Month: October 2014

Revisiting My Emotional Risk Tolerance

What happened during the past weekend made me change my mind on my own emotional risk tolerance.

I had a serious mental breakdown. I was crying uncontrollably on Saturday, and then I was crying uncontrollably on Sunday.

I basically felt very hopeless. My hopes and aspirations of being a full time investor relied heavily on my job performance and my career’s ability to increase salary gradually over time. The problem was I’m struggling with my job right now (my 1st job out of college) since joining my current company this June, and the fear that I won’t get a promotion, or worse, getting fired seemed so imminent.

Survival was a real question, let alone saving up enough money to become a full time investor.

My self worth went down the drain with my job performance as well, since I’ve always strove to live out Charlie Munger’s quote of “The safest way to try to get what you want is to try to deserve what you want. It’s such a simple idea. It’s the golden rule. You want to deliver to the world what you would buy if you were on the other end“, yet here I was struggling and not feeling like I deserved my job. There had been many points in the past few months where I felt that if I were my own boss, I would’ve fired myself for such dismal performances.

And then the topic of emotional risk tolerance just dawned upon me. I am absolutely not prepared for volatile illiquid investment strategies such as NCAV stock strategies at all.

Study after study prove that you can make money off of buying stocks below their NCAV, but in order for it to work, you would need to be ready to hold it for at least 1 year and at most 2-3 years and withstand the volatility throughout holding the stocks.

The thing is, at this stage of life I need every penny of mine to have as much liquid assets as possible to cover my ass when unlucky events happen in my career. One thing I realized since having my serious mental breakdown is that to be able to sleep well at night knowing my ass is covered is such an underrated thing, considering I currently only have 5 months emergency funds and it makes me feel very uncomfortable.

Warren Buffett once said:

We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially.

To be able to reap the benefits of investing, it requires rationality to survive through volatility in order to realize the gains, and every ounce of cash on hand that can help my rationality to stay intact is appreciated.

I remember during my days of being a die hard Boglehead (fanatic of John Bogle’s teachings of using index funds only), I read how fellow die hard Bogleheads fared during the 2008 financial crisis. One account that left a huge impression on me was when a very senior and long time Boglehead by the name of “Sheepdog” started a thread on the Bogleheads forum with this post on Oct 10th 2008:

I have been retired for 10 years. I am one who has said over and over again. Stay the course. Look for the long term. Yeah, sure. That’s fine until today. Today did it. I am just starting to be scared so that I won’t tell my wife what happened today…stocks down…bonds down…I’m down. Our retirement funds are sucking down the drain. I lost today alone a year’s worth of normal distributions for expenses. I keep thinking tomorrow will be a turn around. I have said that for 30 days.
I am 25% capitulating tomorrow, maybe 50% to money markets….maybe all.

This is not me. I will see tomorrow.
Jim

You can read 2 years later his lessons upon the whole ordeal during the 2008 financial crisis, which was:

When a person must take distributions to meet expenses, and I do monthly, an adequate “cash” account should be maintained so that they don’t “have to” sell at market lows. Keep a sizeable cushion. I am doing what I said I would do…..I maintain the “cash” account from which I take distributions at a minimum of 3 years of needs. I sell stocks and bonds every few months to keep it up. When the next big downturn occurs, and it will, I will not have to sell any investments for at least 3 years. I won’t get caught again.

For me, a comfortable amount of liquid assets after serious consideration is 2 years emergency funds as well. The rationale is similar, since if I were to embark on a NCAV strategy, I have to expect my invested capital to be locked in for at least 1 year, and I don’t want to be forced to panic sell when I run out of money before my NCAV stocks hit intrinsic value and earn me a profit.

Also a major reason why I’m moving to a less volatile strategy for now is because my ability to stomach volatility is essentially untested. On theory I understand that true risk is permanent loss of capital instead of volatility, but I have yet to see how I would react when I see my own portfolio have 20% or 50% drops in value. If I have 2 years emergency funds, I can proceed to afford experimenting with different strategies to determine how much volatility I can endure in the pursuit of higher returns.

I also emphasize on the term “liquid assets” instead of cash because of the way I plan to construct my 2 years emergency funds. Liquid assets will also include index funds, but I will only buy index funds heavily after a bear market run and when the index fund prices rise above the 30 week simple moving average to prevent buying too early.

The reason why I include index fund shares bought heavily near the bottom of a bear market run is because I can enjoy the price appreciation and dividends that comes with index funds while buying near the bottom of a bear market run essentially minimizes risk by keeping a floor under the price, where the likelihood of losing money on index funds when I actually need to cash out very unlikely.

The reasons why likelihood of losing money on index funds bought heavily near the bottom of a bear market run is very likely is because prices would be inflated during a bull market run, I’d hedge overvaluation by 2% cash for every 1% overvaluation to gradually cash out before prices drop, and what’s remaining of the shares that haven’t been cashed out during a bull market run have to drop all the way down to the bottom of the previous bear market run. The extremely unlikelihood of all three measures failing is what I’m willing to bet on.

The amount I’m willing to commit to index funds when the bear market run is near its bottom point is everything bar 1 year worth of redundancy fees and emergency funds. The 1 year worth of cash is to help me survive for my next job hunt in the event I get laid off.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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Plan of Action From Now Until NCAV stocks

I’ve had a life changing revelation on October 2nd 2014 in terms of what investing strategy I should be adopting for a small portfolio like mine. Read specifically under  the “Why I think I’m taking too much risk” section of “I Fucked Up On My Investment Thesis“.

To transition into a NCAV stock does pose a problem, which is I don’t have enough capital to actually construct a well diversified portfolio of NCAV stocks. NCAV stocks rely on diversification since a batch of NCAV stocks generating positive returns is needed to offset failures of certain NCAV stocks when the failure rate is ~20%.

Before I have the funds to construct an 8 stock portfolio (you can find out why at least 8 stocks here), I will invest in Vanguard HK’s regional index funds that are below the maximum Graham Number (P/E * P/B = 22.5) and hedge overvaluation by 2% cash for every 1% overvaluation.If all regional index funds are overvalued, I’ll just accumulate cash.

This process will continue on until I have enough money to construct a 8 stock portfolio and there are 8 stocks that meet the most stringent of conditions. I will then proceed to liquidate all my index fund shares and start my global NCAV stock strategy.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

I Fucked Up On My Investment Thesis

I really hate to admit it, but I don’t think The Link REIT is as great as a company as I originally thought. I also think I’m taking up too much risk.

Why I change views on The Link REIT

In my essay on why I thought The Link REIT was a great company, I was wrong in my analysis on The Link REIT’s Favorable Long Term Economics.

I was horrified to only learn of the recent news on September 29th 2014 that The Link REIT sold 5 properties for future purchases and that the previous 4 properties sold last year was to buy 1 property called Lion Rise Mall.

The reason why this realization horrified me is because The Link REIT is forced to consistently make sub-optimal investment decisions due to its REIT status. REITs under Hong Kong law are legally obliged to distribute at least 90% of distributable income, which means that every time The Link REIT sells property, it has to re-invest it immediately lest the cash gets distributed back to shareholders, which also means that when it re-invests the money immediately, the property they buy maybe fair value, but most likely over-valued and definitely not under-valued.

This is because The Link REIT only sells when its property is overvalued, but if your properties on aggregate is overvalued, then the property market in general is most likely overvalued, thus the property The Link REIT buys immediately with the cash will be most likely overvalued as well. No rational person / company sells a property unless they get good money for it or they are strapped for cash.

In the same essay on why I thought The Link REIT was a great company, I said one way The Link REIT could fall from “Great Company” status was if it sold its properties, because:

“The only way you can get dislodged legally by competition is if your strategic locations aren’t strategic anymore (very rare, think of your city’s CBD district and see how frequently it changes places), or most importantly, if you decide to sell your strategic locations and risk never getting a chance to get back into those strategic locations. Property owners are legally allowed to not sell its property regardless of how ludicrously high the offer’s value is.”

So besides The Link REIT not getting great deals in terms of valuations in swapping properties for propertie(s) since everything’s all overvalued, it risks deteriorating its competitive advantage of “control of majority of retail space and car park space situated strategically near dense residential areas covered by MTR stations that most ordinary Hong Kong folk can’t live without” every time it makes a swap deal by being wrong in its analysis of the new properties acquired.

The reason why The Link REIT was so unstoppable was because it basically took over all retail space and car park space originally managed by the Housing Authority (the government body that looks after public housing). If you’re living in public housing, you really don’t have much choice but to use the retail space and car park space nearby. But as The Link REIT moves further away from its core portfolio into new property, the new properties may not have as strong of dependence from nearby residents as the original properties.

If The Link REIT was able to hold onto its cash and wait for properties to be undervalued before pouncing, then that would make the business model great since it would give larger margins of safety in valuation (price paid) and evaluation (competitive advantage) of the new property. Now it just looks decent at best.

 

Why I think I’m taking too much risk

The quote from Charlie Munger to “Don’t go after large areas. Don’t try to figure out if Merck’s pipeline is better than Pfizers. It’s too hard. Go to where there are market inefficiencies. You need an edge. To succeed, you need to go where the competition is low. That’s the best advice I can give to small investors.” has been at the back of my mind consistently for quite some time.

The reason being I felt that I was going after large areas with my bet on The Link REIT, and that the odds weren’t stacked so favorable for me that it warranted an all in. The only realistic areas where I will have an edge would be to buy during a bear market where depressed prices offer huge margin of safety or illiquid markets where NCAV stocks exist.

Charlie Munger’s portfolio during his partnership days were very concentrated just because he only betted aggressively when the odds were ridiculously in his favor.

Reading a Quora answer recently on that one of the best advice to receive for poker beginners was to play Tight-Aggressive (only going in when you’ve got great hands, and aggressively pursuing the win once you’re in) reminded me of Charlie Munger’s quote once again and made me face reality.

I’m going to start reducing my portfolio’s weighting on The Link REIT by stop buying The Link REIT as soon as possible and sell it immediately afterwards. I will start transitioning into a pure NCAV stock strategy soon once I accumulate enough cash.

I’ll bet heavily when I actually have a ridiculous edge. For now, cash will do.