Inflation – The Evil Twin


Inflation erosion

We touched on the subject of inflation before in a previous post on benchmarking, but I would like to return to it briefly just to stress how important it is in your planning.

In the short term, inflation can seem harmless enough. If you leave $100 under your mattress and the rate of inflation is 3%, then next year your $100 will buy 3% less goods and services. In other words, in order to buy the same amount of goods and services you now need $103. When you extend this to 10 years you may think that you now need $130, but the effects of compounding mean that you actually need $134.39. Yes, as wonderful as compound interest is when working in your favor, compound inflation, it’s evil twin, is working against you over time.

So how can inflation affect your long term financial planning? Well first of all it will affect the targets you set. Let’s take an example of someone who wants to have an income of $50,000 per year in retirement in 25 years time:

If you can find a miracle low risk product that generates a 10% annual return, then you need $500,000 in capital at retirement. Then you can live off the interest without spending your capital and it doesn’t matter how long you live.

If we are more realistic and think in terms of a 5% return, then you need $1,000,000 in order to generate $50,000 per year.

What if you can only get 2.5% in retirement? Well then you need $2,000,000.

The problem is that all of these numbers are in today’s money. The table above tells us that over 25 years at 3% inflation, our spending power will more than halve. (it actually goes to 46.70% but let’s keep the numbers simple) That means that with a 5% return we actually need $2,000,000. And with a 2.5% return we need $4,000,000.

This is why it’s important to start saving and investing early. If we are not taking advantage of compound interest on our savings, our nest egg will be getting eaten away by its evil twin inflation!

Winter is Coming!

Winter Is Coming.jpg

By now you may be tired of talk of diversification and asset allocation. Surely there are more interesting things we can talk about with regards to investment? I agree, it can get pretty dry. However, there is a reason we keep coming back to these fundamentals: financial markets have different seasons, and the number one reason that people fail at investing is fear of winter:

Correction – when any market falls by at least 10% from its peak.

Bear Market – when any market falls by at least 20% from its peak.

Fear of these financial winters lead otherwise intelligent people to do some strange things. It wasn’t just stupid people that sold everything at the end of 2008 / early 2009. It wasn’t only fools who sat on the sidelines and did nothing as the market rebounded spectacularly through 2009 and beyond. So how do we overcome this fear of financial winter? Firstly, by understanding it better:

  • On average there has been a market correction every year since 1900.
  • The average correction over the last 100 years has been 13.5%.
  • From 1980 to 2015 the average drop was 14.2%.
  • Historically, the average correction has lasted only 54 days.
  • Less than 20% of corrections have turned into a bear market.
  • Historically bear markets have happened every 3-5 years.
  • Historically the S&P 500 has dropped on average 33% during bear markets.
  • In more than a third of bear markets it has dropped more than 40%.
  • On average, bear markets have lasted about a year
  • Bull markets tend to commence when investor confidence is at a low point.
  • The market hit bottom on March 9th 2009 – the S&P 500 surged 69.5% in the 12 months that followed.

(from Unshakeable: Your Financial Freedom Playbook by Tony Robbins)

You may be surprised to hear that corrections happen so frequently. This means the next one could come at any time. If you follow the news, and in particular the financial news, there are always multiple reasons to be fearful: terrorism, North Korea, conflict in the Middle East, slumping oil prices, budget standoffs, Brexit!

Then there are the doomsday guys who are forever warning of the coming crash. If you listen to these people you will never be able to get started investing. But how often are they actually right? Well if you consistently warn of a coming crash you will always be right eventually! Tony Robbins’ book has a brilliant section where he shows 33 instances of “experts” warning of a market downturn over a three year period, where the market actually went up instead.

Here’s the key: in the years 1980 to 2015, the S&P 500 experienced an average intra-year decline of 14.2%. However, the market ended up achieving a positive return in 27 of those 36 years. That’s 75% of the time. You cannot afford to be sitting on the sidelines while this is happening. In fact, the opportunity cost of doing nothing will cost you far more than any of the corrections, bear markets, and flash crashes:

“From 1996 through 2015, the S&P 500 returned an average of 8.2% a year. But if you missed out on the top 10 trading days during those 20 years, your returns dwindled to just 4.5% a year. Can you believe it? Your returns would have been cut almost in half just by missing the 10 best trading days in 20 years! It gets worse! If you missed out on the top 20 trading days, your returns dropped from 8.2% a year to a paltry 2.1%. And if you missed out on the top 30 trading days? Your returns vanished into thin air, falling all the way to zero!” (from Unshakeable: Your Financial Freedom Playbook by Tony Robbins)

So we need to understand that winter is just one of four seasons and get back to the boring stuff: understand your risk profile, get your asset allocation right, rebalance annually, and ignore the noise!

Buy Low, Sell High!


I’m sure you have heard the mantra “buy low, sell high”. That’s because it is the number one objective of investing. But how do you actually go about this in a fast changing world without constantly having to watch the markets? The answer is more straightforward than you might think:

Let’s keep this really simple – say you have a portfolio that is 60% in stocks and 40% in bonds. (of course your portfolio will be much better diversified than this but we’re going for simple here!) Over the course of a year the stock market soars and the bonds stay about the same. You’ve had a really good year in your stocks. In fact, they’ve done so well that the balance of your portfolio has changed to 70% stocks and 30% bonds. Now, you haven’t changed anything yourself. It’s just that one of your asset classes has increased in value and therefore in weight.

Then the next year, guess what? The stock market continues to do well! Your bonds stay about the same and the stocks have such a great year that the value of your investment goes up significantly. And you go out and celebrate! Your asset allocation is working perfectly!

What you haven’t noticed is that now your portfolio is 80% stocks and only 20% bonds. And what happens the next year? Yes, you guessed it – the stock market crashes, you are over-exposed to it, and all those gains are wiped out…you failed in your attempt to buy low and sell high.

So how can this be averted? Simply, by rebalancing. At the end of the first year you automatically sell some of your stocks (selling high what you bought low) and buy bonds, restoring your asset allocation to 60/40. At the end of year two you do the same.

Then year three comes and the stock market goes down, but the 40% you have in bonds is there to protect you. In fact, it’s quite likely that bonds do well that year. So in that case, at the end of the year, you will sell the some of the bonds (high) and invest back into stocks (low). That’s it!

So, once you have understood your risk profile, and diversified into a blend of assets weighted to match that profile, the last thing to do is make sure you rebalance on a regular basis so the weightings don’t get out of whack.

Rebalancing annually is how you automatically buy low and sell high, without stressing yourself about the direction of the market.


Regular vs Lump Sum investing


When talking about asset allocation, I mentioned that your strategy will need to be different depending on whether you are investing a small amount on a regular basis, or a lump sum at one time.

I would consider these two different types of money. Regular comes from your surplus over expenditure every month. It doesn’t drain your bank account. In fact, the maximum you should contribute to long term regular investments every month should be 50% of your monthly surplus. That way you don’t suddenly find yourself with cash flow trouble when a big bill comes in. Lump sum is money over and above your emergency cash reserve that you have accumulated in the bank. When you look at your asset weighting and find that you are overweight in cash, you might decide to make a lump sum investment into medium term assets in order to correct the overall weighting.

Now if you are going to invest $50,000 tomorrow, you will probably want to be very careful about your asset allocation, particularly if you have a low appetite for risk. If you invest all this money into equities, then a sudden correction or prolonged bear market could have a major effect on your capital. You would want to make sure you were diversified across a broad range of asset classes to protect the downside.

However, if you are starting a long term savings scheme for your retirement and investing $500 a month, then equity market volatility can be your friend. I’m sure by now you have heard the term Dollar Cost Averaging? If not, then take a look at this Investopedia article, which has a great video explaining how it works. A regular investment plan like this can be broken down into three stages:

  1. Capital accumulation – here’s where you take advantage of the averaging effect of buying shares every month. At this stage you can allocate 100% to equities.
  2. Diversified – at some point, when you have build up a weight of capital in the investment, and when current stock prices are higher than the average price you paid for them, you should diversify into an allocation that fits your strategic risk profile. There’s no fixed time frame for doing this. You need to review annually yourself or with your adviser, and when you feel you have built up enough capital that it has become a lump sum in itself, diversify across other assets.
  3. Pre-retirement – this doesn’t have to be about retirement necessarily, but when you get close to using the money you will need to switch to a more tactical allocation to preserve capital. This is typically in the last 1-3 years. During the crash in 2008, many people’s retirement accounts were hit because they were still in a growth focussed asset allocation – no problem for a young person but a disaster for someone about to retire and start spending the money.

I sometimes hear the term “set and forget” for long term investments, however you should be careful about this. Even a small monthly savings plan needs to be reviewed at least once a year to check if it’s time to move into the next allocation phase. Lump sum investments also need to be rebalanced regularly, and we will cover rebalancing shortly.


What’s your risk profile?


We know already that asset allocation is the most important investment decision you will make. So how to decide what percentage of your money should be allocated to which assets? One factor is your stage in life: Young people have time on their side and are looking to grow their money over that time. Someone nearing retirement may no longer be looking for capital growth – they are going to need income from their investments and a significant drop in value would be damaging.

Another thing to consider is your risk tolerance. This can vary wildly from one person to another, even within your family, and it’s important to understand what level of risk you are able to bear.

The first part is to determine your investor experience. This can be summed up fairly simply:

Inexperienced Investor: You have invested in a limited range of asset classes for a period of less than four years and/or your investment knowledge is low or poor. However, you do understand that prices of securities may go up as well as down.

Experienced Investor: You have invested in various asset classes for a period of more than four years and have experienced volatility. Your investment knowledge is good and you acknowledge investment risk.

Professional Investor: You frequently trade various asset classes and have done so for more than four years. As an individual you have in excess of US$1.1 million of ‘investible’ assets and have extensive investment knowledge.

So what really separates an experienced investor from an inexperienced investor? The key term here is that you have “experienced volatility”. Simply put, if you have invested in a variety of assets for four years or more then you will have lost money somewhere!

The next part is to determine your risk tolerance. If you search online you will find numerous risk profiling questionnaires. Try one or two and see what results you get. For reference, here is a typical one from HSBC, and here is a more fun one from Rutgers.

Typically risk profiles are divided into two major categories:

  • Strategic – for long term planning,
  • Tactical – either aggressive trading, or focussed on a specific life stage such as pre-retirement, post retirement, or income generating

We won’t get into the tactical profiles today, suffice to say that needs can change with major life events. If you are retired then long term capital growth is less of a concern and your focus is likely to be on capital preservation and generating income.

Strategic Profiles:

  • Conservative – investors primarily interested in income and modest growth potential. The allocation is relatively defensive but has a modest exposure to growth assets. Looking for income and capital growth from investments.
  • Balanced – investors with some time until retirement. The allocation invests in

    a much broader range of assets than a typical balanced fund, which will result in lower potential for capital loss whilst at the same time offering growth potential. Looking for income and growth from investments, but more focussed on growth.

  • Growth – investors who have a longer investment time horizon, primarily interested in capital growth, and are comfortable with modest short-term capital losses. The allocation is biased towards growth assets, but still invests in a broader range of assets than a typical growth fund.
  • Alpha – investors who wish to adopt an aggressive approach, with the sole aim of long-term capital growth. Medium-term losses should be expected. The allocation is almost entirely biased towards equities and other growth assets.

The names and definitions of the strategic profiles may differ depending on who you ask. Alpha may be called adventurous, for example. The important thing is to start to understand where you fit in on the risk scale so you can plan your asset allocation accordingly.

Active vs Passive Investment


You may remember we talked a little about trade-offs already. Well another investment trade off is active vs passive strategy. This is a trade-off we are hearing more and more about these days. Fifteen years ago, almost nobody was talking about index funds and Exchange Traded Funds (ETFs). You would either buy stocks and bonds directly; or you would buy a mutual fund, run by a manager who was benchmarked against “the market”. Hedge funds were only just becoming accessible to regular investors, rather than being for sophisticated or high net worth investors only.

You may have heard about a bet that Warren Buffet made almost 10 years ago: He bet that a passive investment in the S&P 500 index would beat any given portfolio of hedge fund strategies over a 10 year period ending December 31st 2017. The only takers were an alternative investment specialist firm called Protege Partners LLC, and there is a million dollars riding on it to go to the winner’s charity of choice.

So how’s it going? Well, in truth it’s not even close. Despite starting the bet before the 2008 financial crisis the S&P 500 is sitting on a return of 85.4%. (7.41% p.a.) The hedge funds average is 22%. (2.2% p.a.)

So what can we learn from this? Well here are a few lessons:

  • It’s time in the market that matters, not timing the market.
  • Fees really matter – the hedge funds have performed ok, and with lower volatility. But an annual fixed fee and 20% performance fees are going to eat into investor returns.
  • You have to hang in there! Think back to 2008 – the housing crisis, Lehman Brothers goes down, the stock market plunges, it feels like the end of the world…and you just invested a chunk of your savings in the S&P 500! Be honest here, would you have sat on that bet and waited? It’s easy to say yes with hindsight, but an awful lot of people sold investments at the bottom of the market, when despair was at its highest, and then sat out in fear and missed the big rebound.

So does this bet settle the active vs passive investment debate? Well, not exactly. Hedge funds vs the S&P 500 is not really a good comparison. If, however,  it was US large-cap mutual fund managers vs the index, then we would be comparing apples with apples. According to this article, 66% of large-cap managers failed to beat the index in 2016, and if you lengthen the time period, the numbers just get worse. And out of the managers who do beat the index over a three year period, only about 5% go on to beat the index over the next three years. So we can conclude that it’s very hard to beat the market.

So does this mean we should just lump all of our money into an equity index fund?Although there are worse things you could do, it’s not a very balanced approach. Getting a diversified blend of different asset types, and rebalancing this blend over time, can help smooth out returns, lower risk, and make it easier to sleep at night when the stock market takes one of its downturns. We will look at this in more detail in future posts.


So what returns should I expect?


Ok, we have covered the different asset classes, and we have understood that the basic minimum benchmark is inflation in our base currency. So how are these assets likely to behave over time relative to that benchmark? Well three of the asset classes are correlated to inflation and to each other, so although we can’t predict exactly, we have a pretty good idea what they will do over time in a particular base currency:


Take a look at the diagram above. It shows a rise in the cost of goods and services (inflation) over time. The first thing to note is that in the short term we really have no idea which asset will perform the best. We do know that cash will at least hold it’s value. Stocks, on the other hand, could rise or fall significantly. So, if you have a pile of money and are planning to do something important with it in the next 12 months, like make a down-payment on a house, you would be ill-advised to invest this money in the stock market. It might go down 30%! Therefore money for short term needs should stay in the bank.

Over the longer term, you won’t make money in cash. As you can see, cash tracks inflation to preserve your spending power, but it won’t increase it. If inflation is 2%, you might earn 2.5% in the bank. In Japan, where inflation is near zero, interest on a cash deposit is also very near zero. So if you want to make money over the long term, you have to take some risk.

One way you could take some more risk is by lending money to the government. The price of bonds may fluctuate over time, but in order to attract investment, bonds will pay a better return than cash. Note here that all bonds are not the same. A Japanese government bond may pay low interest, but there is little chance of default. A Venezuelan government bond may pay outstanding interest (10.43% p.a. on a 10 year issue at the time of writing), but there is a greater risk you won’t get your money back at the end of the term. Likewise corporate bonds carry higher risk than bonds issued by solid governments.

If you are looking for still higher returns, then it’s time to invest in the stock market. Although stocks are unpredictable in the short term, historically they outperform over a long period of time. This is because over time the economy and population tend to grow, and workers become more productive. This economic ground swell makes businesses more profitable, which drives up stock prices.

Although the other asset classes are uncorrelated and less easy to chart here, they can add valuable diversification. In building your own investment strategy there are a few things you need to take into account here:

The first is your base currency. The second is your time frame, which may vary from one investment objective to another. And the third is how you feel about the ups and downs in each of these asset classes, otherwise know as your attitude to risk. The better you understand the behaviour of different investments over time, the more you may find you are comfortable taking risk on a certain portion of your capital.

Striking the right balance between the different asset classes and maintaining that balance over time is know as Asset Allocation, a subject we will cover in future posts.

Are my investments any good?


How do you know if an investment you have made is doing well or not? How can you tell if it’s worth paying an investment manager rather than just buying an index fund? Is 8% per year a good return?


The simple answer to each of these questions is, it depends what you compare it to. You need to have something meaningful to measure an investment against in order to gauge how it is doing. This is known as benchmarking. Whether you realise it or not, you are probably already familiar with some benchmarks:

  • MSCI Global Index – covers global stocks
  • S&P 500 – covers US stocks
  • FTSE 100 – covers UK stocks
  • Nikkei 225 – covers Japan stocks
  • Citi World Government Bond Index – covers global bonds

So a mutual fund manager running a US Growth Stock fund might be benchmarked to the S&P 500 index. If he is underperforming the index, he is not worth paying fees to. If he is outperforming the index his fund will be popular. If he is getting a wildly different result to the index then he is doing something very strange and likely won’t keep his job for long!

So is 8% a good return? Well it partly depends on what your expectations are. The S&P 500 has returned, on average, 7.1% per year over the last 10 years, so 8% seems like a pretty good return. However, if your goal was to be aggressive and get a 20% return you might still be disappointed. In 2008 the S&P 500 fell by 37%. Even a 1% return that year would be nothing short of exceptional!

So how should the average investor benchmark their investments? I would say the basic minimum benchmark should be inflation in your base currency. Inflation is defined as the rise in the cost of goods and services over time, and is the reason we don’t just lock our money in a safe. Take a look at the table below showing the effect of inflation on $100:

Inflation erosion

We are currently living in a low-inflation environment, particularly if you live in Japan. However, if you look at the historical average, 3% is a good guide. So at 3% inflation, if you put your $100 under the mattress for 20 years you will still have $100, but it will only buy you $54.38 in goods and services. The spending power of your money has almost halved!

One thing I will stress here is that we are talking about inflation in your base currency. If you are living in Japan, but you are planning to retire in Australia, for example, don’t be fooled by the low inflation rate in Japan. Back home the current rate of inflation is 2.1% and rising. Keeping money in your Japanese bank account is not only a currency risk, but you are losing 2.1% per year in spending power!

Investment trade-offs


There is no such thing as the perfect investment. They all come with advantages and disadvantages, or trade-offs.

One of the simplest explanations of these trade-offs I have heard goes as follows:

Any investment you make needs to balance three factors: low risk, high returns, and liquidity. You can have any two of these but not all three.

If you want high liquidity (easy access to the money) and low risk you are going to have to sacrifice high returns. Your money is going to be in something like a savings account.

If you want high liquidity and high returns you are going to have to take a lot of risk. This could mean an investment in stocks that could go down significantly in the short term.

If you want low risk and high returns, no-one is going to give you that unless they are able to keep your money for a long time. The best performing hedge funds and capital guaranteed products often have lock-ins, preventing investors from withdrawing their money for a fixed period.

Another trade off to consider is capital versus income. Some investments provide capital growth, but little or no income. Income generating investments may have lower prospects for capital growth. Before investing it’s important to understand which is best for you at your current stage in life.

One more trade-off to consider is absolute versus relative return. Absolute return is what an investment returned over a particular period. If a mutual fund returned 10% over the last 12 months is that a good return? Well, it depends on what the rest of the market returned. If the market returned 18%, then 10% is not particularly good. In fact in relative terms it’s a minus 8% return. Active fund managers are benchmarked in this way in order to gauge their performance. We will talk more about benchmarks starting tomorrow.



The Six Asset Classes


Depending on who you ask, you will find that there are varying opinions on the different types of assets out there that you can invest in. In my opinion there are six basic asset classes, plus an extra category we may call “alternatives”.

The main point here is to avoid confusion with investment products. There are thousands of products available, all packaged up with pretty brochures and power point presentations, but the majority of these products are simply investing in one or more of the six basic asset classes.

Let’s start with some simple definitions:

  1. Cash – a means of exchange and a store of value.
  2. Bonds – government or corporate debt.
  3. Equities – stocks and shares representing an ownership interest in a company.
  4. Property – a building or buildings and the land belonging to it or them.
  5. Commodities – raw materials or primary agricultural products that can be bought and sold.
  6. Collectables – items valued and sought after by collectors.

Cash is sometimes confused with currency, but they are not the same thing. If I have ¥10,000 and I step outside my house in Japan and wander into town, I can exchange this for goods and services readily. If I get on an plane and fly to the UK, can I do the same at my destination? The answer, of course, is no. I first need to exchange my Japanese Yen for British Pounds, and this is done at a market determined rate that can fluctuate from minute to minute. The JPY I hold has become a commodity that can be bought and sold.

Bonds are complex instruments, but they have some basic characteristics we can recognise: they have a creditor, who is the bond holder, and a debtor, who is the bond issuer. Bonds have a face value, which represents the amount of principal the bond holder will receive at maturity, and is the amount the issuer pays interest on. They also have a market value, which is what people are willing to pay for them today. They have a maturity date, when that nominal face value amount is typically repaid. They also have a coupon, which is the interest rate the issuer pays to bond holders.

Most people are familiar with the idea of equities or stocks in publicly traded companies. However, it is also possible to own stock in private companies, known as private equity. Private equity is not a separate asset class, however it is less liquid and carries different kinds of risks to investing in listed companies.

For some people property is the simplest asset to understand because it is tangible – you can see it and touch it. Property comes in many different forms: land, buildings, houses, apartments and even collective investments. It’s possible to buy a property fund or Real Estate Investment Trust (REIT) that gives you exposure to the asset class, but with a lower investment amount and potentially higher liquidity. The ability to borrow money to invest in physical property makes it a potentially powerful asset class.

Commodities are exciting due to the high level of price fluctuation, or volatility. This means there are many opportunities to buy low and sell high and make money. It’s also very easy to get it wrong and lose money. Commodities used to be for expert traders only, but these days, with the advent of Exchange Traded Funds (ETFs), it’s simple for anyone to invest in gold, oil or even coffee.

Collectables are about more than just a hobby. An educated investor can make incredible returns  buying and selling artwork, stamps or antiques. However it takes a significant level of knowledge and expertise to make money in collectables and it’s easy for amateurs to get duped. You may want to hang onto that heirloom your grandparents handed down to you though!

As I said, the majority of investment products can be fit neatly into one or a combination of these six categories. However there are “other” investments that may not fit in perfectly. Hedge Funds have long been touted as an asset class all of their own, although I would argue that most hedge funds simply invest in a combination of the above asset classes, albeit it an innovative or original way.

For the average individual investor, concerned with saving and investing for their future, a solid understanding of the six basic asset classes, and the risks and trade-offs associated with them is more than enough to get them started on the path to building wealth.




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