invested. Are you getting paid for the time and expertise? Of course you may think it’s fun and could lead to future opportunities.
Liquidity Private investments tend to be very illiquid and there will often be no ‘bid’ for your stake. At least for short-term financial planning you should probably treat a private investment as ‘dead’ money.
High failure rate There may only be a 5–10% success rate in angel/private type deals. While the pay-out in case of success may be great you should be ready to lose the entire investment. Think about how this extremely high risk/return profile will affect your portfolio and investing life in general.
If you overcome some of the issues involved in making private investments there are some potential great advantages including:
There are often tax advantages to private venture-type investing, particularly in development or clean tech sectors. Use them!
You can use your expertise and skillset to add to your profits.
Depending on the investment there are potentially large pay-outs that an investor investing in broad indices will not have in general (markets don’t go up 100 times). In a book that is extremely anti-get-rich-quick, for the lucky/skilful few, private investments can offer the rare exception.
If private investments are not dependent on general economic conditions, etc. they may be a good diversifier to the rest of your portfolio where the various assets will generally be correlated.
If you make a private investment, despite being a rational and cautious investor, you will probably only do so after long study and serious consideration. This will probably serve you well. Good luck!
Collectibles
Occasionally there will be news about the sale of a painting for an eye-watering sum, triggering a discussion about collectibles as an investment. Collectibles can mean lots of things, but often include art, coins, vintage cars, antiques, coins and stamps – but also esoteric things like sports memorabilia, books or netsuke.7
The issue with collectibles as a financial investment is that it is hard to buy an index type of exposure to a broad range of them. You can’t typically buy one-thousandth of a Renoir painting, only the leg of an antique chair or a sip of a fine wine. You are forced to pick individual items. If you are a great expert in a collectibles field then that may be a profitable venture, but if you are not, then chances are it is a losing proposition even if in some places there are tax benefits from owning art. You can, of course buy shares in fund-like structures, but even these only buy a small sub-set of the market.
While there are certain indices that suggest that art has been a great investment,8 they suffer from a few shortcomings. For one, the studies often focus on segments of the art world that have been successful, suggesting selection bias, and are typically not easily replicable, so gaining exposure to them is not feasible. Also, many indices and the past performance of collectibles ignore the large transactional costs, insurance and storage costs. When you include all of these costs the return from collectibles is far less obvious, and you should not include them in the financial part of your portfolio.
There are, of course, non-economic reasons for buying collectibles. On top of the hope for a financial return, investors in a painting could derive great value from looking at it or reading a first edition book. Similarly, a stamp collector or someone driving in vintage car rallies may derive great pleasure or prestige from ownership. On a larger scale who had heard of Roman Abramovich or Mansour bin Zayed (owner of Chelsea and Manchester City football clubs respectively) before they bought their clubs? I don’t think either expects to make money from ownership. Their objectives were perhaps prestige and having fun, both achieved in abundance if you ask me. And to that end they have spent the equivalent amount of their net worth to that of an average person buying a bicycle.
The non-economic benefit from owning collectibles obviously depends greatly on the individual and is very hard to quantify. Since most people gain some non-economic benefit from owning the asset, if you are purely a financial investor you will probably be disappointed. Perhaps a better way to think about collectibles is to be sure that you collect something you enjoy and that you are at least a reasonable expert. Combining the financial and non-economic gain from the investment may make it a worthwhile undertaking.
1 Although I would generally caution you against leverage, a mortgage on your property is often the cheapest form of leverage you can get, both because of tax advantages, but also because lenders are willing to lend you money at good rates against a fixed asset like your property. So if you need to borrow money and can do it through your property then that may be the cheapest way.
2 Although the quoted property investment companies that are represented in the index trackers only represent a small proportion of the value of the world’s total property that is also true of many other industries. Also, if this small quoted representation of property holding suggested that those quoted were extra attractive we would trust the market to have this reflected in the share price relative to other securities.
3 According to Richard Ferri’s excellent book All About Asset Allocation (McGraw-Hill Professional, 2010) about two-thirds of the total value of commercial property in the US is owned by corporations, many of which you are already invested in through the general equity market index.
4 There is obviously a millennia-long price history of commodities, but to my knowledge not in an aggregated index that can be replicated in financial products like ETFs or mutual funds.
5 The total return index includes interest on the ‘free’ cash when investing in futures.
The collateral on a futures contract is typically 5–10%, leaving 90–95% of capital free to be invested. The assumption is that this money is invested in treasury bills.
6 ‘Historical Returns in Angel Markets’ by David Lambert from Right Side Capital Management www.growthink.com/HistoricalReturnofAngelInvestingAssetClass.pdf.
7 The Hare with Amber Eyes by Edmund de Waal traces the history of a family netsuke collection through a century of tumult. Perhaps far-fetched, but a lesson from the book is how the netsuke maintain monetary and emotional value as the world collapses around them.
8 See for example www.artasanasset.com
part three
Tailoring and implementing the rational portfolio
chapter 10
* * *
Financial plans and the risks we take
Any financial planner worth his or her salt will tell you that the amount of money that you have to spend in retirement will depend mainly on the amount of money you start with, how much you contribute to your savings, the rate of return on your assets and the taxes you pay.
But let’s get concrete. As an example, suppose we wanted to find out how much we have to put aside each year to live comfortably in retirement. I will cover the opportunities and issues with pension plans and insurance-related savings products like annuities later, but for now assume you are saving up and have the luxury of ignoring tax.
Building your savings
Suppose you are 30 years old and have savings of £10,000 after finally paying off your student loan. Let’s say you expect to work until you are 67, and plan to be able to put aside £10,000 a year in today’s money (so real numbers) for your retirement. To be comfortable in retirement you think you’ll need £20,000 a year in today’s money (inflation will make the future number bigger but be equivalent to £20,000 of purchasing power today) on top of other pensions (e.g. the state pension) you have and you expect to live to 90.
Because you are a prudent person you have decided that the way forward is to put half your savings into the minimal risk asset and the other half into world equities. To ensure that the ratio between the minimal risk asset and equities does not get too out of kilter you plan to rebalance the portfolio every year to ensure that the split is 50/50 at the start of the year. The plan is then to move everything (i.e. 100% of your portfolio) to minimal risk assets when you are 67 and will start needing the money.
You may expect to make 0.5% on the minimal risk asset and 5% on the equities (0.5% + 4.5% equity risk premium) before minor fees. While the risk of the equity return has more frequent extreme outcomes than suggested by standard statistics – called fat tails – the annual standard deviation (SD) of that equity return is probably in the range of 20%. Taking into account these fat tails we increase our standard deviation assumption to 25% (a simplification).
To get an idea of the probabilities of having enough money in retirement here is a relatively simple excel model. The inputs are summarised as follows:
You expect to live to age 90 and wish to withdraw £20,000 in today’s money each year after you turn 67, so you will be withdrawing a total of £460,000 for your 23 years of retirement spending. Taking into account that you will make 0.5% on your investment in the minimal risk asset even in retirement you ‘only’ need approximately £434,000 in assets when you turn 67 to have enough money. This is of course excluding the fact that you probably want to have a buffer of additional money in case you live to be more than 90 (unlike an annuity, the buffer is not ‘lost’ when you die – it goes to your descendants)
So will you have enough? Well that depends on the volatility of the equity markets. The results are striking and highlight some important points.
I set up the model to re-run itself 1,000 times with the equity returns generated by a random function. Basically I told the computer to play this game 1,000 times where the return on average was 5% per year, but that this return should vary with a standard deviation of 25%. (Chapter 6 on risk discussed how this is roughly what risk has been in the past, and explained what that meant.) In roughly 68% of the cases the return on equities will be within a range of −20% to +30% (one standard deviation from the mean; average of 5% return and then add or subtract 25% depending whether it is a negative or positive 1 standard deviation move).
The 1,000 iterations of the model reveal greatly varying results. If equity markets are good between now and your retirement you will have far more money than you planned to spend. However, if equity markets between now and retirement are bad, the savings are far from enough to cover the future outgoings and you potentially have a serious problem. The results from the iterations are as follows:
The numbers above represent the outcomes of the 1,000 iterations and are based on the inputs above. The only thing that makes the outcomes vary so much is the impact of having the equity returns vary in risk by a standard deviation of 25% per year (more or less in line with what world equity markets have experienced).
The point I am trying to make is that the uncertainty of equity returns can lead to very large fluctuations in outcomes over a long time horizon and that you as an investor need to be aware of that and plan for it in your financial planning. Depending on how strong or weak equity markets are between now and retirement you might have less than half the money you need, or almost 10 times as much as you need. Those are pretty wild swings, brought about by decades of taking risk in the equity markets. I’m obviously not saying that you should rigidly stick to the strategy above, but the point remains that long-term financial planning can lead to a wide range of outcomes once you introduce risk into the portfolio.
Expected outcomes
If we are as lucky (or unlucky) as the average person we would expect to have the median amount of money, not the average. This has to do with the average versus compounded returns. Suppose two people over a two-year period had the following return profiles:
These people would have had the same average return. But when you compare the returns at the end of the two-year period the person with the least variation in her returns has the higher cumulative returns:
Simply put, this is the same scenario as in our example above. Because the returns vary greatly from year to year, the aggregate return at retirement will be lower with volatile returns than if we had been able to secure the average return every year.1 While beyond the scope of this book, this realisation that as an investor you will over time fare worse than the compounding of your average returns is a critical and often neglected part of finance. You can’t eat average returns – you eat compounding ones.2
So, in returning to our model where we ran 1,000 iterations, the outcome we should expect if we are exactly in the middle is the median, not the average. If this was 1,000 outcomes, then we should expect the 500th, or median outcome.
Figure 10.1 shows the amount of money in our investment account at the age of 67, and the percentage of iterations that fall within various bands.
A couple of things are probably obvious about the graph:
Most cases cluster around the median return, but there are also a few very positive outcomes where we end up millionaires.
There are a high number of outcomes where we were unlucky and ended up with savings short of what we needed for retirement.
Figure 10.1 Amount in investment account at age 67 and percentage of iterations falling within various bands
In my view, this second point is critical and goes to the heart of investment management and the risks we are willing to take with our financial lives.
As outlined above, we need to have accumulated approximately £434,000 by the time we are 67 in order to be able to withdraw £20,000 a year until we are 90. We also know that in the average (median) case we would have assets far in excess of that requirement. But now we also know that in a large number of cases our savings will fall short of that required:
Cases above £434K: 81.2%
Cases below £434K: 18.8%
So in nearly 19% of cases you will not
have enough money for your retirement goals.
To most people a probability of approximately 20% that you will fail to meet your goals would cause great concern, particularly as you probably want some sort of additional reserve in case you live past 90. But what can you do about it?
As a rational investor, the worst thing you can do is to abandon your principles and pursue the promises of higher returns from various active managers or investment schemes. While you may get lucky, on average it would only make the situation worse.
In effect we have a few choices:
We can contribute more annually.
We can start with a higher amount.
We can accept a lower annual amount in retirement.
We can shift the mix between the minimal risk and equity to lower our risk, but at the expense of a lower expected asset base at the age of 67.
The super-cautious saver
If you are unwilling to take any risk that your savings fall short in retirement you could invest only in the minimal risk asset and your savings at age 67 would be £497,000, and far in excess of the £434,000 needed. By allocating some money to equities your expected savings would go up, and while that extra money would surely be nice to have it comes with a risk that there will not be enough. The greater proportion you allocated to equity, the more your median savings will be, but you will also increase the risk of falling short. The security of allocating entirely to the minimal risk asset comes at the expense of having significantly lower expected assets at 67 than if you had allocated some assets to equities – but that is a choice you have.3