‘How’d we go?’
‘On balance, it’s been OK.’
‘Run me through the numbers and please spare me the jargon.’
This was the gist of our dinner conversation on Tuesday night. The conversation was prompted by a meeting we had in Sydney the previous day.
While in Sydney we met with a good friend who runs a very successful hedge fund.
The fund he co-manages has returned over 30% this year (and in excess of 140% over the past three years). Impressive numbers when you consider the All Ords is down 5% for the year and over three years has posted a return of 10%.
I declared up front to my wife that it is unfair to benchmark our financial progress with that of our friend’s fund.
I reminded her of our investment approach. An approach we agreed upon based on our combined investment experiences.
Between you and me, I also gave this gentle reminder because his return was definitely bigger than mine.
We are passive, long term investors with a primary objective of capital preservation. We focus on risk — what is the potential downside? If we both agree the risk is within an acceptable tolerance (a 10–20% downside) then we invest.
If we assess the risk correctly, the rewards will take care of themselves. The fewer questions you have to ask yourself to back your assumptions, the better.
For example when we invested in US dollars at $1.05, the one question to ask was ‘what does the Aussie dollar have to appreciate to for us to lose 20%?’ The answer was ‘$1.26’. Highly unlikely the RBA would have let our dollar strengthen that much.
The more assumptions you have to make to validate your investment decision, the more chances that one of your assumptions will be wrong.
Keep it simple.
The same KISS process applies to our approach to share investments. We will only invest in a low cost ETF index fund.
Because all (and that’s a big all) we have to do is decide whether the market in general represents value or not. There are a number of historical valuation metrics that provide reasonable guidance in this regard.
This way we don’t have to pour over company balance sheets, do background checks on the directors, identify risks from competitors, calculate market demand etc., etc. If you get these assumptions correct, then you deserve to enjoy the fruits of your labour. However, get one or more assumptions wrong and you can tear up some serious dough. Been there and done that on both accounts.
You need an abundance of patience to follow this passive approach. There are no day to day thrills and spills. There are no high fives and hollering out loud when you get it right. It’s as boring as bat droppings.
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Back to the question, how did we go?
At the start of the year my outlook for markets was as follows:
- Australian share market would be negative. This has proven to be the case. The All Ords started the year around 5400 points and at the time of writing is 5150 points. A fall of nearly 5%. Add back dividends and the year has been pretty much a zero sum game for passive share investors. My expectation is there will be a greater level of loss next year.
- Interest rates would fall under 2%. The official cash rate in January was 2.5%. The RBA’s first meeting in 2015 (February) cut rates by 0.25%. Three months later, in May, the rate was lowered again by 0.25% to 2.0%. We didn’t crack the 2.0% mark, but the trend was correct. My outlook for 2016 is for our cash rate to head into the 1.0% range.
- The US dollar would continue to strengthen. The AU versus US dollar exchange rate started the year at US$0.81 cents. It’s currently hovering around US$0.72 cents, meaning we have made an 11% gain on this exposure. My view is there’ll still be more downward pressure on the Aussie dollar next year.
- Gold would maintain the same downward path it started in September 2011, when it peaked at US$1900. Considering the gold price in January 2015 was US$1180 (40% below its peak price) expecting a continuation in selling pressure was not a given. Currently gold is trading at US$1,070. In Australian dollar terms the fall in the gold price has been more than offset by the weakening Aussie dollar. Gold priced in Australian dollars has risen from $1460 to $1490. In August 2015 we invested 5% of our portfolio in gold. To date this investment has done nothing.
- Property — we’ve been long term owners of commercial property with solid rental returns. The yield is around 7% and based on some agent feedback tells us there’s been modest capital growth. But unrealised growth doesn’t interest us. It’s the income (bird in the hand) we focus on…because when it is all said and done you cannot eat unrealised capital gains.
When I apportion the gains, rental income and interest earned — we had some high earning term deposits mature during the year — across our portfolio, we’re nudging a 7% return for the year.
(I told you his was bigger than mine.)
All things considered this return was achieved with minimal downside risk.
Losses could have come if the dollar had appreciated. A fairly low probability in our opinion.
With zero exposure to shares, if the market had tanked we wouldn’t have been exposed to any loss.
The renewal of maturing term deposits has meant we ‘bake in’ lower overall returns into the portfolio. However, that’s a small sacrifice for security of capital.
Gold could fall further, but again with only a 5% exposure even a 50% fall in value would only mean a negative 2.5% to the portfolio. And if gold did fall 50% in value, we would seriously look at mobilising some of our cash to capitalise on that opportunity.
For us, our portfolio passes the sleep test. We do not go to bed worrying about money or what the US share and bond markets might do overnight.
Yes, there are always better returns on offer, but understanding the risk that comes with the reward is where most investors fail.
Even our very astute friend acknowledges that, in spite of his cautious and very considered investment approach, there could be a run of outs that impact negatively on his fund. That is the uncertainty, and at times irrationality, of markets.
Here’s a quick lesson on risk versus reward which some US investors are currently learning the hard way.
The Third Avenue Focused Credit Fund has frozen investor redemptions. The fund has US$780mln (it was US$2 billion at the star of 2015) invested in high yield (junk) bonds.
The fund started life in 2009 at $10 per unit, and the last research I could find stated the fund paid a yield of 10.94%.
Source: Yahoo finance
18 months ago the fund was flying high. The unit price had risen to $12, a 20% gain on the starting price. And investors received nearly 11% per annum income.
However, this is what original investors received. Looking at the chart, my guess is the push up in price during 2013 was when most investors piled into the fund.
Now the fund has lost half its value (last traded at $5.73) and there is no more income being paid. In all probability investors will only see a fraction of the quoted $5.73 value. A lot of these higher yielding bonds will end up being worthless.
Investors in the Third Avenue fund may have (temporarily) earned 11% compared to our meagre 7%, but that extra 4% came with one hell of a cost. 100% downside.
When reviewing the year that was, my wife was satisfied we did OK in the context of where we are at in life, our risk profile and our investment philosophy.
Happy wife. Happy life.
Editor, The Daily Reckoning