Email#1 – What to expect

[I will copy and paste the English version of emails from a financial advising monthly email project I’m doing for my friends every month’s 1st Monday after the 1st weekend. If you want to subscribe, click here.]

(Image by Matt @ PEK from Taipei, Taiwan (Expectation) [CC BY-SA 2.0 (http://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia Commons)

Thanks for the trust and interest in my monthly email project, I really appreciate it and it means a lot to me!! As Warren Buffett once said, “It’s so much fun when you’re trusted and worthy of trust.” I will do everything I can to ensure that that trust is warranted.

So what do I want to achieve with this project? I want to achieve two things:

  • Monthly update on valuation of US stock market
  • Food for thought on personal finance (a hugely underrated topic in the topic of wealth preservation / growth) and of course investing

As this is the first email in hopefully a very long list of future emails, besides giving everyone a monthly update on valuation of US stock market, I want to explore thoroughly why I strongly favor incorporating valuation into investing in index funds, why this is the only strategy so far that I am comfortable in recommending to friends, and what I’m going to do to ensure my interests are aligned with yours regarding this strategy (hint: I’m going to put money where my mouth is).

So before you doze off, let me go straight to the monthly update on valuation of US stock market and what the actionable implications are. If you are still interested, then you can proceed to read on to hopefully learn a thing or two about why I only recommend such a strategy for friends.

[Monthly update on valuation of US stock market]

So how does the US stock market’s valuation look like? You are in luck, because for the 1st time since April this year [1] you can finally find the US stock market undervalued enough to start buying.
Market Value - 5Nov2016.PNG
The US stock market is currently 4% undervalued (I will explain in next month’s email why I use Morningstar’s Market Fair Value for valuation purposes), which using my formula of X% undervaluation X2, means you should invest 8% of money you can invest in (exclude emergency fund money [2]).
Bob #1.PNG
So let’s use imaginary Bob as an example of how this works:
As you can see, Bob has $10,000 in net worth (for simplicity sake, let’s assume it’s all in cash), but he has $3,000 in his emergency fund because his monthly expenses is $1,000, so all in all his investable fund has only $7,000.

Since the US stock market is 4% undervalued, he should at most invest only 8% of his $7,000 in the S&P 500 Index ETF (stock code is 3140 in Hong Kong stock exchange).

One thing to note is, if the “should invest ($)” is less than $6,250, wait until the “should invest (%)” is big enough that your “should invest ($)” is greater than $6,250 before you invest. This is to ensure that commissions you pay for buying stocks doesn’t kill your returns [3].

[Food for thought on personal finance and investing]

So let’s refer to the 3 points I wanted to make about this investment strategy:

  • Why do I strongly favor incorporating valuation into investing in index funds
  • Why this is the only strategy so far that I am comfortable in recommending to friends
  • What I’m going to do to ensure my interests are aligned with yours regarding this strategy

Why do I strongly favor incorporating valuation into investing in index funds

Warren Buffett once commented that “Among the various propositions offered to you, if you invested in a very low-cost index fund — where you don’t put the money in at one time, but average in over 10 years — you’ll do better than 90% of people who start investing at the same time.

And the reason why you shouldn’t put the money in at one time? You don’t want this to happen to you:
Nikkei Lost Decades.PNG
This is the stock price of Nikkei 225 (Japan stock market), and as you can see, if you had put all your money into the Nikkei 225 in 1990, even 26 years later you would’ve still lost money.

And the reason? Valuations were nose-bleedingly high, with investors willing to pay prices which would give them only 1.7% yield [4] (in comparison, you could’ve bought super safe 10 year US treasury bonds at 8% yield).

I’m a strong believer in the power of investing in index funds, but there are times where even index funds aren’t the best choice and it would be prudent to just stay in cash. This is why I take valuation very seriously.

Why this is the only strategy so far that I am comfortable in recommending to friends

Successful investing requires two elements:

  • An investing strategy that works (eg. Investing in index funds)
  • Being able to stick to the investing strategy through thick and thin

And timing your entry into the US stock market through valuation is one great way to ensure you are able to stick to the investing plan through thick and thin.

Let me talk about why being able to stick to the investing plan through thick and thin is important before I delve into why this strategy makes it easier for you to stick to the investing plan through thick and thin.

A study by Barron’s and Morningstar showed that even though the best performing mutual funds had 18+% return / year, investors who bought funds on average had -11% return / year.

Investors performance hurt by jumping in and out.PNG
The reason? Investors bought when performance was good but sold when performance was bad, which meant that because of mean reversion, they bought precisely when performance most likely would turn bad and sold precisely when performance most likely would turn good.
Don’t be that kind of investor. Once you’ve bought an index fund at a good price, hold it until you really need the money and thus must sell, because on average over a 5 year holding period, if you were out of the market for 30 days where stocks had their biggest gains, a theoretical $100,000 would have turned from $341,722 to a mere $153,792 [5]. Don’t jump in and out of the US stock market unnecessarily lest you want to miss out on your best paydays.

And so how does this strategy of gradually entering the US stock market based on valuation help you better stick to the investing strategy through thick and thin?

The keyword is this: Cash.

The number one reason why investors aren’t able to stick to an investing strategy through thick and thin is that psychologically speaking, the pain you feel from losses are much more than the joy you feel from gains [6].

By virtue of following this investment strategy, you will hold cash (and lots of it relative to your net worth) for long periods of time because the US stock market is never always on bargain sale. What this implies is that if the US stock market does drop 10%, 20% or even 50%, while everyone is panicking because they are fully invested, you would feel much more calm as the bulk of your portfolio is in cash and thus doesn’t get as hurt by the drops.

In the ideal case, not only you gain from the benefit of being calm while everyone panicks because of the amount of cash you’re holding, you will definitely beat the majority of the people who end up being on panic sell mode, and also perform better than people who are 100% invested in the US stock market (and have nerves of steel to still hold onto their investments even during a 2008-2009-esque 50% price drop) because you avoid the huge drops that are hugely detrimental to your investment returns [7]. In the worst case, you match or slightly undeperform the US stock market, but you have the peace of mind and ability to stick to the investment strategy through thick and thin.

What I’m going to do to ensure my interests are aligned with yours regarding this strategy

I’m a strong believer that you should prioritize advice where the person giving the advice has skin in the game. The reason is simple: if I were to give you advice which I follow myself, I better make sure it’s some good advice lest I get screwed over by the quality of my own advice.

So here’s my commitment to all of you: I will follow my own formula of X% under-valuation X2, I will show a monthly snapshot of my portfolio as proof that I put my money where my mouth is, and if I ever do sell the S&P 500 for non-investment reasons, I will disclose in the monthly emails.

This shows how much I believe in my own advice, and ensures that I will do my best to ensure the advice is good, do my best to update the advice if needed to make it better, and if the advice hurts everyone I will hurt as much as you do.

[Closing Remarks]

So I think that’s enough information for the 1st email. I hope none of you are dying from information overload… And I hope this email was informative and helpful 🙂

For next month’s food for thought, I want to explore on the topic of valuation so that in the event that I die or am unable to issue monthly emails anymore, you can independently make a judgment of when to enter the US stock market yourself through simple understandings of valuation. After all, my goal is to let you be equipped with the knowledge to make better financial decisions, and if one day you don’t need me anymore to make good financial decisions, that means I’ve succeeded.

[Footnotes]
[1] This assumes that you buy on the Monday following the 1st weekend of the month, which is the release schedule of this monthly email project
[2] My advice for emergency fund money has always been to keep at least 3-6 months of living expenses in cash for emergencies. I personally keep 6+ months of living expenses in cash for emergencies.
[3] Costs is the only component of investment return you can control, so being as cost efficient as possible is crucial to your investment success. The $6,250 figure comes from the fact that at most you should allow for your costs in investing to be 0.5% / year since that’s the lower end of annual costs you can get from most funds. Assuming you hold the stocks for at least 5 years, the Vanguard S&P 500 Index ETF‘s annual costs is 0.18% / year, and most banks charge minimum $100 / stock purchase, then that means you can afford to pay $100 commissions for a $6,250+ stock purchase since that amounts to 0.32% annual costs / year if you hold the stocks for 5 years, which means on aggregate your costs over 5 years is 0.5% / year.
[4] The P/E ratio was 60 times earnings, which meant that in an ideal world where you were the owner of the company and could pull out 100% earnings out of the company every year, it would take you 60 years (!!!) to get back your money, thus 1.7% yield (100 / 60).
[5] One Up On Wall Street: How To Use What You Already  To Make Money In – Peter Lynch (Location 303 of 6290)
[6] The human mind is designed to survive, so if you are feeling pain from losses from investment, it is equivalent to the brain of threats like running out of food, so your brain is tempted to cut losses and run so that you can survive another day. This is a temptation you need to train yourself out of, not something most people naturally can just emotionally disconnect from.
[7] It’s far easier to lose money than win money percentage wise in investing. 10% loss means you need 11% to break-even, 20% loss means you 25% to break-even, 33% loss means you need 50% to break-even, 50% loss means you need 100% break-even.

[Disclaimer] Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured

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