Break all Term Deposits and Invest in Cheap Shares

[Sauce]

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]

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.

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]

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]

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]

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]

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]

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]

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]

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]

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