Break all Term Deposits and Invest in Cheap Shares

[Snoopy]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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