Before getting into the third and final instalment of lessons learned over the past 30 years, we start with a quick review of the week.
The US market is making an assault on its May 2015 peak. Earnings are falling but stocks are rising. Doesn’t make sense, but then again a lot of things since 2008 haven’t made sense.
This is the world of central banker manipulation, where the impossible is now possible. You can lend money to a government or European corporation and, courtesy of negative interest rates, pay for the privilege.
The Germans think enough is enough. The Australian Financial Review reported on Wednesday:
‘[German Finance Minister Wolfgang] Schaeuble’s belief that the ECB’s ultra-easy monetary policies will ultimately prove disastrous is so strong that he is now ignoring the convention that requires politicians to respect the independence of central banks by not commenting on monetary policy.’
Most politicians wait until they leave office to talk sense, so Schaeuble’s comments are a refreshing change.
The increasingly desperate actions of central banks are leading us down a path of economic destruction, and in spite of protest from Germany, powerful vested interests means there’ll be no deviation from this course.
The Mexican Government had to extend a US$4.4 billion lifeline to its ailing state owned oil company Pemex. According to CNN Money:
‘…the state-owned oil company is under serious financial stress, forcing it to cut jobs and slash spending. Pemex lost nearly $10 billion in the final three months of 2015 alone.
‘Pemex admitted it was facing a “liquidity problem” due to the “difficult situation of global low oil prices.”’
Sound familiar? This story of financial distress — due to the fall in commodity prices — is being played out all over the globe.
China’s US$21 trillion debt binge from 2008 to 2014 pushed commodity prices through the roof. Far too many business people believed the illusion, and geared up for the good times to continue indefinitely.
The oil price has retraced some ground from its low earlier this year, but is it a bounce or a recovery? What happens when the US dollar starts to strengthen again?
There is more pain ahead.
The businesses that are facing financial stress, in my opinion, did not properly assess risk. They did not ask the question ‘if prices fall to $X, what would be the impact?’
With risk assessment in mind, here’s the final instalment of the lessons learned series.
Higher risk can mean greater loss
Have you heard the saying ‘High Risk/High Return’? It’s not entirely true. In some cases high risk pays off handsomely. However, high risk can mean greater losses.
Financial planners must (as a matter of compliance) undertake a risk assessment on clients. This usually involves a series of questions designed to unearth the inner risk taker or risk avoider.
Some risk assessment questionnaires are more detailed than others, but in my opinion there’s a flaw in this assessment process. Social mood tends to ebb and flow with market movement. In 2007, after nearly four years of 20+% per annum returns, subconsciously investors tended to gravitate towards the higher end of the risk curve.
Ironically the client risk profile indicates their willingness to accept greater risk at exactly the same time the market contains the most risk.
The common perception (consciously or not) is, ‘If I accept higher risk I will participate in the higher returns.’
Unfortunately, accepting higher risk at a market top is a recipe for greater losses. Just ask anyone who invested in the markets with a margin loan in 2007.
Conversely, when a market has performed abysmally for an extended period, the risk appetite is almost negligible. This is precisely when capital should be allocated to an unloved and undervalued asset class.
Personally I prefer a low risk/high return investment profile.
How is this possible? Buy low and sell high.
Far too many people buy high and sell low.
A disciplined approach to value investing, using a number of long term valuation metrics, can assist in determining when markets are a ‘buy low’ or ‘sell high’ proposition.
Do not invest for tax reasons
No one likes to pay more tax than they have to, but never invest solely for tax reasons. The taxman tells you up front the percentage of your income and capital gain he intends to extract from you. The market does not give you any indication of the percentages it can take from you.
If you are a successful investor, you must pay tax. There are certain structures you can use to minimise tax, but ultimately the investment must be sound.
Over the years there have been numerous agricultural, film, wine, cattle and tree schemes that offer attractive upfront tax offsets. Very few schemes have been successful. The majority have failed, and provided a great source of revenue for receivers.
Negative gearing and depreciation allowances are enticers used by the property industry to make an investment appear more affordable. What happens if the government of the day (in search of tax revenue) abolishes negative gearing and reduces the depreciation allowances?
Personally I would rather have a positively geared investment property (rental income exceeds interest and other holding costs), and am more than happy to pay tax on the additional income.
Being motivated to invest primarily for tax reasons is an error of sound investment judgement.
Think of it this way. A massive capital gains tax bill means you have been a successful investor. Far better than having a capital loss to carry forward.
If it sounds too good to be true
Listen to your inner voice. If it’s saying ‘this is too good to be true,’ take the advice. You may genuinely miss out on the once in a lifetime opportunity, but from my experience you have more than likely dodged a bullet.
Guaranteed rental return is one ‘too good to be true’ that comes to mind. In reality the property developer (while they remain in business) guarantees to give you back your own capital as taxable income.
Another favourite is ‘proven system for growth’. The Chinese government is the only group I know of that has a proven formula for growth. They pump vast sums of money into infrastructure spending, and then pluck a growth figure out of thin air. Guaranteed growth at the press of a button. Unless the corporation offering you the ‘proven system’ is backed by the Chinese government, forget about it.
A few years ago I remember reading about a group marketing a trading programme. They boldly claimed a ‘proven track record of 800% per annum growth’ over so many years. Sounds impressive, until you do some quick math. If your initial investment were a mere $1, five years of 800% p.a. growth would make your portfolio greater than US GDP.
Nigerian scams, lotto wins in foreign countries etc. continue to thrive because of people’s gullibility.
The prospect of a quick road to riches or instant wealth is tempting. The harsh reality is ‘the too good to be true’ is a salivating wolf in sheep’s clothing.
The magic of math
There is an old saying that, ‘The market goes down by the elevator and up by the stairs.’ If a market loses 50%, for you to break even it has to recover 100%.
The 50% loss can happen in a blink of an eye, whereas the recovery process can take years. Look at the All Ords graph from Lesson 2. More than eight years later, it’s still well below its 2007 peak.
Calculating your downside is far more critical than focusing on your potential gains.
As an example, one of my investments in 2012 was to buy US Dollars.
Buying in at $1.05 my guess was the downside was probably 5% (if the AUD rose to its previous high of $1.10). However the upside could be over 100% if the AUD falls heavily into the $0.50 range (which happened in early 2000s).
To lose 50% on this investment, the AUD would have to appreciate to over $2 against the USD — highly unlikely. In relation to this investment in USD, there was limited downside (perhaps 5%) with a very high upside (potentially 100%). In my opinion this qualified as a low risk/high return opportunity. To date this investment has been profitable.
To update readers on my market thesis, I am strongly of the opinion the share market could fall up to 80% to 90% in value over the coming years. Sounds dramatic. However, mathematically it’s possible if the S&P 500 P/E ratio revisits its Great Depression low and US corporate earnings revert to mean.
Time will tell whether this transpires or not. However, for the point of this exercise let’s assume the market does fall 80% in value and the All Ords index comes to rest around 1000 points.
We know the market never moves in a linear fashion — so zigging and zagging its way to an 80% correction is going to leave a very jagged line on the index graph.
Let’s say the market falls to around 2500 points (approximately 50% below the current level). At that level plenty of people (understandably) will be saying to buy.
However, thanks to our crystal ball we know the market is destined to go to 1000 points.
Therefore a buyer at 2500 points — even though they dodged the initial 50% fall — can still lose 60% of their capital value (the fall from 2500 points to 1000 points).
To make their dollar whole, the market would need to rise 150% (from 1000 points to 2500 points). As we have seen since the GFC, this level of gain does not happen overnight.
If my Secular Bear market thesis becomes a reality and the market falls much harder than anyone ever anticipated, my strategy for readers of Gowdie Family Wealth is to dollar cost average in their exposure to investment markets. This is a proven risk management strategy in markets driven by fear and panic.
Understanding the math is absolutely critical to your ability to take calculated risks.
In a boom investors (inexperienced and experienced alike) ‘hang on tight and enjoy the ride’. Everyone’s happy. Rarely is the sustainability of the boom questioned. Don’t jinx the market. Enjoy it.
But we know from history that the party always ends.
In my experience investors are not mentally prepared for the bust…especially one that wipes 50+% off market values. There is rarely a Plan B. No-one told you this could happen. Which explains why the default position is panic followed by fear…and plenty of it.
My Plan A is also my Plan B. My strategy is firmly focussed on understanding the downside…what can go wrong and if it does, what is the likely cost? Is this an acceptable or unacceptable cost? If these factors have been accurately assessed then you can make a reasoned decision on where to allocate your capital and the upside can take care of itself.
Knowing your tolerance for loss is far more important than dreaming about the riches that await you.
Personally my tolerance for loss is around the 10% to 20% level. Any more than this would make me uneasy.
The following chart of the S&P 500 index clearly shows the prospect of a significant fall from current levels is not without precedent.
What’s your Plan B for a fall from this height? If you don’t have one, seriously consider reducing your market exposure to a level that can handle the next (and possibly most severe) downward leg in this Secular Bear market.
Source: Yahoo Finance
My investment strategy these days is best summed as ‘Winning by not Losing’.
I sincerely hope these lessons have been of benefit to you, and assist in helping you make considered decisions with your finances.
Editor, The Daily Reckoning