Break all Term Deposits and Invest in Cheap Shares [Archive]

ENP

09-08-2011, 10:53 AM

For example.

RYM- Ryman Health Care

People will still want somewhere to retire. People still need a place to call home with their facilities. Older people with money have most of their money in term deposits etc, so won't be largely affected.

SKT- Sky TV

People will still watch Sky Sports, support the All Blacks, etc. If people lose their jobs due to the economic climate, they will spend more time at home anyway and will want to watch TV.

How are these two companies affected by the USA downgrade and the fact that Greece and others can't pay bills? Not much if you ask me.

POT- Port of Tauranga

Now I see your point on this one. Lots of agriculture/horticulture/other exports is the main business. If people in Europe/USA don't want to buy our milk/lamb/cows, etc then this could be a big problem for a company like POT. Hence, if gone off them as of late.

Plenty of other companies in NZ and OZ that aren't affected greatly. CCL, WOW, DMP. All food based. Someone is not going to say, no sorry due to Greece not being able to pay their bills, I'm not going to buy a coke, pizza, do my grocery shop today.

Lizard

09-08-2011, 11:24 AM

Hi ENP,

How long does it take to break the term deposits and then get the money into the market?
How much will it cost you in forgone interest and break fees to hold the money in a cash account vs the term deposits if this downturn lasts another 21 months?
How sure are you that you will be able to invest near the bottom rather than on a dead cat bounce?
Remember that if the market falls 50%, but you think it is safe to invest after it has fallen 25%, you will still watch a third of your money seemingly evaporate - how will you feel if that happens?

Since we're not supposed to give financial advice, I'm hoping that answering those questions will tell you what is right for you!

And just to pontificate further about where this market might go:

At this stage, it is pretty difficult to guess when this downturn will finish. It depends a lot on whether we end up with an austerity-poverty downward spiral or whether consumer and business spending holds up enough for businesses to maintain divs.

We don't have the same balance sheet challenges (and potential dilution) that we were facing last time, so there is a better chance that shares bought before the bottom will eventually recover if you happen to mis-time purchases.

For now, I'm reasonably optimistic that dividends will hold this season and underpin the market. NZ in particular has enough earthquake-response stimulus already budgeted for, that some pullback in consumer and business spend can be absorbed without triggering the death spiral. The path to reforms that produce manageable borrowings in the west is going to take time to go down, but with enough political will, the path should keep getting clearer. At some point, the markets will start to believe that there is a path. Although, a major banking crises is the precipice to the right of the path and the possible injury from sliding down it, unpredictable.

All-in-all, I remain cautiously optimistic, but recognise that there is a lot more to be gained by investing near the bottom than holding through. Don't rush. Rushing is for day-traders and those who have to make a daily living finding the next trade!

voltage

09-08-2011, 12:53 PM

Okay great buying opportunity but what do I buy everything on sale. Topped up RYM, looking at Mainfreight and BHP. What about global companies coke etc

Snoopy

09-08-2011, 03:45 PM

I have around 23k in term deposits.

I'm thinking of breaking them and investing in shares since they have all gone on sale. The fundamentals of the businesses I would buy won't change during this "crisis" the markets are currently having.

So why not?

Thoughts please?

Hi ENP,

Some good advice dished out by others on this thread so far. I would say at times like this it is time to reaffirm your investment objectives, and see how the market opportunities stack up relative to those.

It would certainly tempting to break all of your term deposits. But sometimes I think it is worth the extra discipline of just waiting for those term deposits to mature. That will give you more time to evaluate those competing investment opportunities. Of course another factor is how far out those term deposit maturity dates are. But I can't see a great fix for, in particular, the Eurpean debt crisis for years. So there may be other opportinities for the patient coming in the market similar to what it has dished up in the last couple of days.

IIRC you are saving towards a decent house deposit, in perhaps a couple of years time. There is no guarantee that in a couple of years you will able to sell out of any investments made this week at a profit. But I would say this opportunity is too good to pass up and do absolutely nothing. If I was in your situation I might just break enough of that term deposit portfolio to make one purchase (say $6k or so) now, just to satisfy that investment itch. Then I could wait for the rest to mature on a rolling basis, and make the decision on what to do with those funds later.

Saving for a property, I would tend to look for a sharemarket listing that had a property component to it. That way if the property market goes up in the next two years, then so should the underlying investment. If the property market tanks then your investment may go down. But since you then wouldn't need as much money as a deposit to buy your own property, this would not matter.

Of the shares you have considered, the obvious one that meets this criteria is RYM. Has the market gifted you the opportunity of correcting your mistake of 'selling out' a few months ago?

SNOOPY

lou

09-08-2011, 06:08 PM

And don't give me this "don't catch a falling knife" rubbish

If it was good value at $1 a week ago, it's even better value at 80 cents today.

Don't catch a falling knife unless you are a talented circus performer.
Wait for it to hit the floor and then pick it up.

Sauce

09-08-2011, 06:15 PM

Saving for a property, I would tend to look for a sharemarket listing that had a property component to it. That way if the property market goes up in the next two years, then so should the underlying investment. If the property market tanks then your investment may go down. But since you then wouldn't need as much money as a deposit to buy your own property, this would not matter.

Hi Snoopy,

Your posts are usually littered with good sense and rationality, but I simply do not follow this logic at all.

The way I see it, the only rational decision for ENP, were he to cancel his term deposits, would be to invest in what he believes has the greatest odds of beating his cost of capital - i.e. his term deposit rate rate + break fees - regardless of other considerations. If the choice of vehicle is equities this would usually mean the best quality business at the best available price. And this may, or may not, have anything to do with residential real estate.

In regards to any risk to his future property buying power - that's simply a 'go there' or 'don't go there' decision. Once he decides to 'go there' then he needs the best odds of success, which means making the best choice. Limiting yourself to the property sector to link your potential loss or gain to residential property prices, is simply madness. Especially so at a time when property has more fundamental downside risk than upside potential, during your assumed 2 year time frame. And when there are seriously undervalued but fundamentally excellent businesses to choose from.

Even if it was a sound strategy, it would be big stretch of the imagination to assume that any 'business' could provide this speculative volatility 'marriage' to residential property 'prices' - the extreme amount of variables in businesses returns, not even to mention the market forces of both shares and property, are just too complex. No business returns or share price returns are likely to follow residential property prices with any predictability at all.

I believe that idea is long on emotional comfort and short on rationality. I look forward to being corrected Snoopy ;)

Regards,

Sauce

P.s. For the record I am all for ENP using the funds to buy RYM. Wise choice in my opinion. But for very different reasons than Snoopy! :)

ENP

09-08-2011, 08:34 PM

Sauce

09-08-2011, 08:51 PM

Hi ENP.

Yes, that its a totally flawed way of thinking. For instance, one might feel happier owning CEN because power prices were rising, but the business only generates returns on equity of 5%. RYM generates returns on shareholders funds of 30%.

Simply put, the investor in RYM will be able to pay for a lot more power in ten years than the investor in CEN.

Snoopy knows this of course, and undoubtedly would have been assuming you were still going to buy a good business within the property sector, but it still doesn't make sense to me.

Things might be even worse if subconsciously you were not so worried about turning the lights off at night because you owned CEN. Sounds far fetched but it similar thinking in my opinion. Now that would be a perverse incentive.

Regards,

Sauce

Sauce

09-08-2011, 09:09 PM

P.s. All funds I could get my hands on is, as of today, fully invested. Personally, I think you would be very wise to do what you are considering, and if it was me I would do the whole lot..

DYOR of course and good luck, you sound like a smart and independent thinker who can go against the herd, so share market should be a good match for you.

AMR

09-08-2011, 10:51 PM

ENP, are you still looking to buy investment properties?

Snoopy

10-08-2011, 12:16 AM

Hi Snoopy,

Your posts are usually littered with good sense and rationality, but I simply do not follow this logic at all.

The way I see it, the only rational decision for ENP, were he to cancel his term deposits, would be to invest in what he believes has the greatest odds of beating his cost of capital - i.e. his term deposit rate rate + break fees - regardless of other considerations. If the choice of vehicle is equities this would usually mean the best quality business at the best available price. And this may, or may not, have anything to do with residential real estate.

If you need a deposit for a house in say two years time Sauce, then 'good sense and rationality' would see you not invest in the market at all. Why? Because I think ENP is disciplined enough to reach his home deposit goal by just saving salary and using term deposits. ENP would achieve his objective with next to no risk this way. Now I know we are all sharemarket investors and no-one wants to hear the 'don't invest' message. Indeed, if ENP had, say, a six year time horizon before buying a house then I would tend to agree with your investment strategy Sauce. It is ENP's two to three year time horizon that I see as the issue here.

I think if ENP put all his term deposit money in carefully selected 'recession proof' shares today, he would likely do very well in two years time, maximise his return on capital in your terms. However as Liz points out you cannot be certain of this. What happens if in two years time just as ENP is readying his house deposit money Italy gets downgraded to junk bond status? We could end up with another sudden market plunge. And what was looking like a nice deposit for a home is bled of cash overnight. ENP is back in the rental market, through no fault of his own. And how is he going to explain that to his significant other?

While I think the chances of such a financial disaster is low, the consequence of the unlikely happening is very significant - ENP doesn't get his house. That is why I don't buy your maxmise your return philosophy Sauce, in this case.

Limiting yourself to the property sector to link your potential loss or gain to residential property prices, is simply madness.

Even if it was a sound strategy, it would be big stretch of the imagination to assume that any 'business' could provide this speculative volatility 'marriage' to residential property 'prices' - the extreme amount of variables in businesses returns, not even to mention the market forces of both shares and property, are just too complex. No business returns or share price returns are likely to follow residential property prices with any predictability at all.

P.s. For the record I am all for ENP using the funds to buy RYM. Wise choice in my opinion. But for very different reasons than Snoopy! :)

I have to admit to slightly gritting my teeth as I wrote my last post Sauce.

Yes I know a speculative sharemarket volatility 'marriage' to residential property 'prices' will never quite work. But I think that if there was ever any hope of such a fit, Ryman and residential property is probably about as good a fit as you are ever likely to get. I also know that ENP has studied Ryman before and been an RYM shareholder before. And I know that Ryman is a soundly run company for all sorts of reasons that you are well aware of. So for ENP, investing in Ryman would not be a spur of the moment decision, as he would have a pretty good idea exactly what he was investing in.

Personally I am not invested in Ryman, because while I am convinced of long term soundness of the business model, I am not convinced of the relative bargain status of RYM at this time. But then again I would say exactly the same thing about buying property in Auckland. This is another way that my 'match' loosely works.

SNOOPY

Snoopy

10-08-2011, 12:34 AM

I agree Sauce.

I don't understand these people that buy investments as a "hedge"

Hedge against bank fees by buying WBC, ANZ, etc. Hedge against electricity prices by investing in CEN. I think this is silly thinking.

It reminds me of this Martin Hawes article... http://www.martinhawes.com/recent-articles.shtml

He is hedging against oil buy investing in NZ Oil and Gas.

If you want to hedge against something, buy the best performing asset you think rather than simply investing because of what industry it is in and the expense you are trying to hedge against.

I hadn't seen that Martin Hawes article before ENP. I think you have to consider that Hawes IMO primarily writes for people in the 50+ age bracket, with retirement in their sights, and those already retired. For this age group I would argue his article largely does make sense.

For someone such as yourself with decades of work time ahead of you should you choose it, the Hawes article is probably less valuable, except in one sense.

'Company choice lifestyle hedging' does mean that you focus on what is important to you and not what 'the market' is doing. Doing this I think will lead you out of being blinded by day to day market happenings that are injurous to your wealth. And less savvy investors who only see the 6pm news and think day to day share price movements are important in a long term investment plan, are likely to reduce their 'noise trading' if they consider their investments as more of a hedge.

Having said I basically agree with Hawes in context, there is one failure of logic in this referenced column that I see. NZO may be loosely in the oil industry. But it is not seriously correlated with pump petrol prices! Hawes, IMO, would be much better owning NZR if he truly wanted to stick to his fuel hedging plan!

SNOOPY

Snoopy

10-08-2011, 12:46 AM

For instance, one might feel happier owning CEN because power prices were rising, but the business only generates returns on equity of 5%. RYM generates returns on shareholders funds of 30%.

Getting off topic, but I think you will find things are not as simple as that Sauce. CEN may only generate an ROE of 5% on the book value of their assets. But IIRC, the book value of CEN assets was magically increased a few years ago to better reflect the market value of those generation assets. All of that magical increase in generation asset value has gone indirectly into the pockets of shareholders. If you look at the ROE on the original floated value of those assets, I believe it is far greater than 5%.

SNOOPY

ENP

10-08-2011, 07:20 AM

ENP, are you still looking to buy investment properties?

My own home rather than investment property. Intend to buy a house with my long term partner in 2013 and rent out the spare rooms.

ENP

10-08-2011, 07:25 AM

If you need a deposit for a house in say two years time. It is ENP's two to three year time horizon that I see as the issue here.

Yes my time frame is 2 years.

We could end up with another sudden market plunge. And what was looking like a nice deposit for a home is bled of cash overnight.

I am aware of this.

And how is he going to explain that to his significant other?

I don't think I would want to. It would be pretty gut wrenching if this happened.

I also know that ENP has studied Ryman before and been an RYM shareholder before.

It's the only company on the NZX I'd be happy to invest in. I know more about this company that any other investment in the world.

So for ENP, investing in Ryman would not be a spur of the moment decision, as he would have a pretty good idea exactly what he was investing in.

As per above. I have studied this company's annual reports, etc since it started.

ENP

10-08-2011, 07:33 AM

buns

10-08-2011, 08:03 AM

ENP

Mate you are learning fast

I don't know many who are at your age, with that much capital, and have read all the 'no brainer' or 'sure thing' stories on this site and others yet kept on the sidelines. Good work. You seem to have the head for it. This is all totally the opposite to how I began.

I've merely scanned this thread but also put 1 vote towards cashing up and buying undervalued shares. Hopefully you have spent the last 6 months finding these values and should be able to pull the trigger pretty quickly with the cash in hand. If this research has not been done, be careful, take a step back and maybe learn from this (not being ready), as you are young and these situations (or similar) will return.

Another thing. On that house, remember the market (price of your shares) may not look like how you want it in x months/years. Share prices could be 20% above your 'value' in 3 months, or could be 20% less than 'what you pay' for them in 2 years. Who knows? That is the market, that is why these discounts are here today. Over time, the price will come back to value.

If you HAVE to have this house on date x, I don't think shares are for you. You will understand this, but may have missed it as we always think about differences between value and price when wanting to enter a share, not exit.

Sauce

10-08-2011, 09:47 AM

While I think the chances of such a financial disaster is low, the consequence of the unlikely happening is very significant - ENP doesn't get his house. That is why I don't buy your maxmise your return philosophy Sauce, in this case.

Actually, I agree with you completely on this point. If he needs the money for something else in 2 years, it would be wise to decide the the market risk is too great with such a short time frame. But that was not my point. You will note what I wrote here:

Posted by Sauce:

In regards to any risk to his future property buying power - that's simply a 'go there' or 'don't go there' decision. Once he decides to 'go there' then he needs the best odds of success, which means making the best choice.

Posted by snoopy:

I have to admit to slightly gritting my teeth as I wrote my last post Sauce.

Yes I know a speculative sharemarket volatility 'marriage' to residential property 'prices' will never quite work. But I think that if there was ever any hope of such a fit, Ryman and residential property is probably about as good a fit as you are ever likely to get. I also know that ENP has studied Ryman before and been an RYM shareholder before. And I know that Ryman is a soundly run company for all sorts of reasons that you are well aware of. So for ENP, investing in Ryman would not be a spur of the moment decision, as he would have a pretty good idea exactly what he was investing in.

Sure. That all makes sense. But the idea of attempting linking returns to the property market is still one based on emotional comfort. But RYM is a good choice for the other reasons.

Personally I am not invested in Ryman, because while I am convinced of long term soundness of the business model, I am not convinced of the relative bargain status of RYM at this time. But then again I would say exactly the same thing about buying property in Auckland. This is another way that my 'match' loosely works.

Your right, it's not a bargain. I sold 20% of my RYM holding last week at 2.59 to buy a couple of 'relative bargains' on the ASX :)

But its also not as expensive as it will appear to people who don't appreciate the rate of return at which it is able to reinvest shareholders money. 6% cash yield, half paid out as a dividend and half reinvested at 30% return? Your 6% becomes 12% pretty quickly...

Regards,

Sauce

Sauce

10-08-2011, 09:54 AM

Getting off topic, but I think you will find things are not as simple as that Sauce. CEN may only generate an ROE of 5% on the book value of their assets. But IIRC, the book value of CEN assets was magically increased a few years ago to better reflect the market value of those generation assets. All of that magical increase in generation asset value has gone indiectly into the pockets of shareholders. If you look at the ROE on the original floated value of those assets, I believe it is far greater than 5%.

SNOOPY

Sure. Same as RYM if you look at ROE its 15%. But this is incorrect if you are working out the return generated on retained earnings because of the IFRS treatment of paper portfolio gains.

But the point still holds. RYM will provide shareholders more future purchasing ability than CEN - for power or any other thing you decide to spend the money on. Company choice lifestyle hedges are irrational.

Cheers

JBmurc

10-08-2011, 10:06 AM

Snoopy

10-08-2011, 11:30 AM

In the big scheme of things, this is basically to accumulate my house deposit faster.

My half share for a deposit is 45-50k (me and my long term partner will go 50/50) so should achieve this in 2-2.5 years time with my current savings levels.

If I was to invest in shares (RYM) and achieve say a 30% return after those 2 years, then my 23k will grow to roughly 30k. After tax will leave me with a little under 6k. It takes me about 7-8 months to save that. So I will have my house deposit 7-8 months faster. Likewise, if I keep the same time frame, I will have a larger deposit.

However, if say the shares lose 30% of 23k then I will be left with 16k from my original 23k. That 7k will take me 8-9 months to save additionally, meaning I will have to postpone out house purchase for 8-9 more months.

I intend to sell the shares when I have accumulated enough deposit (45-50k) no matter what has happened to them, if I sell at a loss then so be it.

You have done a sensitivity analysis and added up the possible outcomes, both good and bad. This provides a good context on why I suggested that only one quarter ($6k) of your cash should be in the sharemarket as of yesterday.

With one quarter of your cash in the market a 30% sharemarket loss would reduce your capital by $1.8k, down to $21.2k. With 2-3 months saving, and the associated 2-3 month delay in your house purchase you could make that loss up. Everyone must make their own decision on downside risk of course. But in my books that would be acceptable.

I could equally accept the argument that with such a small change to the house purchase plan even if things go right this whole idea of boosting your investments over a relatively short time frame isn't a goer.

Having said all of that RYM has rocketed in price from $2.49 yesterday to $2.64 as I write this. A 30% gain on $2.49 would take RYM to $3.24. A 30% gain on RYM from $2.64 takes RYM to $3.43. It looks like the time for doing this deal was yesterday, although given the volatility around it might also be tomorrow.

SNOOPY

biology12

10-08-2011, 11:42 AM

get on some banks, wbc is good, and a great yeild 7.5% for divs in december better return than in a term deposit.just hold till then

Snoopy

10-08-2011, 01:25 PM

You will note what I wrote here (Previously Posted by Sauce):

In regards to any risk to his future property buying power - that's simply a 'go there' or 'don't go there' decision. Once he decides to 'go there' then he needs the best odds of success, which means making the best choice.

Not buying a house is a fairly straightforward procedure. Buying a house is less so. Unless you buy a house with 100% cash, I would argue buying a house is not a simple 'go there' decision.

In my way of looking at things it is mainly the bank that owns your first house, notwithstanding the fact that you can decide what colour to paint the walls. You can decrease the relative power of the bank by putting more than the minimum equity required into your purchase, or purchasing a smaller house and maintaining more net cash than you otherwise would. Such a decision may effect how much you can spend on upgrading your house in the near future for a start. That means I would argue that buying a house is anything but the 'go there' binary decision you claim it to be Sauce.

As for chasing the 'best odds of success', I would argue that is subtley different from 'chasing the best odds of success to achieve your goal'. The difference being of course that the goalpost can move. I would argue that if you can couple your investment returns and your investment goals that is likely increase your task of reaching your goal. The downside is you might achieve a worse total return. The upside is that what you thought was going to be your best total return becomes insufficient due to the goalposts moving.

The idea of attempting linking returns to the property market is still one based on emotional comfort. But RYM is a good choice for the other reasons.

You are saying that 'emotional comfort' (whatever that means) is not a good thing?

SNOOPY

Snoopy

10-08-2011, 01:33 PM

get on some banks, wbc is good, and a great yield 7.5% for divs in December better return than in a term deposit.just hold till then

I like the cut of your idea bio12. Making money out of them before they start making money out of you appeals to my hedging (there's that word again) instinct. But again your strategy depends on being able to sell your bank shares for more than you paid for them to avoid capital loss. You have to ask the question even if a capital gain seems more likely what happens to your 7.5% return if you can't?

SNOOPY

Sauce

10-08-2011, 02:44 PM

Not buying a house is a fairly straightforward procedure. Buying a house is less so. Unless you buy a house with 100% cash, I would argue buying a house is not a simple 'go there' decision.

You've taken my words wrong - I wasn't talking about whether he buys a house or not. The decision I am talking about is whether or not to use some or all of his future house deposit fund to buy shares, in context with the discussion, a binary decision. And I agreed with you that it would be perfectly rational to make the decision not to do it all based on market risk.

However, If he makes the decision to do so, then the most rational thing to do is to invest his funds with the greatest risk weighted odds of achieving the highest return. Attempting to somehow attach a potential return to house price fluctuations is not in the slightest bit helpful to obtaining the greatest odds of having a bigger deposit in two or three years.

You are saying that 'emotional comfort' (whatever that means) is not a good thing?
SNOOPY

In the context of our discussion, No, it is not a good thing at all. It is not rational to forgo a potentially better performing investment, so that you can sleep at night knowing that if the value of your shares go down, you might be alright because you might be able to buy that house cheaper in two years anyway!!! That's is a flawed way to look at investing.

If RYM or CEN are the right investments, it is not because they are linked to my rising or declining personal costs. I have often remarked that there is something strangely satisfying about funding your retirement through owning retirement villages. But that is simply an emotional feeling. If it's a bad investment, then it won't help me retire. If I find a better investment elsewhere then I should invest in that or I wear an opportunity cost - such as what I did with RYM this week for instance. So the investment simply needs to taken on its merits and emotional comfort ignored.

The true hedge against rising costs, is simply to own the best performing investments you can get, regardless of how they make their money.

I have a Wife that I get a lot of emotional comfort from. But that is a different context and discussion :)

Regards,

Sauce

Sauce

10-08-2011, 03:59 PM

As for chasing the 'best odds of success', I would argue that is subtley different from 'chasing the best odds of success to achieve your goal'. The difference being of course that the goalpost can move. I would argue that if you can couple your investment returns and your investment goals that is likely increase your task of reaching your goal. The downside is you might achieve a worse total return. The upside is that what you thought was going to be your best total return becomes insufficient due to the goalposts moving.

This is flawed. If you aim for the greatest risk weighted odds of achieving the highest return your goal is quite simply the best possible hedge if house prices rise. And If house prices fall, then you win on both sides. That is the best way to ensure you stay on the right side of the "goal posts".

Trying to link your returns to the "goal posts" is simply a way of attempting to ensure house price volatility doesn't make you feel bad. This is false security which is highly likely to carry intangible loss (opportunity cost) even if it was possible, which it is not. If ENP required this kind of emotional comfort, I would suggest staying out the share market entirely. But I suspect he has a stronger temperament.

The reality is you can't actually achieve the link between house price movements and individual share prices anyway. So the real "goal post" is to make a better return than your cost of capital (the interest rate + break cost of the initial funds), this will put you in a better deposit situation than if you decided not to break the term deposits. House price movements are in fact completely irrelevant in the context of what investment he should choose. But would become relevant to other decisions such as when to buy the house, when to cash in investments, etc etc.

Regards,

Sauce

Snoopy

10-08-2011, 05:35 PM

The decision I am talking about is whether or not to use some or all of his future house deposit fund to buy shares, in context with the discussion, a binary decision.

Sauce, sorry for any previous misunderstanding of your point. But look at what you just wrote. How can deciding the percentage of house deposit funds to invest be a 'binary decision'? There are 100 integer choices, starting from 1% and ending with 100% for a start. And the percentage figure you choose will affect both the upside and the downside risk for the same underlying sharemarket investment.

However, If he makes the decision to do so, then the most rational thing to do is to invest his funds with the greatest risk weighted odds of achieving the highest return. Attempting to somehow attach a potential return to house price fluctuations is not in the slightest bit helpful to obtaining the greatest odds of having a bigger deposit in two or three years.

OK then, which of any equity investments available will provide the best return in two years? If the oil price goes up to $US300 per barrel then one of the best NZX50 investments around is likely to be Contact Energy. Their renewable generation assets have a known fixed operating cost. CEN's profit will be the difference between the marginal cost of generating new baseload power minus the (low) operating costs of their existing baseload renewables generation assets.

OTOH if oil drops to $US50 per barrel all these new geothermal power plants that Contact wants to bring on line are in big trouble. High operating costs will see them mothballed and the holding interest costs will likely destroy Contact's profitability.

So what will the oil price be in two years time: $US50 or $US300? Once you can figure that out whether or not to invest in Contact is a no brainer :-P!

Of course using the product/service hedging investment philosophy, you do not need a crystal ball. You invest and whatever the result in two years time you will wear it. If power costs are high, so are your dividends from Contact. If power costs are low you take a haircut on your Contact investment but your power bills will be offsettingly low.

I have used power as a conceptually simple example of how product/service hedging investing works. But I hope you can see that I could use exactly the same argument for using the product/service (in this case the product is a property) hedging argument for housing.

Whether you can actually find a listed entity that follows house prices the way that Contact follows power bills is another question. But IMO, conceptually, the product/service hedging strategy regarding property is sound.

SNOOPY

Sauce

10-08-2011, 08:15 PM

Sauce, sorry for any previous misunderstanding of your point. But look at what you just wrote. How can deciding the percentage of house deposit funds to invest be a 'binary decision'? There are 100 integer choices, starting from 1% and ending with 100% for a start. And the percentage figure you choose will affect both the upside and the downside risk for the same underlying sharemarket investment.

Haha, I knew you would say that. You are steering the debate away from my point to argue semantics. But, for the sake of a bit of banter: For me the initial decision is "yes or no" i.e. Binary. If the answer is "yes", THEN the question becomes how much? (I believe Boolean Logic applies to binary decisions ;) ) And yes, how much is an important question, I agree. You can focus on this if you want, but the banter below is the real discussion.

OK then, which of any equity investments available will provide the best return in two years? If the oil price goes up to $US300 per barrel then one of the best NZX50 investments around is likely to be Contact Energy. Their renewable generation assets have a known fixed operating cost. CEN's profit will be the difference between the marginal cost of generating new baseload power minus the (low) operating costs of their existing baseload renewables generation assets.

OTOH if oil drops to $US50 per barrel all these new geothermal power plants that Contact wants to bring on line are in big trouble. High operating costs will see them mothballed and the holding interest costs will likely destroy Contact's profitability.

So what will the oil price be in two years time: $US50 or $US300? Once you can figure that out whether or not to invest in Contact is a no brainer :-P!

I can say "the market for retirement villages is forecast to grow by X in the next 20 years" or "The price of oil is likely to be higher in the future because we are running out" and those kind of considerations are important when analysing CEN or RYM, as long as they are combined with understanding the business, it's competitive position and its value.

But that is very different than your thesis, which is that there is an offset that somehow protects you if power prices go down, or house prices go down, or retirement village prices get cheaper. The fact is that those reductions in personal expenses are there regardless if you own CEN or RYM or not. There is NO offset to a capital loss from your personal expense reduction, because you will get that benefit regardless of what you invest in. You have just lost that capital.

If you buy CEN you are in effect making a bet that CEN will outperform other investments. I.e. your opportunity cost. End of story.

Of course using the product/service hedging investment philosophy, you do not need a crystal ball. You invest and whatever the result in two years time you will wear it. If power costs are high, so are your dividends from Contact. If power costs are low you take a haircut on your Contact investment but your power bills will be offsettingly low.

Are only Contact shareholders entitled to lower power bills Snoopy?

This reasoning is completely irrational for the reason above. You get the downside benefit regardless of whether you invest in contact or not, so its only the upside that you should be interested in.

I have used power as a conceptually simple example of how product/service hedging investing works. But I hope you can see that I could use exactly the same argument for using the product/service (in this case the product is a property) hedging argument for housing.

Whether you can actually find a listed entity that follows house prices the way that Contact follows power bills is another question. But IMO, conceptually, the product/service hedging strategy regarding property is sound.

SNOOPY

Although it comes with a degree of emotional comfort, your hedging strategy is flawed.

Even if your hedging strategy wasn't flawed, in ENP's case the variables are too complex to find any reliable link between house values and business results/share prices, as you allude to.

However, I very much enjoy the banter Snoopy :) and as previously mentioned, I always enjoy your generally rational and wise investment views. So no disrespect is desired here, but I simply cannot agree.

Regards,

Sauce

peat

10-08-2011, 10:05 PM

my thoughts would be that you shouldnt break term investments to speculate (or get your house faster) because this loss that you take on the break fees means you have to do even better on the risky investment to break even where break even means a risk adjusted reward. Term deposits are there to preserve capital and decrease volatility/risk in the overall portfolio. You should have made some decisions on goals and ways to achieve those goals earlier and not be restrategizing every time the Vix farts. (not that I think this is just a fart - but it may well be)
If you were using the bond market to achieve your goals faster(instead of equities) look how only a few weeks ago you might have gone short on bonds thinking inflation was going to kick in - there were whole page articles in the Herald if i recall correctly, but no - we're not going there just yet.
Goals under five years away shouldnt be steered towards in a volatile investment vehicle.

Sauce

10-08-2011, 10:12 PM

Sound advice Peat.

Snoopy

11-08-2011, 10:01 AM

Your thesis: which is that there is an offset that somehow protects you if power prices go down, or house prices go down, or retirement village prices get cheaper. The fact is that those reductions in personal expenses are there regardless if you own CEN or RYM or not. There is NO offset to a capital loss from your personal expense reduction, because you will get that benefit regardless of what you invest in. You have just lost that capital.

Sauce, hedging is used as a technique to moderate potential losses and potential gains under conditions of market uncertainty. After the event, when the market has spoken, it is very easy to make any prior hedging look silly.

Your presentation of 'my thesis' is only partial and muddled. A product/service hedge in the electricity market from a consumer perspective will protect you if the price of electricity goes up and will punish you if the price of electricity goes down. But if you knew which way the market would go, there would be no point in making a hedge in the first place.

Your statement that if the share price of (CEN in this case) goes down you have lost capital is true, but meaningless in this discussion. Taking out a hedge implicitly means that you do not know whether the share price of CEN will go up or down until after the event.

SNOOPY

Snoopy

11-08-2011, 10:19 AM

Are only Contact shareholders entitled to lower power bills Snoopy?

No, and thanks for raising this issue which I meant to tackle myself.

If you believe in 'power hedging' at the retail customer level, then you should buy shares in either Trustpower or Contact because these are the only options available.

If you are a Meridian customer, perhaps you would be warmer and fuzzier holding Meridian shares. But since Meridian at the time of writing is 100% owned by the government you can't own Meridian shares. So you would buy Trustpower or Contact as the next best available expense tracking vehicles.

Taking the argument further, I tend to clock up a few domestic and international air miles during the year. To best track my expenses, I should own Air New Zealand shares. But IMO, the whole airline industry is a lousy business model from an investor perspective. So instead I own Sky City Enertainment shares as a proxy for my 'leisure spend', even though I haven't set foot inside a casino in this country for around ten years! That may sound crazy. But in my assessment owning the best business in the general sector that you spend in makes sense.

Take the best business you can find in the general sector you are spending in is my philosophy. It doesn't have to be an exact match.

This reasoning is completely irrational for the reason above. You get the downside benefit regardless of whether you invest in contact or not, so its only the upside that you should be interested in.

If you can't see that if you have a series of bills to pay coming up that they are always subject to both upside and downside risks, then I think you are missing the point.

SNOOPY

Snoopy

11-08-2011, 10:34 AM

In ENP's case the variables are too complex to find any reliable link between house values and business results/share prices, as you allude to.

Ideally you would want a listed vehicle that rents out houses. I know that retirement villages are not pure renting in the traditional sense. But I would argue that with Ryman you are buying into a 'rental company plus'. The plus factors include a generallly lower turnover rate of tenants, tenants less likely to soil their nests, and tenants that you don't have to give 'the bond' back to in the end. The Plus of course also includes all of the captive healthcare and associated services that Ryman offers to the inmates.

If I was 'hedging on housing' and there was a pure house owning entity on the NZX it is very unlikely that I would buy it. Not with Ryman sitting there as an alternative housing sector investment, even though RYM is not as good a match. RYM has the better business model, which is what it is all about in the end.

SNOOPY

Sauce

11-08-2011, 04:48 PM

Sauce, hedging is used as a technique to moderate potential losses and potential gains under conditions of market uncertainty. After the event, when the market has spoken, it is very easy to make any prior hedging look silly.

Your statement that if the share price of (CEN in this case) goes down you have lost capital is true, but meaningless in this discussion. Taking out a hedge implicitly means that you do not know whether the share price of CEN will go up or down until after the event.

SNOOPY

You are confusing my point again, every consumer benefits if power prices go down, even if they are not in the share market. So owning CEN provides an investor with absolutely NO downside hedge to start with. Unlike what you suggest here:

Of course using the product/service hedging investment philosophy, you do not need a crystal ball. You invest and whatever the result in two years time you will wear it. If power costs are high, so are your dividends from Contact. If power costs are low you take a haircut on your Contact investment but your power bills will be offsettingly low.

That is not a hedge. Lower power bills might make you feel better, but that is an illusion. If I buy a non-power related stock that triples in value in the next three years, and power prices plunge, I get triple my money, plus lower power prices. If I buy CEN and power prices plunge, I get a capital loss and lower power prices. Can you explain how the person who has purchased CEN has gained any relative benefit from the lower power prices i.e. how is the downside hedged ?

Since I would have received the lower power bills regardless of my CEN investment it is irrational to factor that in as some kind of "win".

Buying CEN is simply a bet that the investment will be a good one. It does give NOT give you a natural hedge against falling power prices. It simply exposes you to the risk of falling power prices, with the prospect of gain if power prices rise. So, I will say it again, an investor should only be interested in the upside potential of CEN relative to other potential investments.

The only rational decision making process, is to buy the best investment you possibly can, whether that business is linked to your personal consumer costs or not is completely immaterial. It makes no difference. But, potentially, making a bet on higher power prices in the future might have some merit.

Regards,

Sauce

Snoopy

11-08-2011, 07:05 PM

Every consumer benefits if power prices go down, even if they are not in the share market. So owning CEN provides an investor with absolutely NO downside hedge to start with.

Sauce, let me try explaining again. Consider four different customer scenarios.

1/ Contact customer (not a shareholder) gets a rise in their power unit price.
2/ Contact customer (not a shareholder) gets a cut in their power unit price.
3/ Contact customer and shareholder gets a rise in their power unit price.
4/ Contact customer and shareholder gets a cut in their power unit price.

We assume that consumer power price cuts result in a loss of earnings to the company Contact Energy.

Q1/ The power price goes down to the consumer. Is the consumer in scenario 2/ or scenario 4/ better off?
A1/ The best off is customer 2, the non shareholder.

Q2/ The power price goes up to the consumer. Is the consumer in scenario 1/ or scenario 3/ worse off?
A2/ The worst of customer is customer 1, the non shareholder.

The non shareholder is both best off (if the power price is reduced to them) and worst off (if the power price is increased to them). But this is irrelevent to the topic under discussion because this customer is not hedged.

A shareholder customer is not 'downside hedged' or 'upside hedged'. They are just 'hedged'. Whatever happens to the power price they will be less affected than the unhedged customer when exposed to the same market forces. That does not mean they will automatically be better off if they are hedged, as you seem to think I claimed.

SNOOPY

Sauce

11-08-2011, 07:06 PM

If I was 'hedging on housing' and there was a pure house owning entity on the NZX it is very unlikely that I would buy it. Not with Ryman sitting there as an alternative housing sector investment, even though RYM is not as good a match. RYM has the better business model, which is what it is all about in the end.
SNOOPY

Finally a hint of rationalism! :)

By exactly the same reasoning, if ENP finds an investment that he believes has a much higher probability of returning more than RYM in two years, but had no housing market link at all. He would be wisest to choose that over RYM, as it will give him the greatest odds of achieving his goal, regardless of what house prices do.

Regards,

Sauce

Sauce

11-08-2011, 07:18 PM

A shareholder customer is not 'downside hedged' or 'upside hedged'. They are just 'hedged'. Whatever happens to the power price they will be less affected than the unhedged customer when exposed to the same market forces. That does not mean they will automatically be better off if they are hedged, as you seem to think I claimed.

Snoopy, a hedge is a position intended to offset potential losses. Since a long position in CEN provides no offset to lower power prices, relative to investing in something else. You are EXPOSED to power prices, not HEDGED to them. If you buy a short and long position you are hedged because you make a gain on the downside that OFFSETS your loss.

The ultimate issue here is one of opportunity cost. If you invest in CEN you are making a bet that it will do well. If you can find an investment that is more likely to do better than CEN then that is what you should do. Your personal power bills are irrelevant.

Snoopy

11-08-2011, 07:23 PM

That is not a hedge. Lower power bills might make you feel better, but that is an illusion. If I buy a non-power related stock that triples in value in the next three years, and power prices plunge, I get triple my money, plus lower power prices. If I buy CEN and power prices plunge, I get a capital loss and lower power prices. Can you explain how the person who has purchased CEN has gained any relative benefit from the lower power prices i.e. how is the downside hedged ?

Sauce, your example is with the benefit of hindsight. It is impossible to go to your broker and buy a share that is guaranteed to triple in value within three years (a certainty). I am sure it is possible to buy a share that will triple in value in three years. The problem is it will take three years for us to know what that share is! Hedging is about mitigating uncertainty. If there is no uncertainty, then you cannot hedge.

SNOOPY

Snoopy

11-08-2011, 07:26 PM

Snoopy, a hedge is a position intended to offset potential losses.

No, that is a misconception.

SNOOPY

PS The purpose of a hedge is to provide certainty of price. The certainty is the benefit. The customer price paid, in relation to the spot market price on contract settlement date, may be either favourable or unfavourable.

Snoopy

11-08-2011, 07:32 PM

If you invest in CEN you are making a bet that it will do well.

No doubt as a shareholder you have invested in CEN hoping it will do well. But you are not making an exclusive bet that CEN will do well. Because if CEN does not do well you have also made a bet on the downside by sharing that downside. A shareholder in CEN has actually taken both an upside and a downside bet all wrapped up in one shareholding contract.

SNOOPY

Sauce

11-08-2011, 07:39 PM

Sauce, your example is with the benefit of hindsight. It is impossible to go to your broker and buy a share that is guaranteed to triple in value within three years (a certainty).

Of course there is no guarantee. As I have been saying all along, an investor should be purchasing the investment with the best odds, weighted for risk, of making the highest return. When weighing up CEN as a possible choice, her personal power bills are irrelevant because she will benefit from lower costs regardless of what she invests in.

Sauce

11-08-2011, 07:47 PM

No, that is a misconception.

I am happy to be corrected on this Snoopy, I have no problem being wrong. Here are three quick definitions:

From Dictionary.com :

1. a row of bushes or small trees planted close together, especially when forming a fence or boundary; hedgerow: small fields separated by hedges.

2. any barrier or boundary: a hedge of stones.

3. an act or means of preventing complete loss of a bet, an argument, an investment, or the like, with a partially counterbalancing or qualifying one.

From Wikipedia:
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.

From investopedia:
What Does Hedge Mean?
Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

Investopedia explains Hedge
An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

Sauce

11-08-2011, 07:52 PM

No doubt as a shareholder you have invested in CEN hoping it will do well. But you are not making an exclusive bet that CEN will do well. Because if CEN does not do well you have also made a bet on the downside by sharing that downside. A shareholder in CEN has actually taken both an upside and a downside bet all wrapped up in one shareholding contract.

You avoided addressing the point of my post, quoted part of it, and then steered the debate towards a semantic point.

For the sake of the banter: When someone places a BET they have a desired outcome. The desired outcome in context is profit. It is the upside the investor is interested in with his BET. There is upside and downside risk sure. And you can make a BET either way, or both ways.

Lets perhaps try to avoid the rabbit hole of semantics we are traveling down :)

Snoopy

11-08-2011, 09:57 PM

I am happy to be corrected on this Snoopy, I have no problem being wrong.

From Wikipedia:
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.

Sauce, I think in an investment forum you should take a look at the specialist investor definition of 'hedge'. However, I will try to clarify not those, but the Wikipedia definition above. Because I think that is the definition of hedge that is closest to that commonly understood.

I think that the motive behind most companies or individuals taking out a 'hedge' is to avoid potential loss. However, that is not the same as saying that any hedge taken out has a sole consequence of avoiding the initiator's loss. There are other consequences of taking out a hedge contract that are not so loudly trumpeted.

------

If avoiding a loss was the only hedging consequence, it follows that somewhere, there in downtown New York, there is partnership named "Whizzkid Hedge Interative Traders", or WHIT for short. The members of WHIT are all Harvard Graduates and all are on megasalaries. WHIT is a service based business and exists solely for the purpose of helping corporate customers out. If there is a fear of loss in the corporate world, WHIT comes in. WHIT guys don't deal with underlings. They go straight to the CEO. Exactly what goes on behind those corporate doors we outsiders will never know. Except that all the partners to the negotiation on each side of the corporate desk always smoke cigars.

Negotiations are cut throat. But the WHIT boys always swagger out of the corporate suite with their suits uncrumpled. They take the 'big hedging hits' for the corporates, and with their connections and fantastical intellectual capability are there again for the corporates should any more loss relief be required......

-----

Now I know you know a fair bit about how businesses operate Sauce. And I imagine that if you spend a little time thinking about the WHIT business model I have outlined, you will come to the same conclusion as I would regarding its long term viability!

I think to understand hedging you have to look at the hedge from the perspective of both sides. A hedge is of necessity a trade off. Very few corporate reports are going to emphaise that hedging contracts are not a one way steet. But they can't be a one way street if those WHIT boys above are ever going to make an honest buck.

You aren't 'wrong' with your thinking about hedging Sauce. You just need to remove yourself from the immediate distraction of just the customer perception of the deal to get a more all enveloping perspective of what is going on.

SNOOPY

Snoopy

11-08-2011, 10:30 PM

If ENP finds an investment that he believes has a much higher probability of returning more than RYM in two years, but had no housing market link at all. He would be wisest to choose that over RYM, as it will give him the greatest odds of achieving his goal, regardless of what house prices do.

'believes has a much higher probability of returning' is the key pharse here Sauce. You and I both know that that ENP is a smart investment cookie. There is every chance that his share selection will perform as he believes. But there is some chance that his investment selection will not perform as he expects.

I am sure that ENP would like to make as much as possible from his investment. But his immediate goal is $50k, not squillions of dollars. ENP doesn't need the greatest possible return to reach his immediate goal. This is where hedging can come in.

Suppose ENP identifies an investment that makes squillions but is very risky. Would it not make sense for ENP to find another market player to guarantee him $50k, but still allow him to hold his investment to allow him to particpate in the ongoing global upside of his investment gem? Of course it would! Naturally this other market player would want to take his cut. ENP might say goodbye to half of his future profits when he signs such a profit sharing deal. But it would be worth it to ENP to guarantee that $50k that he wants.

ENP is a winner in this deal because it gets him to where he wants to go. And you can be a winner without maximising your return if the other trade offs are right.

I have steered this debate away from housing and towards energy, because the risks in energy are easier to see. But there are all sorts of risks in housing too, which most choose not to think about.

ENP has a 'deposit target'. But by stating a target like this is it not implicit in that:

1/ House prices will not move upwards significantly within the next two years.
2/ The percentage deposit that the bank requires will not change within the next two years.
3/ Mortgage Interest rates will not soar to 12%+ in the next two years.

Personally I don't believe any or all of the above happening is likely. But that doesn't mean it is impossible. And if you can devise an investment strategy that will still work if any or all of the above happened, why would you not do it, even if it meant giving away the potential cream on your investment returns?

SNOOPY

Sauce

12-08-2011, 04:32 PM

1/ House prices will not move upwards significantly within the next two years.
2/ The percentage deposit that the bank requires will not change within the next two years.
3/ Mortgage Interest rates will not soar to 12%+ in the next two years.

Personally I don't believe any or all of the above happening is likely. But that doesn't mean it is impossible. And if you can devise an investment strategy that will still work if any or all of the above happened, why would you not do it, even if it meant giving away the potential cream on your investment returns?

SNOOPY

Read your last paragraph a few times and have a think about what you are saying here.

First you state that you believe it is very unlikely that your given scenario will actually happen. Then you suggest we should protect for that very unlikely occurance at the expense of greater profit.

Rational?

Hmmm.... I think in one paragraph you have summed up the lunacy of the idea myself.

ENP

12-08-2011, 06:16 PM

Sauce

12-08-2011, 06:44 PM

Snoopy,

Here are the two statements I believe are misleading:

Snoopy:

Saving for a property, I would tend to look for a sharemarket listing that had a property component to it. That way if the property market goes up in the next two years, then so should the underlying investment. If the property market tanks then your investment may go down. But since you then wouldn't need as much money as a deposit to buy your own property, this would not matter.

And

Snoopy:

Of course using the product/service hedging investment philosophy, you do not need a crystal ball. You invest and whatever the result in two years time you will wear it. If power costs are high, so are your dividends from Contact. If power costs are low you take a haircut on your Contact investment but your power bills will be offsettingly low.

Both of these statements imply that there some kind of 'win' or 'offset' in these respective situations if house or power prices go down. This is simply incorrect and I believe you know it. You have steered the debate away from this point and ignored my attempts to bring it back. This was the crux of my original point.

Since ENP will get the benefit of lower house or power prices regardless of what he invests in there is no REAL 'offset' or 'win' with lower prices, contrary to your suggestion.

Regards,

Sauce

Sauce

12-08-2011, 07:09 PM

Hmm..

Thought the markets would continue to fall. At current prices, RYM doesn't look like a bargain buy at all. Still invested in TD's.

Concerning putting only a portion of my funds is shares and the rest in cash as Snoopy pointed out. I couldn't do that. I'm an all or nothing guy! Can't go half measures. :D

Interesting discussion between you two. I've enjoyed reading it.

Haha I like your all or nothing attitude. A good contrast to Snoopy's wise and conservative nature perhaps? :)

My opinion (for what its worth.. i.e. nothing ):

As you are well aware (intelligently IMO) RYM is a very very good business. Perhaps even unrivaled in a small market like NZ for competitive dynamics that give it incredible odds of becoming a very large business while returning exceptionally large returns to shareholders. So, if you were to own it for the long term, I personally believe there is a case for buying RYM with a slimmer 'margin of safety' if you truly understand it.

Unfortunately I think the real issue is that two years is really too short a time frame... As others have wisely pointed out.

They are NOT over priced. In my opinion of course. Before I took the top off my RYM shares last week, they made up about 35% of my portfolio. So as you can see, I am not averse to the odd 'all in bet' myself :)

Regards,

Sauce

Snoopy

12-08-2011, 08:42 PM

Read your last paragraph a few times and have a think about what you are saying here.

First you state that you believe it is very unlikely that your given scenario will actually happen.

Yes

Then you suggest we should protect for that very unlikely occurance at the expense of greater profit.

Yes

Rational?

Yes, because although the chance of the strategy failing is low (ENP is liable to be a good share picker and understands the Mr Market parable) the consequence of failure is high (ENP doesn't get his house). It does make sense to give away some profits if it means you can secure your goal. I think you are getting it Sauce!

SNOOPY

Snoopy

12-08-2011, 09:20 PM

Both of these statements imply that there some kind of 'win' or 'offset' in these respective situations if house or power prices go down. This is simply incorrect and I believe you know it. You have steered the debate away from this point and ignored my attempts to bring it back. This was the crux of my original point.

Sauce you are doing it again. You are looking at only one half of what I said in those quotes. In both of those quotes I talked about the respective markets going up or down. Yet you chose only to focus on what I said about each market going down. You are looking at only one end of the handshake.

Perhaps it might make more sense to you if I said that my buying shares for product/service hedging is a smoothing strategy. I am prepared equally for the market going up or down. I do not have to guess whether the market will go up or down for my strategy to work. The purpose of my strategy is to have more certainty over the amount of capital at the end of it all. And yes to get that certainty I will be giving some of those market profits away, in a calculated rational way.

SNOOPY

Sauce

13-08-2011, 12:31 AM

Yes, because although the chance of the strategy failing is low (ENP is liable to be a good share picker and understands the Mr Market parable) the consequence of failure is high (ENP doesn't get his house). It does make sense to give away some profits if it means you can secure your goal. I think you are getting it Sauce!
SNOOPY

Perhaps it might make more sense to you if I said that my buying shares for product/service hedging is a smoothing strategy. I am prepared equally for the market going up or down. I do not have to guess whether the market will go up or down for my strategy to work. The purpose of my strategy is to have more certainty over the amount of capital at the end of it all. And yes to get that certainty I will be giving some of those market profits away, in a calculated rational way.

You are right. Hypothetically, if ENP could somehow attach his returns to the rise and fall of the value of his future house, he can know with certainty how much capital he will have 'in proportion' to his future house value. Unfortunately, he will be in no better position to actually buy the house. In fact, the more successful his is in his attempt to 'smooth' things out, the more he is effectively 'hedged' against achieving his goal:

If house prices rise by 10%, he needs a 10% bigger deposit to buy the house. If his investment is 'hedged' as such, and goes up by just 10%, he is no closer to home ownership. If property prices fall by 10% he needs a 10% lower deposit, but his investment is 10% lower also - now he is actually WORSE off than if he had stayed in the term deposits. So your hedging strategy has only provided an upside that is capped at a position where he can't even achieve his goal and the downside is massive, because it includes any fall in property prices PLUS his lost interest and break fees.

The truth is, he can't really win at all with your strategy. It's a bit like running on a fast treadmill with a shark infested pool behind you.

His goal is to be closer to home ownership than he will be in term deposits. Hence why he is taking the risk of going into equities in the first place.

So the only two rational decisions are to either:

1. Stay in term deposits and take no undue risk
2. Invest his funds with the greatest risk-weighted probability of beating his term deposit return.

The reality is that his whole reason for pursuing an equity investment is a very intelligent bet that:

1. The housing market is in the doldrums after a huge boom, with odds favoring flat, or lower, prices over the next 2 years
2. An irrational panic caused by political and financial instability in the world has caused share markets to under value businesses
3. The micro-economics of certain companies will not be affected by world events.
4. Due to the bargain prices they can be purchased at, and rate that the underlying businesses are compounding at, they are exceptionally likely to outperform his term deposits.

The only argument for linking his returns to house prices, is if you believe house prices will RISE more than his term deposits. I.e. He will beat his opportunity cost. His cost of capital. You of all people should understand this Snoopy.

You might feel warm and fuzzy believing you are somehow 'hedged' to your future house purchase, but by ignoring the opportunity cost (just staying in term deposits), you are understating the true risk. It is a flawed strategy that is actually just a bet on rising house prices, and not a good one at that.

Regards,

Sauce

Snoopy

13-08-2011, 11:18 AM

You are right. Hypothetically, if ENP could somehow attach his returns to the rise and fall of the value of his future house, he can know with certainty how much capital he will have 'in proportion' to his future house value.

Right. That is the whole point of the product/service investment hedge idea I am proposing

Unfortunately, he will be in no better position to actually buy the house.

Correct. But he will also be in no worse a position to buy his house.

If house prices rise by 10%, he needs a 10% bigger deposit to buy the house. If his investment is 'hedged' as such, and goes up by just 10%, he is no closer to home ownership.

I agree

If property prices fall by 10% he needs a 10% lower deposit, but his investment is 10% lower also - now he is actually WORSE off than if he had stayed in the term deposits.

I agree again. But you have missed one crucial sub text of this plot Sauce. ENP does not know in advance if house prices will fall by 10%. It is very easy to be wise after the event and say.

"Well what a fool you were ENP!" "You would have been better off not investing in Ryman (for example) with the share price tanking 10%." "You should have just held onto your term deposits."

Such a criticisim would be spurious. Because you can only make investment decisions with knowledge you have at the time you take the investment out.

So your hedging strategy has only provided an upside that is capped at a position where he can't even achieve his goal and the downside is massive, because it includes any fall in property prices PLUS his lost interest and break fees.

Sauce, ENP will achieve his goal. Because his main input is savings from his job. All he really needs is a mattress to stuff his cash into. A bank term deposit, a hedging investment strategy coup-led with any higher risk returns on equities he cares to make are cream on the core of ENP's scheme.

The truth is, he can't really win at all with your strategy.

No he can't. Hedging isn't about winning. It is about certainty of result.

SNOOPY

Sauce

13-08-2011, 11:25 AM

No he can't. Hedging isn't about winning. It is about certainty of result.
SNOOPY

Wow you just completely ignored my entire point. He has practically absolute certainty that his term deposit will outperform against ALL outcomes in your strategy except a rise in house prices above his term deposit return.

So to take away the certainty he already has, he needs to make a judgement about how likely that is to occur, or he is making a mistake.

You are ignoring the costs and risks involved with your strategy.

As a suggestion; research concepts like 'opportunity cost' and 'cost of capital' and 'time value of money' .

Regards,

Sauce

Sauce

13-08-2011, 11:49 AM

I agree again. But you have missed one crucial sub text of this plot Sauce. ENP does not know in advance if house prices will fall by 10%. It is very easy to be wise after the event and say.

"Well what a fool you were ENP!" "You would have been better off not investing in Ryman (for example) with the share price tanking 10%." "You should have just held onto your term deposits."

Of course you don't know what house prices will do. That's why pretending that swapping the certainty of term deposits for the uncertainty of house price movements, and then dressing that up as if its something that's certain, is absurd.

Such a criticisim would be spurious. Because you can only make investment decisions with knowledge you have at the time you take the investment out.

Yes you have to work with the knowledge you have at the time. The only knowledge that is certain is how much money you will have when your term deposits mature.

So, armed with that information, the only two rational decisions are to either:

1. Stay in term deposits and take no undue risk
2. Invest his funds with the greatest risk-weighted probability of beating his term deposit return.

Regards,

Sauce

Snoopy

13-08-2011, 11:51 AM

His goal is to be closer to home ownership than he will be in term deposits. Hence why he is taking the risk of going into equities in the first place.

ENP is giving us mixed messages about his goal. On the one hand he says that he wants his house deposit of $50k in two to two and a bit years.

On the other hand he is an 'all or nothing kind of guy' and would only consider investing his total savings in the market at this stage. Yet he is aware that the value of his Ryman shares (say), could go down by 30% becasue of 'market factors' in two years even while the underlying business plan at Ryman remains intact. If that happens then ENP will not be able to meet his savings goal in the timeframe he wants.

That may not be a problem if he is prepared to work and save for another year to make up his losses. But the way I see it ENP can't have both the certainty of achieving his investment goal within a a two year timeframe AND be fully invested in the sharemarket up until that point.

Note carefully what I have just said here, and what I have not said. Clearly it is possible to be invested fully in the NZ sharemarket and achieve your investment goal within two years. But it is not possible to do this with any certainty.

So the only two rational decisions are to either:

1. Stay in term deposits and take no undue risk
2. Invest his funds with the greatest risk-weighted probability of beating his term deposit return.

Suppose the highest risk weighted probability is to invest in something like Contact Energy. I think even you would acknowledge Sauce that the price of energy is not well correlated to house prices.

If ENP put all his capital into CEN and it did not perform, he could be much worse off than if he had put that same money into Ryman shares. Even if Ryman shares had a lower risk weighted probability return at the time the investment was made.

The only argument for linking his returns to house prices, is if you believe house prices will RISE more than his term deposits. I.e. He will beat his opportunity cost. His cost of capital. You of all people should understand this Snoopy.

There is an alternative argument. He should invest in an equity linked to house prices in the unlikely event of house prices rising, so that even if that unlikely event occurs ENP can still achieve his goal of home ownership. If he could do this so that in the unlikely event of house prices falling significantly over the next two years, such a strategy wouldn't damage his chances of home ownership, then he sould seriously consider implementing such a strategy.

It is a flawed strategy that is actually just a bet on rising house prices, and not a good one at that.

You are being consistently unidirectional in your viewpoint Sauce. Are you sure you are not a Cantabrian?

SNOOPY

Sauce

13-08-2011, 12:12 PM

There is an alternative argument. He should invest in an equity linked to house prices in the unlikely event of house prices rising, so that even if that unlikely event occurs ENP can still achieve his goal of home ownership. If he could do this so that in the unlikely event of house prices falling significantly over the next two years, such a strategy wouldn't damage his chances of home ownership, then he sould seriously consider implementing such a strategy.

On balance of probabilities, you are saying you are more likely to make a lower return than you could from leaving the money in the term deposits. This is an investment mistake that has a negative expected value.

If you are going to break the certainty of your term deposits, you simply have to make a judgement about the future returns of your replacement, or you are being foolish. If your judgement is that the balance of risk is to the downside, then you look for an investment with better odds of success. If it is all too uncertain to call, then you should stick with the term deposits.

That is the only rational way to approach the problem.

Your idea, is simply swapping existing certainty for downside weighted risk, while ignoring possible alternatives and the true costs associated with breaking the term deposits.

You are being consistently unidirectional in your viewpoint Sauce. Are you sure you are not a Cantabrian?

No, it's a family trait :)

Cheers
Sauce

Snoopy

13-08-2011, 12:56 PM

Wow you just completely ignored my entire point.

No you are replying to my message faster that I can concoct my response

You are ignoring the costs and risks involved with your strategy.

As a suggestion; research concepts like 'opportunity cost' and 'cost of capital' and 'time value of money' .

I am well aware of all of these concepts. None of them are very relevant to a savings plan with a two year time horizon.

SNOOPY

Sauce

14-08-2011, 11:46 AM

I am well aware of all of these concepts.

I was pretty sure you were. I have been reading, enjoying and learning from your great posts for many years.

None of them are very relevant to a savings plan with a two year time horizon.

With all due respect, this is dead wrong.

Those concepts are in fact central to investment, savings and capital management. Especially capital allocation decisions.

All capital has a 'cost' that is related to the 'time value of money'. ENPs equity capital currently receives a near certain interest rate at the maturity of his term deposits. If he breaks his term deposit, his forgone interest and break fees become his 'hurdle rate' that all alternative options must beat, including any linked to house prices. This is his 'opportunity cost of capital'. If his new investment does not beat this return he has made a bad decision that has a very real 'cost'.

Regards

Sauce

Sauce

14-08-2011, 11:52 AM

Contrary to what you probably think, I understand your point of view. You are trying to ‘hedge’ against ‘volatility’. Not volatility in his wealth, but volatility in his ability to buy a house in two years time. The assumption is that if you attach his return to house prices, you guarantee his house purchasing power is ‘no better off’ and ‘no worse’ off in two years time than it is today, regardless of which way house prices go.

However, this thinking is flawed. Contrary to your assumption, if his returns are attached to property prices and they fall, his house purchasing power IS worse off. By the amount he would have had in two years if he had left the money in the term deposits.

This is the ‘time value’ of his current savings over the next two years. This is the ‘hurdle rate’ he must beat to be rewarded for his risk.

The reality is that your entire product/service ‘hedge’ concept is an illusion because it doesn’t take into account the fact that all investment returns must be judged against the risk-free rate of return. You are unwittingly making a bet only on prices rising above the risk-free rate, and if it goes the other way, you are falsely thinking you are no worse off, when you are in fact, worse off.

If you get emotional comfort from such a strategy it might have some intangible value that makes it worthwhile for you. But more rationally, it does not make financial sense.

Regards,

Sauce

Lego_Man

16-08-2011, 12:21 PM

It seems there's some confusion here as to what a hedge is.

To say "you should just invest in the asset with the highest possible return" doesnt make any sense.

Well of course, we would all do that. The whole idea of the hedge is that it dampens our losses in the case that we're wrong. It's all very well to say XYZ share will yield X% over 5 years but that may not materialise. But if i have a global equity portfolio i may have a short position on oil in case global growth disappoints leading to poor returns on equities and a slump in commodities (very rough example).

On the other hand, Hawes is a moron for suggesting that a simple investment in NZO is an oil price hedge. He completely ignores company specific risk which has (laughably) cleaned him out since he posted that.

Sauce

16-08-2011, 12:33 PM

It seems there's some confusion here as to what a hedge is.

Well of course, we would all do that. The whole idea of the hedge is that it dampens our losses in the case that we're wrong. It's all very well to say XYZ share will yield X% over 5 years but that may not materialise. But if i have a global equity portfolio i may have a short position on oil in case global growth disappoints leading to poor returns on equities and a slump in commodities (very rough example).

On the other hand, Hawes is a moron for suggesting that a simple investment in NZO is an oil price hedge. He completely ignores company specific risk which has (laughably) cleaned him out since he posted that.

I agree with you entirely Lego Man.

Snoopy seems to think he somehow has downside protection to lower power prices if he buys Contact energy as an investment. His assumption is he will have lower personal power prices, which will offset his investment losses.

But he is ignoring the fact that he would enjoy the benefit of lower personal power prices, even if he wasn't invested in contact energy. So he gets no true 'loss dampening' or offset at all. Hawes and Snoopy are not rationally considering that they are no financially better off if oil prices or energy prices fall, relative to putting there money anywhere else.

These investments, at least in context of the discussion, should be looked at exactly like any other. Make a judgement on the 'probability' of rising energy prices, the company specific risk, and whether there are better alternatives out there, and then make the bet if its a good one.

If however, someone owned contact energy and had a short position on power prices, he would be dampening his potential losses, and have a hedge.

Cheers

Sauce

Sauce

16-08-2011, 02:19 PM

To say "you should just invest in the asset with the highest possible return" doesnt make any sense.

My point is not that we are able to know what the highest possible return is in advance. My point is that we have to weight for risks rationally. And that there is a hurdle rate, which is the risk-free-return. This, plus some margin to reward our risk, is the minimum return that our investment choices should be compared to. This is fundamental to finance.

In ENPs case he wants to break a term deposit which is his future house deposit. The funds will be used to buy shares. His reasoning and goal is:

Posted by ENP:

In the big scheme of things, this is basically to accumulate my house deposit faster.

Posted by Sauce:

His goal is to be closer to home ownership than he will be in term deposits. Hence why he is taking the risk of going into equities in the first place.

So the only two rational decisions are to either:

1. Stay in term deposits and take no undue risk
2. Invest his funds with the greatest risk-weighted probability of beating his term deposit return.

Snoopy suggested he should attempt to link his returns to house prices as a hedge, that way if house prices go down and his investment tanks, he has lower deposit requirements to offset this risk.

Posted by Snoopy:

Saving for a property, I would tend to look for a sharemarket listing that had a property component to it. That way if the property market goes up in the next two years, then so should the underlying investment. If the property market tanks then your investment may go down. But since you then wouldn't need as much money as a deposit to buy your own property, this would not matter.

My point right from the start is that Snoopy's idea is irrational in ENPs case. Here are the main reasons:

1. If house prices (and his investment) go down over his two year time frame, he has a loss, and no 'offset'. Because if he stayed in his risk-free investment he would have received the benefit of lower house prices plus interest on his capital, and no break fees. Snoopy's 'offset' ignores the opportunity cost.

2. As Snoopy himself implied, house prices are more likely to stay the same or fall than they are to rise, so his risk is weighted to the loss outlined in 1. So Snoopy's option would make no sense.

Regards,

Sauce

Snoopy

18-08-2011, 04:25 PM

Posted by ENP:

In the big scheme of things, this is basically to accumulate my house deposit faster.

Posted by Sauce:

His goal is to be closer to home ownership than he will be in term deposits. Hence why he is taking the risk of going into equities in the first place.

So the only two rational decisions are to either:

1. Stay in term deposits and take no undue risk
2. Invest his funds with the greatest risk-weighted probability of beating his term deposit return.

Sauce your idea of calculating a 'hurdle rate' for a potential investment is not helpful to ENP. You are only considering the fastest likely hurdle rate, when you should be considering the spread of times your best hurdler can achieve in different races under different circumstances.

Your crusade to get ENP to put all of his house money into the highest risk adjusted returning NZX listed asset possible ignores any consequence of such an investment turning bad. I agree it is not likely to turn bad. For this is why your highest risk adjusted screening process have identified your ‘best’ investment as the most suitable. But it is also true that investment in equities is inherently a risky process. There are all sorts of greater government and market forces that can conspire to torpedo the returns of your best investment baby. No matter how fine your due diligence is, you cannot ignore the consequences of your investment going wrong even if you used the best decision process possible to select it.

You regard ‘linked investment hedging’ as a ‘warm fuzzy comfort intangible’, when in fact it is anything but this. I am going to throw some numbers at you in a final attempt to unstick your unidirectional thought process.

Scenario 1: ENP invests all of $24k of his accumulated savings in a ‘linked to property’ sharemarket investment that gains 25% ($6k) in two years. But house prices go up so that he requires $56k for his share of a house deposit- not $50k. How much extra time does ENP have to work to save for his greater than expected home deposit?

Answer 1: No time at all, because his sharemarket investment return has exactly covered the extra deposit required.

Scenario 2: ENP keeps all of his $24k of accumulated savings in term deposits and in two years is able to save the $50k. But house prices go up so that he requires $56k for his share of a house deposit- not $50k. How much extra time does ENP have to work to save for his greater than expected home deposit?

Answer 2: If he can save $1k per month, he will have to work an extra six months.

Big Question 1: Can you see that six months work is a fully tangible thing (well at least the money earned from 6 months work is tangible ) , with no warm fuzzies attached?

Scenario 3: ENP invests all of $24k of his accumulated savings in a ‘linked to property’ sharemarket investment that loses 25% ($6k) in two years. But house prices go down so that he requires $44k for his share of a house deposit- not $50k. How much extra time does ENP have to work to save for his now less than expected home deposit?

Answer 3: No time at all. Because although his sharemarket investment loss has reduced his capital, he requires an equivalently reduced smaller deposit than he originally anticipated.

Scenario 4: ENP keeps all of his $24k of accumulated savings in term deposits and in two years is able to save the $50k. But house prices go down so that he requires $ 44k for his share of a house deposit- not $50k. How much less time does ENP have to work to save for his less than expected home deposit?

Answer 4: If he has been saving at a rate of $1k per month he will be into his house six months sooner than he anticipated. Very nice for ENP, but this is really a bonus to him in meeting his original investment goal.

Big Question 2: Which of the above four examples would be acceptable outcomes in ENP’s goal of obtaining his house deposit within two years?

Big Answer 2: Scenarios 1, 3 and 4 would allow ENP to reach his goal. Scenario 2 would be unacceptable, as ENP would then be faced with explaining to his SO, why they would have to wait six months longer to achieve their combined savings goal. Is there a way to avoid Scenario 2? Yes, by the fully tangible process of ‘investment hedging’ as per Scenarios 1 and 3.

If ENP does this then the failure option (Scenario 2) is eliminated. However this certainty of obtaining his goal does come at a cost. The unexpectedly positive Scenario 4 is also eliminated by this hedging strategy.

Your solution Sauce would be none of the above but to choose ‘Scenario 5’ putting all of your funds in what you perceive as the highest return sharemarket investment, regardless of category. But by doing this you also face the possibility of a significant loss far greater than the decline of property prices. ENP might have to work for years to recover the capital loss in your suggested investment. That is why IMO, just going for the highest weighted return is not the wisest choice to make, in this situation.

SNOOPY

Sauce

18-08-2011, 11:45 PM

Sauce your idea of calculating a 'hurdle rate' for a potential investment is not helpful to ENP. You are only considering the fastest likely hurdle rate, when you should be considering the spread of times your best hurdler can achieve in different races under different circumstances.

Actually I believe that he needs to carefully consider his all his alternatives !

I am not aiming for the fastest return, but simply the best way to achieve his stated goal without taking on too much risk. The hurdle rate is implicit in his goal.

A quick reminder:

Posted by Sauce:

2. Invest his funds with the greatest risk-weighted probability of beating his term deposit return.

To remind you that ENP quantified his goal for us:

Posted by ENP in context with breaking his term deposits:

in the big scheme of things, this is basically to accumulate my house deposit faster.

You seem to be confusing his goal with 'We want to reduce the small risk that house prices rise to the point that our down payment will be insufficient if we stay in term deposits"

As you have gone to lengths to point out, that is the only upside that your option can provide over and above him staying in term deposits.

The elephant in the room 1: As you yourself have agreed the property market is more likely to be flat or declining, so the ‘benefit’ of your option is unlikely to be realised.
The elephant in the room 2: Any sharemarket related company ENP invests in that is linked to property, can fail just like any other sharemarket investment. There is no less catastrophe risk JUST because the sharemarket investment is in property! Your investment doesn’t care what you want to use the money for.

Snoopy, under your scenario ENP leaves the certainty of his term deposits for an investment vehicle that could just as easily go bust and he could lose everything AND it is operating in a declining market. On the balance of probabilities, without knowing in advance what will happen, it’s a bad bet - at least without considering the company specific risks, just like any other investment.

If he leaves the safety of the term deposits then he simply has to way up the odds of his new investment beating his term deposit return, vs the relative risks they carry, regardless of whether it is linked to property or not.

However, if his sharemarket investment had property market upside potential, and limited or NO property market downside, and in fact could still potentially outperform his term deposits during a poor property market, then he would have himself a good bet indeed! Can you think what that might be and the reasoning behind it Snoopy? I think you will get it immediately :)

I look forward to you putting your thinking cap on :)

Regards,

Sauce

Snoopy

19-08-2011, 06:28 PM

Posted by ENP in context with breaking his term deposits:
"in the big scheme of things, this is basically to accumulate my house deposit faster."

You seem to be confusing his goal with 'We want to reduce the small risk that house prices rise to the point that our down payment will be insufficient if we stay in term deposits"

Sauce, you have it right that I see these two as the same. Because IMO they are the same even if they don’t appear to be that way on casually reading them. Let me explain.

The only way to accumulate a house deposit faster, with no downside, is to take out a risk free investment and accept the risk free rate of return. This is similar to what ENP is doing with his term deposits. To accumulate your savings faster than the risk free rate of return carries an implied downside risk as well, even if that downside risk is not openly stated.

Conversely, no one would consider an investment (even a hedging investment) where a negative return, on balance, was certain. The risk that an investor ends up worse off must always be balanced by the possibility that the same investor ends up better off. Otherwise what our investor would be doing would be akin to flushing money down the toilet rather than investing.

Upside and downside are of necessity an integral part of the investment process. That doesn’t mean the magnitude of the upside is always exactly equal to the magnitude of the downside. It doesn’t mean the consequence of the upside will exactly balance the consequence of the downside. But it does mean that when you take out an investment you have to consider all possibilities of what will happen, not just a summary expressed as the weighted average most likely outcome.

The elephant in the room 1: As you yourself have agreed the property market is more likely to be flat or declining, so the ‘benefit’ of your option is unlikely to be realised.

Correct. But that is not a reason to ignore investment hedging if the consequence of an unlikely event is significant. And not getting your house deposit by the desired date is very significant.

The elephant in the room 2: Any sharemarket related company ENP invests in that is linked to property, can fail just like any other sharemarket investment. There is no less catastrophe risk JUST because the sharemarket investment is in property! Your investment doesn’t care what you want to use the money for.

I disagree. I think if you look at what is available on the NZ sharemarket, listed property investments are less likely to go bankrupt (a plus) and also offer lesser capital growth return potential than non property NZX investments (the associated minus). Sure, a property company can still fail if geared up inappropriately. But I would weed out that possibility in my investment selection net.

If his sharemarket investment had property market upside potential, and limited or NO property market downside, and in fact could still potentially outperform his term deposits during a poor property market, then he would have himself a good bet indeed! Can you think what that might be and the reasoning behind it Snoopy?

An investment in Ryman might meet these investment ideals Sauce. My understanding of the Ryman business model is that as the units roll over to new ownership, the capital gain accrued under the just surrendered ownership accumulate to Ryman on resale of that unit to a new owner. In effect buying Ryman today will lock you into the unrealized property value increases of the last 5-7 years (being the average licence to occupy holding time of a Ryman unit). Provided Ryman is not unfairly priced today, this certainly looks like a greater upside than downside bet. I think the potential downside for Ryman is more general market related than company specific related.

SNOOPY

Sauce

21-08-2011, 08:37 PM

The only way to accumulate a house deposit faster, with no downside, is to take out a risk free investment and accept the risk free rate of return. This is similar to what ENP is doing with his term deposits. To accumulate your savings faster than the risk free rate of return carries an implied downside risk as well, even if that downside risk is not openly stated.

Conversely, no one would consider an investment (even a hedging investment) where a negative return, on balance, was certain. The risk that an investor ends up worse off must always be balanced by the possibility that the same investor ends up better off. Otherwise what our investor would be doing would be akin to flushing money down the toilet rather than investing.

Upside and downside are of necessity an integral part of the investment process. That doesn’t mean the magnitude of the upside is always exactly equal to the magnitude of the downside. It doesn’t mean the consequence of the upside will exactly balance the consequence of the downside. But it does mean that when you take out an investment you have to consider all possibilities of what will happen, not just a summary expressed as the weighted average most likely outcome.

This is exactly what I mean. "the greatest risk weighted probability of beating his term deposit returns" is just a succinct way to express it. There is no summary or short-cut in the process itself. That should be obvious? It is implicit that all possible outcomes of all your options are considered as best as you can.

Ironically you have just outlined my point, and I totally agree!

If, first and foremost, you are looking to beat your term deposit return, then it makes no sense to limit yourself to just property related shares. Everything needs to be open to consideration, and other options may carry less risk and greater returns than property or property related shares - especially when the risk of flat or lower property prices is high. Amongst property companies something might have overwhelmingly favorable odds regardless of the sector risk, so you wouldn't necessarily exclude them either.

I never defined any investment boundaries. For instance, it might make sense to invest in a basket of companies, rather than a single company. Etc. Nor did I imply that other possibilities were not considered, quite the contrary. I believe it is your hedging strategy that defines a small circle of potential investments.

Correct. But that is not a reason to ignore investment hedging if the consequence of an unlikely event is significant. And not getting your house deposit by the desired date is very significant.

If ENPs goal is indeed to "avoid the small risk that house prices move so far that in two years time our deposit is insufficient" and he is happy to wear some cost to achieve this, then you are right Snoopy. Hypothetically, linking his returns to property prices would be a fine way to achieve this goal. And, at least when considered against that specific risk, I guess 'hedge' is an appropriate word for the investment. So you win on all fronts there.

Of course I see it differently. This was not the goal, and if it was, it shouldn’t have been. Firstly, ENP never stated it. Secondly, the problem with 'home ownership' as the sole objective, is that it carries a lot of emotional desire that is counter productive to sound financial reasoning.

There are many examples of this but for instance the ‘fear of being priced out’ can cause immense financial folly: During the frenzy of 2006/2007 home buyers were so scared that if they didn't buy a house immediately they would be 'priced out' of the rising market. Many buyers tendered huge prices 'just to get in' to 'hedge' themselves against rising prices and are now sitting on highly leveraged losses and some have lost their homes. This psychological feedback loop played a large part in causing the boom and bust. Those more level headed are in a better financial position.

So from my perspective it is more rational to consider the financial implications first and foremost and try your best to suppress or eradicate the emotional desire to own a home above all else. Especially if you are a young first home buyer who is borrowing a lot of money and has little or no other assets in case things go wrong.

In my opinion your hedging option does provide a degree of comfort (less risk of not getting into the market 'on time') but it is not the best investment/financial advice. I think it is more sensible to save and grow your wealth/deposit as fast as you can, while preserving your capital by not taking undue risk, which may mean staying in term deposits. When you reach the point you have enough funds for a decent house deposit you should enter the market if it makes as financial sense as well as emotional sense.

I have spent a third of my life watching people buy houses on a daily basis. Their motivations and the financial impact of such has been a fascination of mine for a very long time.

I disagree. I think if you look at what is available on the NZ sharemarket, listed property investments are less likely to go bankrupt (a plus) and also offer lesser capital growth return potential than non property NZX investments (the associated minus). Sure, a property company can still fail if geared up inappropriately. But I would weed out that possibility in my investment selection net.

Good point.

Cheers

Sauce

Sauce

21-08-2011, 09:09 PM

An investment in Ryman might meet these investment ideals Sauce. My understanding of the Ryman business model is that as the units roll over to new ownership, the capital gain accrued under the just surrendered ownership accumulate to Ryman on resale of that unit to a new owner. In effect buying Ryman today will lock you into the unrealized property value increases of the last 5-7 years (being the average licence to occupy holding time of a Ryman unit). Provided Ryman is not unfairly priced today, this certainly looks like a greater upside than downside bet. I think the potential downside for Ryman is more general market related than company specific related.

Nice work Snoopy, not exactly what I had in mind, but sound reasoning indeed.

My reasoning is that RYMAN experience a tailwind when house prices are booming as they can increase the prices of their units in-line with rising house prices. Yet the demand for their products has very little to do with the wider residential housing market, and is booming when demand for residential property is at its lowest in a decade. Property prices have arguably dropped by 5 - 15% since the peak yet RYM have not dropped their prices at all, and are not going to. They still have 6 month - 1 year waiting lists at their villages and as good as 100% occupancy. Not only that, they are the lowest cost producer, and have a lot of latent pricing power - something I have confirmed as fact, not speculation. Of course strategically they are making the right move in keeping their prices under what competitors can profitably offer the same product for.

So RYM will get a boost if property prices take off, the odds are great that they will perform very well even if property prices decline, and the return is highly likely to beat term deposit returns either way, market risk aside. And as you originally pointed out ENP understands the business so it seems a perfect match.

Even the dividends alone would give ENP more than half what he can get in the bank, and the other half of the his share of the profits would be reinvested internally at an annual compound rate of 30%. So the underlying asset performs ridiculously better than his term deposits even at prevailing prices.

Cheers

Sauce

Sauce

21-08-2011, 09:15 PM

Sorry, I should note that more recently both Auckland and Christchurch are experiencing a resurgence in housing demand, but the point about RYMs demand was true throughout the housing downturn of the last three years, and will be true if it weakens again.

Snoopy

25-08-2011, 03:06 PM

This is exactly what I mean. "the greatest risk weighted probability of beating his term deposit returns" is just a succinct way to express it. There is no summary or short-cut in the process itself. That should be obvious? It is implicit that all possible outcomes of all your options are considered as best as you can.

Ironically you have just outlined my point, and I totally agree!

I obviously didn't make my point well enough. What I tried to say was after evaluating all investment possibilities and scenarios and coming up with a strategy that gives the best risk weighted outcome, you may or may not choose that strategy. A good reason for not choosing the so called best strategy is if one of the unlikely outcomes that is nevertheless part of your best risk weighted scenario could come to pass and deliver an unacceptable outcome to your savings plan. I think that is quite a different point to the one that you were making Sauce.

If you didn't go with the so called best risk weighted outcome, you could still choose an inferior risk weighted strategy which doesn't carry the potential sting of your so called optimal strategy.

If ENPs goal is indeed to "avoid the small risk that house prices move so far that in two years time our deposit is insufficient" and he is happy to wear some cost to achieve this, then you are right Snoopy. Hypothetically, linking his returns to property prices would be a fine way to achieve this goal. And, at least when considered against that specific risk, I guess 'hedge' is an appropriate word for the investment. So you win on all fronts there.

Of course I see it differently. This was not the goal, and if it was, it shouldn’t have been. Firstly, ENP never stated it. Secondly, the problem with 'home ownership' as the sole objective, is that it carries a lot of emotional desire that is counter productive to sound financial reasoning.

ENPs goal is home ownership Sauce. He did not ask to be given a lecture on the risks of 'emotional desire' and whether his decision is financially sound. There could be all sorts of reasons why he wants to buy a house that are not financially sound, yet he would not be wrong in proceeding with his house purchase. For example, he might be in a band and need a large double garage to practice in, something that a landlord might not be keen on. He may own two very large dogs that need land to roam on. ENP hasn't told us if he is in a band or owns large dogs and neither should he. He has told us he is saving for a house. It is not up to either you or I to lecture him on the optimal financial merits of his decision!

There are many examples of this but for instance the ‘fear of being priced out’ can cause immense financial folly: During the frenzy of 2006/2007 home buyers were so scared that if they didn't buy a house immediately they would be 'priced out' of the rising market. Many buyers tendered huge prices 'just to get in' to 'hedge' themselves against rising prices and are now sitting on highly leveraged losses and some have lost their homes. This psychological feedback loop played a large part in causing the boom and bust. Those more level headed are in a better financial position.

Perhaps those sitting on heavily leveraged losses have been exposed as sub optimal purchasers. But that does not necessarily mean they were wrong in purchasing their house. If it was their plan to own a property for ten years, and they have negative equity after five, so what? As long as they can afford the payments it is where the market will be in another five years that will determine the wisdom or otherwise of their purchase.

So from my perspective it is more rational to consider the financial implications first and foremost and try your best to suppress or eradicate the emotional desire to own a home above all else. Especially if you are a young first home buyer who is borrowing a lot of money and has little or no other assets in case things go wrong.

Contrary to some opinion banks do not like to foreclose on homeowners, even if things do go wrong. If things are liable to go wrong you can derisk your purchase by paying more than the minimum deposit.

In my opinion your hedging option does provide a degree of comfort (less risk of not getting into the market 'on time') but it is not the best investment/financial advice.

My strategy does not necessarily provide the highest risk weighted return on investment. I agree, and that is deliberate.

SNOOPY

Sauce

29-08-2011, 12:04 AM

I wasn't lecturing anyone. My professional view is that first home buyers should consider the potential financial damage that can be caused by acting on the natural strong emotion that comes with purchasing a home - it is at the end of the day a highly leveraged asset as well as a home. That it is sensible advice whether you can see it or not.

There are actually quite a few reasons why I don't like your idea as advice for a first home buyer but the fact that it is born from one of the most financially dangerous emotions - the fear of missing out - is actually a very good reason not to like it. You have a different view, and thats fine.

At least we have finally gotten somewhere Snoopy :)

Regards,

Sauce

h2so4

01-09-2011, 02:53 PM

Sauce

01-09-2011, 03:57 PM

First home buyers are quite visionary and their decision to buy a house is born from the need for a home and financial scurity. I doubt if fear comes into it. In fact the better it gets the better it gets.:)

Hi h2, careful it's a slippery thread this one :)

When property prices were rising at 15%pa and people were missing out on houses they had fallen in love with, they would chase the market up, and pay a lot more on their next attempt. This what we mean by 'fear of missing out' h2. The fear of missing out on the home you have fallen in love with combined with the fear of having to pay a lot more if you don't get into the market soon. As we all know, chasing a rapidly rising market up can be a financially destructive thing to do. The housing market is no different.

So the point is, that Snoopy advising a first home buyer to 'hedge' against the danger of rapidly rising house prices, is the same kind of thinking that causes people to make those mistakes.

Anyway, first home buying aside, Snoopy wisely started to acknowledge my point about the opportunity cost that his strategy would wear. If he thinks about it hard enough he will realise that when the opportunity cost is factored in, owning contact shares to hedge against electricity prices and other so called 'consumer cost hedges' are in actual fact irrational. It might give people the warm fuzzies, but financially, it's not a clever way to think about investments.

Regards,

Sauce

h2so4

01-09-2011, 04:27 PM

Hi h2, careful it's a slippery thread this one :)

When property prices were rising at 15%pa and people were missing out on houses they had fallen in love with, they would chase the market up, and pay a lot more on their next attempt. This what we mean by 'fear of missing out' h2. The fear of missing out on the home you have fallen in love with combined with the fear of having to pay a lot more if you don't get into the market soon. As we all know, chasing a rapidly rising market up can be a financially destructive thing to do. The housing market is no different.

So the point is, that Snoopy advising a first home buyer to 'hedge' against the danger of rapidly rising house prices, is the same kind of thinking that causes people to make those mistakes.

Anyway, first home buying aside, Snoopy wisely started to acknowledge my point about the opportunity cost that his strategy would wear. If he thinks about it hard enough he will realise that when the opportunity cost is factored in, owning contact shares to hedge against electricity prices and other so called 'consumer cost hedges' are in actual fact irrational. They might give people the warm fuzzies, but financially, not so bright.

Regards,

Sauce
Yes but that is an observation of the current market. A first home buyers decision is not born from that.
Ha!, I know snoopy hedges fast food prices by buying RBD shares.:)

Sauce

01-09-2011, 05:42 PM

Yes but that is an observation of the current market. A first home buyers decision is not born from that.
Ha!, I know snoopy hedges fast food prices by buying RBD shares.:)

My post was in context of Snoopy's hedging idea for first home buyers. It's Snoopy's 'hedge' idea that is born from the 'fear of missing out'. It is literally designed to 'protect' against rapidly rising house prices with a cost attached. It is wiser, financially speaking, to help people eradicate this kind of emotional thinking rather than to devise strategies around it. This is after all an investment forum as Snoopy pointed out.

Personally, from much experience with the home buying process, I don't think its a good thing to promote to first home buyers.

Cheers

Sauce

Sauce

01-09-2011, 05:52 PM

Ha!, I know snoopy hedges fast food prices by buying RBD shares.:)

Haha, if thats true perhaps he should consider some wakefield hospital shares as well.

h2so4

01-09-2011, 07:12 PM

My post was in context of Snoopy's hedging idea for first home buyers. It's Snoopy's 'hedge' idea that is born from the 'fear of missing out'. It is literally designed to 'protect' against rapidly rising house prices with a cost attached. It is wiser, financially speaking, to help people eradicate this kind of emotional thinking rather than to devise strategies around it. This is after all an investment forum as Snoopy pointed out.

Well good luck with that.

h2so4

01-09-2011, 07:15 PM

Haha, if thats true perhaps he should consider some wakefield hospital shares as well.

I am sure his wellbeing comes from munching on chicken wings and getting fat on dividends.
cheers

Snoopy

02-09-2011, 05:42 PM

Ha!, I know Snoopy hedges fast food prices by buying RBD shares.:)

Very observant SSD, but my food hedging policy is a bit more general than that. I hedge food prices in general by investing in RBD. I know that long term the price of food in general should be correlated with the RBD share price, because RBD’s product range covers many food groups. As for the RBD product itself, I indulge very infrequently. Last month was a rare exception.

I visited KFC for the purpose of cashing in my shareholder voucher and to get my first taste of the new KGC wings. But not fancying any of the vege sides from the KFC menu (I looked before I went), I boiled up my own fresh vegetables at home, stuck them in a heat retaining plastic container then went along to order the chicken for my ‘big meal out’. Combined with the wings and apricot sauce, I reckon I got a moderately healthly dinner out of my visit. So no reason to get those Wakefield shares to hedge my health just yet!

SNOOPY

Snoopy

02-09-2011, 05:45 PM

The fear of missing out on the home you have fallen in love with combined with the fear of having to pay a lot more if you don't get into the market soon. As we all know, chasing a rapidly rising market up can be a financially destructive thing to do. The housing market is no different.

Sauce, you perpetuate the myth that banks are just waiting to trick you into taking out as large a mortgage as possible so that when the market turns they can toss you out on the street and reclaim their cash in a mortgagee sale leaving you destitute and homeless. This is not a sustainable business model for banks. Banks do not enjoy doing this and do not plan to do this when taking on new mortgage clients. In fact they go to extreme lengths to make sure a mortgagee sale is not on any event horizon they can paint.

You cannot suggest that everyone who buys a property in a housing boom is financially destroyed. Whatever the market says about the value of you house, you are only financially destroyed if you can’t make your interest payments. Market valuations come and go. Acting on those capital market valuations is always optional.

SNOOPY

Snoopy

02-09-2011, 05:47 PM

Snoopy wisely started to acknowledge my point about the opportunity cost that his strategy would wear. If he thinks about it hard enough he will realise that when the opportunity cost is factored in, owning contact shares to hedge against electricity prices and other so called 'consumer cost hedges' are in actual fact irrational. It might give people the warm fuzzies, but financially, it's not a clever way to think about investments.

Sauce there are certain so far undiscussed assumptions behind your ‘optimum investment savings’ strategy.

As a conceptual point, I believe you are assuming that you can plot all of your potential investment strategies on a unidirectional line. The zero point on this line represents stuffing your cash in your pillowslip each week (no risk). Move slightly along the line and you get to the putting all of your money in bank term deposits strategy. Move further along the risk scale and you come to listed property trusts. Keep going and you arrive at listed companies, the riskiest investments.

I should point out here that when I say risk, I am not referring to volatility. I am referring to the downside risk of losing the purchasing power of your capital.

Now one point where you and I agree Sauce is that the skilled investor can assess individual company investment risk and by prudent selection deliver an overall return higher than just investing in an index of all companies.

Do you subscribe to the single line risk model? If so the only rational thing you can do is choose the investment that makes the highest weighted sum of all possible scenarios return. This is no matter whether you are saving for a house or holiday or health. Picking the best performing strategy is the best you can do in all situations. This is as near as I can tell Sauce your position. If I subscribed to the same risk model I have described myself I would be in full agreement with your conclusion.

However, and this is the point you don’t seem to get Sauce, the reason I don’t agree with you is not that I in some conditions accept sub optimal returns to produce a ‘not so bright’ (your words) result. Nor do I seek the comfort of being warm and fuzzy, which albeit might be an acceptable result if being warm and fuzzy was indeed your goal.

No the reason I disagree with your ‘always go for the optimal investment’ answer is that I do not accept the underlying structure of the ‘risk line’ investment model I have just described to you. That model is flawed in this circumstance and that is why I keep coming back to the point that your conclusion is flawed in this circumstance. IMO you are using the wrong investment model to evaluate ENP’s situation. Your argument has merit for a non-specific goal investment strategy with longer timeframe. But IMO it is not applicable to the investment question that ENP posed.

SNOOPY

Sauce

02-09-2011, 08:09 PM

Sauce, you perpetuate the myth that banks are just waiting to trick you into taking out as large a mortgage as possible so that when the market turns they can toss you out on the street and reclaim their cash in a mortgagee sale leaving you destitute and homeless. This is not a sustainable business model for banks. Banks do not enjoy doing this and do not plan to do this when taking on new mortgage clients. In fact they go to extreme lengths to make sure a mortgagee sale is not on any event horizon they can paint.

You cannot suggest that everyone who buys a property in a housing boom is financially destroyed. Whatever the market says about the value of you house, you are only financially destroyed if you can’t make your interest payments. Market valuations come and go. Acting on those capital market valuations is always optional.

SNOOPY

Hi Snoopy

Sigh. Shifting the debate to irrelevant detail again Snoopy, I think you understand full well what I was getting at :) But to spell it out:

I wasn't perpetuating some view about banks at all. I never said 'financially destroyed' I said 'financially destructive'.

Imagine you beat 6 other offers in a frenzy to buy a typical Wellington suburban 3 bedroom house during 2007 for $550k with 10% down (55k). Say an interest only loan at 7% for the rest. Rates, insurance, average annual maintenance and interest would be approximately $820pw or $42,650pa. Typical rent they would otherwise paying on a 3 bedroom suburban home in Wellington would be $23,400pa and comes with no maintenance costs. So your annual net cashflow (after taking off the rent you would pay for the same lifestyle if you didn't own it) is -19,250. Market tanks in 2008. You hold through a period of negative equity where you are stuck in the home because its impossible to move without wiping yourself out financially. No problem, its now in the bottom draw, your happy to stay in one place, its your home after all. Property always comes right. Ten years later 2017 rolls round. Property has indeed recovered, and has even risen way above its previous peak of 2007. You have now got two kids and its time to go. You put the house on the market and at a competitive auction or tender you get three bids and happily sell the property for $700,000, a tidy profit of $150,000 less $20,000 marketing and agents costs, for a net gain of $80,000. Lucky it all worked out right?

In total you paid $192,500 above the cost of renting the same home. You also put in capital of $55,000. For a total cost of $247,500. The equity realised from the sale was $135,000 for a total loss of -42,500 over ten years.

Now add the opportunity cost of what could have been done with that money over the ten year period (risk free bank deposits make a good proxy) and it looks even worse.

The point is that paying too much for a home matters. It matters a lot. And your financial future can be a hell of a lot better if you treat your first home as a financial asset.

Chasing up ANY asset can be financially destructive whether the bank takes it off you or not. You are right that banks do not work in the manner you suggest. But that was not what I meant. If you feel I implied that, then hopefully the above example provides an example of what I meant.

Don't forget, I am not saying this kind of example happens often, all the time, or is likely to happen to ENP. I am trying to explain that the thinking behind your 'hedge' idea exists from the same kind of emotional desire for home ownership regardless of financial considerations that leads to people making home purchasing mistakes like the example above. This is why I don't like it. Personally I have seen people who think like this make bad financial decisions.

Clearly its a subjective debate that is getting quite rediculous, but in general I think its bad advice for first home buyers. You are entitled to your view, and I accept that.

Cheers

Sauce

Sauce

02-09-2011, 09:54 PM

Sauce there are certain so far undiscussed assumptions behind your ‘optimum investment savings’ strategy.

Don't forget, I was coming from the point of view of what ENP originally said: "in the big scheme of things it is to accumulate a house deposit faster" NOT your interpretation that achieving home ownership in two years was more important than the fiscal consideration.

As a conceptual point, I believe you are assuming that you can plot all of your potential investment strategies on a unidirectional line. The zero point on this line represents stuffing your cash in your pillowslip each week (no risk). Move slightly along the line and you get to the putting all of your money in bank term deposits strategy. Move further along the risk scale and you come to listed property trusts. Keep going and you arrive at listed companies, the riskiest investments.

No, wrong. I think the risk free rate is the benchmark. Once you head out from there, there are many variables that relate to riskiness, one of the largest being your level of understanding of your potential investment options.

And herein lies the point. If I buy contact shares because I have power bills, but I don't understand the investment, then I have a false sense of security: If it goes down, but I feel OK because my power bills might be lower, I am ignoring my opportunity cost. Even worse, if I use this thinking to purchase without understanding the business properly, I ignore the company risk, which is insanely risky and quite stupid. Its just not a clever way to think about investments.

Its more rational to think about each investment on its own merits and try and have a full understanding, if you don't, then don't invest. This is assuming you have chosen to invest directly in the first place, which for some people may be a mistake also - they would be better off in an index etc.

I should point out here that when I say risk, I am not referring to volatility. I am referring to the downside risk of losing the purchasing power of your capital.

We have the same definition of risk.

Now one point where you and I agree Sauce is that the skilled investor can assess individual company investment risk and by prudent selection deliver an overall return higher than just investing in an index of all companies.

Yes. I agree. And once someone has made the call that they are such a person, there is no need to cloud their thinking through such nonsense as their power bills as a reason to invest in Contact Energy, when it might be a poor investment.

For instance, take me for an example. If I convince myself that I should put the money I have in RYM in Contact Energy because I might have higher or lower power bills to pay in the future, is that a smart investment move? Indeed, is that a wise way to justify the investment? Surely you can see the absurdity in that?

If I understand RYM and I don't understand contact (which is the case for me personally) then it would be an investment mistake to purchase Contact over Ryman. It would increase my risk under our mutual definition.

If you tell me that I need to go out and learn Contact and its prospects, then you are simply saying the same thing as me anyway. That it needs to stack up as a growing investment in its own right to be considered. In which case I could then compare it to RYM, or others I understand, and make a call as to which one I deemed to be the better investment. If I liked them both on their merits I might choose to own both etc.

But IMO it is not applicable to the investment question that ENP posed.

When you look at the fact we both interpreted the goal completely differently its obvious why there were differing points of view. Under my interpretation your strategy makes it impossible for ENP to achieve his goal and is therefore wrong. Under your interpretation, I acknowledge your idea fits your interpretation of the goal, but in my personal opinion it is a poor way to think about purchasing an important financial asset.

Cheers

Sauce

Snoopy

03-09-2011, 02:56 PM

Imagine you beat 6 other offers in a frenzy to buy a typical Wellington suburban 3 bedroom house during 2007 for $550k with 10% down (55k). Say an interest only loan at 7% for the rest. Rates, insurance, average annual maintenance and interest would be approximately $820pw or $42,650pa. Typical rent they would otherwise paying on a 3 bedroom suburban home in Wellington would be $23,400pa and comes with no maintenance costs. So your annual net cashflow (after taking off the rent you would pay for the same lifestyle if you didn't own it) is -19,250. Market tanks in 2008. You hold through a period of negative equity where you are stuck in the home because its impossible to move without wiping yourself out financially. No problem, its now in the bottom draw, your happy to stay in one place, its your home after all. Property always comes right. Ten years later 2017 rolls round. Property has indeed recovered, and has even risen way above its previous peak of 2007. You have now got two kids and its time to go. You put the house on the market and at a competitive auction or tender you get three bids and happily sell the property for $700,000, a tidy profit of $150,000 less $20,000 marketing and agents costs, for a net gain of $80,000. Lucky it all worked out right?

In total you paid $192,500 above the cost of renting the same home. You also put in capital of $55,000. For a total cost of $247,500. The equity realised from the sale was $135,000 for a total loss of -42,500 over ten years.

Now add the opportunity cost of what could have been done with that money over the ten year period (risk free bank deposits make a good proxy) and it looks even worse.

The point is that paying too much for a home matters. It matters a lot. And your financial future can be a hell of a lot better if you treat your first home as a financial asset.

Yes paying too much for a home can affect your later wealth in a significant way, no argument there. The problem is a buyers need for housing may not neatly fit within a down cycle in the property market.

I won’t disagree with your numbers Sauce, but an interest only loan? Surely one of the purposes of getting a house is to build your equity otherwise, “what’s the point” as your example so clearly demonstrates.

By taking a mortgage you are also building trust with your bank that you can handle a loan. That means that when you want to borrow money at a later date, to buy shares for example, you can access that money at lower interest rates than those borrowing money to invest in shares directly (your renter). This will be a huge advantage to you later in life which you could not take advantage of if you just continued paying rent to a landlord.

Other times people buy houses to get into a certain school zone. Your analysis takes no account of reasoning like that. I presume you would dismiss ‘buying in a school zone’ as simply another warm fuzzy benefit?

Sauce, you provide a good argument against overstretching your financial resources, which I agree with. Save more than the minimum deposit required if you think this will be an issue. IMO you have presented an argument against irrational exuberance and buying property, not a justification to rent instead of buying.

SNOOPY

Snoopy

03-09-2011, 03:05 PM

And herein lies the point. If I buy Contact shares because I have power bills, but I don't understand the investment, then I have a false sense of security: If it goes down, but I feel OK because my power bills might be lower, I am ignoring my opportunity cost. Even worse, if I use this thinking to purchase without understanding the business properly, I ignore the company risk, which is insanely risky and quite stupid. Its just not a clever way to think about investments.

Sauce, I have never said that you should hedge with your investments without understanding what you are investing in. That would be stupid indeed, I agree. A real example: In my own case I seem to end up taking a fair few aeroplane flights each year. Following my hedging investment theory, I should buy some shares in an airline. But I do have a good understanding of the airline business to the extent that I don’t believe I can find an airline investment that I would class as ‘good’. So I have expanded my investment horizon from ‘airlines’ to ‘tourism’. I have found a tourism investment that I understand and like, Sky City Entertainment. So I regard my ‘travel’ money as my investment in Sky City. You may think this Sky City/Travel connection is tenuous. But I feel it is necessary, as the first priority in any investing is that the underlying investment is good, even at the expense of making the investing hedging less concomitant.

If I convince myself that I should put the money I have in RYM in Contact Energy because I might have higher or lower power bills to pay in the future, is that a smart investment move? Indeed, is that a wise way to justify the investment? Surely you can see the absurdity in that?

You should first determine that both your possible investments in Ryman and Contact are good underlying investments before proceeding. Using hedging investment thinking, I would regard an investment in Ryman as an investment in living space. Since everyone needs a space to live just as everyone needs power, it might make sense to transfer some of your investment in Ryman to an investment in energy, like Contact Energy, if you owned nothing in this sector.

The question you would put to me is:
“Can you make a case for Contact Energy as a better investment than Ryman, given that both are good?”

I would class myself as investment savvy enough to digest that annual report information that should enable me to answer this question. However, I cannot answer because I see the drivers of both shares as quite different.

I could say something like:
“If world energy prices go up and energy demand in New Zealand keeps going up then this will be beneficial to Contact with their renewable fixed cost generation base.”

I could say that:
“If Ryman can maintain the cost advantage of their in house construction team, they will be able to maintain better construction margins that will give them pricing flexibility unmatched by their competitors.”

The problem is I cannot be sure that world energy prices and NZ demand will continue to go up. Nor can I be sure that Ryman will be able to retain their construction margins, particularly in the light of the competition for workers for the coming Christchurch rebuild. So how can I compare the future earnings effects of these two statements on the respective companies? In truth I can’t, and I don’t think anyone can.

The beauty of investment is that you don’t have to choose in a situation such as this. The wisest investment decision in this case, IMO, is to invest in both companies. Provided of course that you can buy them at the right price.

SNOOPY

OldRider

03-09-2011, 04:06 PM

I concur with your last post Snoopy. Though one doesn't have to know everything to make a choice,
pick what is thought best at the time, always realising by tomorrow things may be different.
by next month they will be different. In fact we never remotely approach knowing everything
on any subject. It doesn't take much thought to realise I cannot compete stockwise with the
professionals and their budgets, but this still doesn't stop me from knowing something
they don't, and so seeing things differently. By far the best source of information is one's
own eyes and ears, talking to the staff of a company and looking at their hard assets.

It was once said that life is a journey from cocksure ignorance to thoughtful uncertainty,
only the young and the stupid know the answer for sure.

Life is not about getting evreything right, it's about handling what goes wrong when it
goes wrong, as it surely will sooner or later, and the sooner we see the difficulty and react
the better it will be.

h2so4

03-09-2011, 06:40 PM

Sauce

06-09-2011, 12:31 PM

Yes paying too much for a home can affect your later wealth in a significant way, no argument there. The problem is a buyers need for housing may not neatly fit within a down cycle in the property market.

Sauce, you provide a good argument against overstretching your financial resources, which I agree with. Save more than the minimum deposit required if you think this will be an issue. IMO you have presented an argument against irrational exuberance and buying property, not a justification to rent instead of buying.

SNOOPY

The real point I was making is that your idea that ENPs goal was "to be able to buy a property in two years time no matter what" rather than his stated goal of "obtaining a house deposit faster" is born of the same kind of emotional thinking that drives the kind of exuberance that causes the financial destruction I outlined.

In your mind you have some view that ENP may have a personal situation that means this is a justifiable idea, but this is a general discussion, on an investment forum. Speculating about possible subjective circumstances so that your goal fits is not the right way to give general advice. Yes, of course some people have genuine lifestyle considerations that make home ownership important for them, but this is general discussion on an investment forum regarding a first home buyer.

You say "the problem is that a buyers need for a property may not fit neatly within a property market down cycle" But then you go on to suggest that if someone is going to stretch their financial resources they should "save a larger deposit". Hmmm.

Hang on a second. Didn't you just advise a first home buyer who wisely said they were looking for a way to achieve a larger deposit, that they should instead forgo a larger deposit to guarantee themselves that they could get into the property market on their desired date no matter what? That way they would hedge themselves if prices were to rise rapidly, and that their goal of home ownership was more important than the negative financial considerations of your strategy?

I believe you understand what I am getting at Snoopy, but you are intentionally steering the conversation to subjective detail and semantics, and not addressing the real point.

It is better advice, generally speaking, for first home buyers on average, to consider the entire situation. They need to consider their deposit size, loan servicing ability, how rising interest rates in the future will affect their loan servicing ability, AND whether the price they are paying is reasonable and if the market is overheated or not. Some judgements about an uncertain future will have to be made but given the information available good decisions are very achievable.

It is way too simplistic to advise someone that to "achieve home ownership in two years" they should link their investment returns with house prices, so they are in no better or worse position in regards to their deposit percentage, and that way if house prices go crazy again, they will still be able to buy the house. This is simply NOT good general advice for the average first home buyer - and it has elements of irrational exuberance to it - even though you may justify it through speculating about unknown lifestyle considerations.

If a first home buyer cares about owning a house so much that they are happy to wear substantial costs and risk much lower future purchasing power to do so, then your advice might suit them - but it will be a minority that it is right for. As general advice, on an investment forum, for the average first home buyer, it not very good advice.

Regards,

Sauce.

Sauce

06-09-2011, 05:00 PM

P.s. My example wasn't a justification to rent instead of buying in general.

But while house prices are still so high relative to incomes I think there is a strong argument and saving/investing for a bigger deposit and for renting over buying. At least as a better financial strategy for those with low deposits i.e. most first home buyers. As their deposit grows and wage inflation catches up with house prices (which I suspect it will in the medium term) or house prices come down to meet wages, then a more optimal purchasing time will present itself. I suspect this is akin to what ENP had in mind, but regardless of my speculation about his intentions, I think its acceptable advice for the average first home buyer at this current point in the property cycle.

Sauce

06-09-2011, 06:18 PM

The problem is I cannot be sure that world energy prices and NZ demand will continue to go up. Nor can I be sure that Ryman will be able to retain their construction margins, particularly in the light of the competition for workers for the coming Christchurch rebuild. So how can I compare the future earnings effects of these two statements on the respective companies? In truth I can’t, and I don’t think anyone can.

The beauty of investment is that you don’t have to choose in a situation such as this. The wisest investment decision in this case, IMO, is to invest in both companies. Provided of course that you can buy them at the right price.

SNOOPY

Well I disagree that no-one could compare Contact and RYM and make a wiser decision between the two in terms of which has greater odds of superior returns. I can also say with confidence that your lack of CHCH builders theory is unlikely to derail RYMs excess profitability in the short term either - in fact it could well be good for them as they are the only ones with in-house construction resources so its the competitors that are more likely to suffer. But those are distracting discussions so lets not go there...

Reading your post it appears you have changed the reasoning behind your 'hedging strategy' during the course of the discussion. Lets review your original thesis:

using the product/service hedging investment philosophy, you do not need a crystal ball. You invest and whatever the result in two years time you will wear it. If power costs are high, so are your dividends from Contact. If power costs are low you take a haircut on your Contact investment but your power bills will be offsettingly low.

Since then you have wisely acknowledged the opportunity costs associated with the view that lower power bills provide downside protection and abandoned it. Your argument has changed to one that really sounds more like diversification. Holding a basket of assets across different sectors to protect against uncertainty is a perfectly acceptable strategy. But the reality is there is simply no need to try and make such links between your own personal costs and those investments. Diversification, and inflation beating returns, can be provided without thinking about personal costs. Just make diversification across sectors part of your portfolio weighting strategy.

So, lets look at your worked travel example:

A real example: In my own case I seem to end up taking a fair few aeroplane flights each year. Following my hedging investment theory, I should buy some shares in an airline. But I do have a good understanding of the airline business to the extent that I don’t believe I can find an airline investment that I would class as ‘good’. So I have expanded my investment horizon from ‘airlines’ to ‘tourism’. I have found a tourism investment that I understand and like, Sky City Entertainment. So I regard my ‘travel’ money as my investment in Sky City. You may think this Sky City/Travel connection is tenuous. But I feel it is necessary, as the first priority in any investing is that the underlying investment is good, even at the expense of making the investing hedging less concomitant.

Here you are pointing out that the closer you stick to the hedging idea, the more it narrows your investment choices meaning you may not be able to invest in good businesses. Since you intuitively know this is stupid, you abandon the hedging idea to find an investment with better odds of success and then you slap a tenuous link to travel in your mind, I can only assume to tickle some form of sentiment.

Please tell me Snoopy, exactly what is the benefit you feel you derive from this idea of linking your personal costs to your investments?

If you had initially phrased your point as "A good strategy to hedge against inflation (destruction of purchasing power) is to hold a diversified basket of high quality businesses that have the ability to pass on their own rising costs to customers" then I would have applauded that strategy (it is my own). However whether the products and services of those businesses are directly related to your own personal costs is completely inconsequential. Your own personal purchasing power will simply depend on the success of your portfolio.

Regards,

Sauce

Snoopy

09-09-2011, 01:56 PM

Reading your post it appears you have changed the reasoning behind your 'hedging strategy' during the course of the discussion. Lets review your original thesis:

Snoopy wrote:
“Using the product/service hedging investment philosophy, you do not need a crystal ball. You invest and whatever the result in two years time you will wear it. If power costs are high, so are your dividends from Contact. If power costs are low you take a haircut on your Contact investment but your power bills will be offsettingly low.”

Since then you have wisely acknowledged the opportunity costs associated with the view that lower power bills provide downside protection and abandoned it. Your argument has changed to one that really sounds more like diversification.

You have me wrong Sauce. I haven’t changed my position on investment hedging as regards energy. In fact earlier this year to satisfy the lack of energy shares in my portfolio I added some more Contact. I guess you would regard that as an emotional purchase which I have subsequently been punished for (recent acquisition price $5.90). However since my overall average holding price for Contact shares is $4.60, I am not so worried about my investment timing.

I should add that I regard resources that are consumed (milk and electric power in my own portfolio case) and where demand is increasing to be good investment prospects. Provided, that is, these commodities come from low cost generation sources that are sustainable. My main objective is to maintain a resilient portfolio, and yes that does mean diversification.

But the needs of life are diversified. So I think that I can have both a diversified and an investment hedged portfolio all at the same time. There is no need to go in one camp or the other.

If you had initially phrased your point as "A good strategy to hedge against inflation (destruction of purchasing power) is to hold a diversified basket of high quality businesses that have the ability to pass on their own rising costs to customers" then I would have applauded that strategy. However whether the products and services of those businesses are directly related to your own personal costs is completely inconsequential.

There is another reason I practice investment hedging that I haven't discussed before. If I invest in something with some connection to my lifestyle, I will automatically be in touch with market developments just by living. And I will be interested in keeping up with the news on the subject. Better information in without consciously trying should ultimately help my investment performance.

SNOOPY

Snoopy

09-09-2011, 02:02 PM

So, lets look at your worked travel example:

Here you are pointing out that the closer you stick to the hedging idea, the more it narrows your investment choices meaning you may not be able to invest in good businesses. Since you intuitively know this is stupid, you abandon the hedging idea to find an investment with better odds of success and then you slap a tenuous link to travel in your mind, I can only assume to tickle some form of sentiment. A casino as a travel hedge? I think even people that buy into the product hedging idea would struggle to swallow that one.

From my experience when I travel by air I always have to stay somewhere and eat somewhere. Given that Sky City Entertainment run both hotels and restaurants, I think SKC makes a good travel hedge. The casino side of it I understand you may find a bit hard to swallow. But although I don’t go casinos, I might go to a show or a sporting event or an exhibition or some form of ‘entertainment’. I regard the ‘casino bit’ of SKC as a substitute for those. Holding SKC as an overall ‘travel hedge’ still works for me.

SNOOPY

Snoopy

09-09-2011, 02:05 PM

The real point I was making is that your idea that ENPs goal was "to be able to buy a property in two years time no matter what" rather than his stated goal of "obtaining a house deposit faster" is born of the same kind of emotional thinking that drives the kind of exuberance that causes the financial destruction I outlined.

Sauce, I may have been bringing in information from another thread. I am sure that ENP has stated within the last twelve months on this forum, although perhaps not on this thread, that his aim is for he and his partner to buy a house in 2-3 years. I think ENP has also mentioned that if he had saved his deposit sooner then he would buy sooner. He saw the sharemarket dip and wondered if this would be an opportunity to buy shares while they were cheap and so do just that (assuming share prices would return to normal levels within two years). He didn’t state that last clause. I inserted in brackets. But it was implicit.

Following that I recall that you and I both agreed that given the timeframe of one to two years was short in investment terms, ENP might find it best just to keep saving using cash and term deposits. At least at that point you recognized that no matter how good that share-buying opportunity looked, it might not be the right thing for ENP to do. At that point you recognized that putting all his capital into the sharemarket might have a downside even though the odds were probably weighted for ENP coming out ahead.

Since then you have trotted out this “obtaining a house deposit faster” line. Suddenly the fact that there could be a downside is forgotten or deemed irrelevant as a sub optimal outcome of what at the time might seem at optimal investment strategy. I don’t see why you suddenly changed your position as regards downside risk Sauce. The excuse you trotted out, that:

“ENP only asked after obtaining a house deposit faster”,

doesn’t wash with me.

If ENP had instead posed a different question:

“I have found an investment strategy that would allow him to obtain my house deposit faster, a one way adjustment to my savings strategy with no downside risk, so should I do it?

Then this would have been one of the shortest threads on Sharetrader. Everyone would have said:
“ Yes, do it.”, and they would have been right.”

Instead ENP asked about “obtaining a house deposit faster”, because he knew that any strategy suggesting piling his savings into shares had risk. You are right Sauce in that ENP didn’t say:

“What about this idea of obtaining a home deposit faster, factored against the possible downside risk?”

But ENP didn’t need to put in that last clause. Because it was implied by him asking the “obtaining a house deposit faster” question on its own. If ENP did not want us to consider downside risk (because he saw it as a near zero probability, nothing to worry about outcome) he had no need to pose the original question in the first place! He would have just bought the shares without posting the original question.

SNOOPY

Snoopy

09-09-2011, 02:10 PM

You say "the problem is that a buyers need for a property may not fit neatly within a property market down cycle" But then you go on to suggest that if someone is going to stretch their financial resources they should "save a larger deposit". Hmmm.

Hang on a second. Didn't you just advise a first home buyer who wisely said they were looking for a way to achieve a larger deposit, that they should instead forgo a larger deposit to guarantee themselves that they could get into the property market on their desired date no matter what? That way they would hedge themselves if prices were to rise rapidly, and that their goal of home ownership was more important than the negative financial considerations of your strategy?

Sauce, I said that if ENP wanted to get into a house in 2-3 years he should consider investment hedging a part of his deposit in an investment linked to house prices. The part of the deposit to hedge would depend on his tolerance for the volatility of his total investments. I did not try to second-guess the direction of house prices in the meantime. I did not try to ‘logicalize’ ENPs request to be in a house within 2-3 years. I took that goal as a given. I did not make any judgement on whether this is right goal for ENP. I don’t know ENP’s full circumstances and nor do I wish to know them, and nor do I need to know them to answer his question. Negative financial considerations of my strategy are one possible outcome, yes. These are balanced by being able to afford a more expensive house if house prices in general rise. You don’t get something for nothing.

It is way to simplistic to advise someone that to "achieve home ownership in two years" they should link their investment returns with house prices, so they are in no better or worse position in regards to their deposit percentage, and that way if house prices go crazy again, they will still be able to buy the house. This is simply NOT good general advice for the average first home buyer - and it has elements of irrational exuberance to it - even though you may justify it through lifestyle considerations, as many did who will now be regretting it.

The hardest step getting into the housing market is the first step Sauce. If you make a mistake by paying a little too much for your first house, provided you can deal with the mortgage payments you will not be perpetually badly off.

Logically, and this may seem counterintuitive until you think about it, you should hope that the value of the first house you buy goes down. Why? Because if the market in general keeps going down then the cash bridge you will have cross to upgrade to a better house will be shorter. Ideally the value of each house you own should go down all through your working life as you upgrade. Then right before the last chapter where you sell up to go into a retirement village, then and only then will it be a good thing if your house price rises.

With your accountant brain fired up Sauce, you will be of the opinion that aspiring to own a perpetually devaluing asset throughout your working life is poor advice. However, in terms of the quality of the house you are living in, space and features per dollar, I hope you can see that you will live in a far better quality home throughout your life if the property market is as weak as possible for as long as possible. Here ‘emotional weakness’ in buying a so-called overvalued property has resulted in you leading a higher quality home environment life, throughout your life. Overall, I seriously doubt that most people who moderately overpaid (with the benefit of hindsight) for their first house live in the constant state of regret that you think they do. Sometimes the maligned emotional thinking solution turns out to be the right one.

SNOOPY