The Investment Scientist

Archive for the ‘wealth management’ Category

unnamed (11).jpgYesterday, what got lost in the panic selling was the Federal Reserve’s announcement that $1.5T will be injected into the banking system. 

Nowadays, money is created not through Treasury’s printing press, but through the Fed’s central bank balance sheet expansion. I won’t bore you with the mechanism. Suffice to say that yesterday, $1.5T of new money was created, and this new money has to go somewhere.

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Let me start with my usual disclaimer that I can not predict the market. This article is an exercise in which I think through possible scenarios for the market. Also, while the media and common folks like to use “crash”, “tumble”, “fall,” etc to describe the market, I prefer to use the term“discount”. The former signifies danger while the latter signifies opportunity. 

As of the market close yesterday, after dropping 2000+ points, the Dow is right at the edge of correction territory (meaning down barely 20%.) The 2000+ point drop was the result of the double whammy of coronavirus out of control in Italy, and oil prices dropping 30% because of a price war between Russia and Saudi.

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Predicting the market is a dangerous business, but there are enough people asking me this question that I thought I’d give it a try.

First things first, Covid19 is not a Pandemic yet.  It is primarily in China and even within China, 88% of the cases and 95% of deaths are in Hubei province which has 60mm people. The second worst-hit province is Guangdong (my hometown). There are 586 existing cases and 7 deaths there as of this writing and this goes up by one or two cases every day. Guangdong has a population of 113mm people. So my sense is that outside of the epicenter province, the situation is under control within China.

That said, the virus has spread beyond  China and infected hundreds of people in Japan, Korea, Italy, and Iran. The first three countries are unlikely to implement draconian measures limiting movements of people, the latter country does not have the medical resources to detect and fight the virus. The chances of Covid19 becoming a pandemic are increasing. So asking how that will affect your investments is a reasonable question.

The best way to answer the question is to study close historical precedents. The most recent, I believe, is the H1N1 swine flu pandemic. We have the added benefit that this virus was first detected in the U.S., which took the worst economic hit. Covid19 has barely reached the U.S. shores yet. Whatever impact it will have economically, it should be less than H1N1.

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Part of Wall Street analysts’ job is to make earning forecasts of covered firms so as to guide investors’ actions. In 1996, Professor Rafael La Porta discovered an interesting phenomenon: the better the forecasts, the worse the returns! Twenty years have passed since his last paper, now we have two more decades of data. Does the new data confirm or contradict his original discovery? Well, see this graph, which I lifted right from his new paper.

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Before we discuss the cost of advanced taxation (or the benefit of deferred taxation,) I need to first introduce the concept of time value of money. That is to say, $100 a year from now is different from $100 today.

Let’s say I owe $100 in taxes due to be paid next year, but for some tricky reason, the IRS wants me to pay that now. How costly is this advanced taxation to me? Well, if I didn’t have to pay the tax today, I could invest the $100. Let’s also assume the return is 8%, so by next year, I would  have had $108. I could pay the $100 tax and get to keep the remaining $8. If I have to pay $100 today, I forgo that $8. That’s the cost of advanced taxation. 

With this concept established, now let me run an experiment with the following assumptions:

  • The investment cycle is 20 years.
  • The investment return per year is 8%.
  • Of  the 8%, 2% is dividend distributions that are taxed at a 50% marginal income tax rate.
  • The remaining 6% is the capital gain. Capital gain distributions (“CGD”) range from 0% to 5%, and they are taxed at the long-term capital gain tax rate of 20%.

The study is about how changing the CGD rate affects the investor’s tax liability as a percentage of initial principal investment.

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km1-taxation-in-germany.jpgThe following is a hypothetical but highly realistic example of mutual fund advanced taxation. You invest $100,000 in a stock mutual fund on Dec 20th. You get a distribution of $10,000 on Dec 23rd. The distribution is reinvested. When you go check your account balance at year-end, the account balance has gone down a little to $99,950. No big deal.

In January, you get a 1099-DIV form from the mutual fund company showing you have dividend income of $2,000 and capital gains of $8000. (They add up to $10,000). You have to pay taxes on those! You jump from your chair: “What! I lost money in the investment, and I have to pay taxes on income and gains I don’t see?! What gives?”

It turns out that mutual funds are required by law to distribute any dividend incomes and all net capital gains by year-end. Usually, they have a record date in December. If you are a fund-holder on record at that time, you will receive the distributions. Most mutual funds have their record dates fall between December 10 and December 20.  Read the rest of this entry »

Last week’s newsletter article “Why It’s Awesome To Have a Loser in Your Portfolio” has proven to be quite controversial. More than a few of my readers emailed me to warn that my Finance professor at Oxford was full of bullshit. Let’s put that aside for now, and consider this question:

If there is an investment that has an average return of 25%, would you invest in it? 

If you did not jump in right away, you are a smart investor! Investment A falls 50% in one year and gains 100% the next, giving it exactly a 25% average return. If you invest $1000, however, you make absolutely $0 on this investment. On the other hand, investment B gains 25% in both years, so it also has exactly a 25% average return, but now the gain from $1000 investment is $562.5. You can not pick an investment in isolation of its volatility. Because …

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Don’t take my word for it, this was covered in my Finance class at Oxford. Let me see if I can get the gist across with a few graphs.

The graph below shows the risk/return profiles of a continuum of two stock portfolios of Coca-Cola and Intel. The vertical axis represents the expected return, and the horizontal axis represents volatility risk.

 

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As you can see, Coca-Cola by itself is a low risk – low return stock, while Intel by itself is a high risk – high return stock. By using different weighting in the two stock portfolios, we can create different risk return trade-offs, represented by the curve.  Read the rest of this entry »

4c458964d197788163d689ce046fbe26.jpgThis happened over the past weekend. A reader of my newsletter signed up for my free 2nd opinion financial review.

As I went over his 401k investments, I saw that he had invested the entire balance in a target-date fund which normally is a good choice. Upon closer examination, I realized that the target-date fund has an expense ratio of 0.8%. That’s high. I went through the list of available investment options since most 401k plans limit them. I found an S&P 500 index fund, an international stock index fund, and a bond index fund, all with an expense ratio of only 0.05%. I constructed a portfolio made up of these three funds, saving him 0.75% a year. The entire exercise took me around 15 minutes.

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How would you feel if you were told by your broker that your IRA had to pay $60k in taxes to the IRS? This is not just some grim fairytale, this is actually happening to a new client of mine. I share this horror story so all of you can learn something.

The IRA account was transferred under my management last year. The entire amount was invested in a private partnership, something I have never thought highly of. They are an investment vehicle that is unregulated and not registered with the SEC and thus is not supposed to be sold to the public. They nevertheless find their way into wealthy investors’ portfolios since brokers love to peddle them due to their exorbitant fees. My client invested in 2006, long before he became my client. After 13 years, it has a grand total return of only 40%. A 50/50 portfolio of stock and bond index fund would have more than doubled his money over the same period of time.

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How a financial crisis comes about?  I am gonna use a simple styled example to illustrate the key elements that lead to a financial crisis: easy creditleveragecontagionshock amplification.

ABC Shipping has 100 vessels. The market value of a vessel is normalized to 1. (You can imagine that as 1 million dollars.)  Because of easy credit (low-interest rates,) the company uses debt financing to the fullest extent. Banks demand a loan-to-value ratio of no more than 60%, so ABC Shipping borrows 60, and has its own capital of 40.

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Now imagine, ABC Shipping is doing well operationally speaking, but the industry is Read the rest of this entry »

Why was the Great Depression so bad? Are we likely to experience something like that in our lifetimes?

This month and next, I plan to write a series of articles about financial crisis. The ideas for this series will come from my Oxford University economics class. The class was taught by Professor Oren Sussman, a prominent scholar on the subject of financial crises. My aim is to explain concurrent economic policies, as well as to answer important questions like those posted above.

Irving Fisher (1867 – 1947) was an American economist who had a very simple theory about the great depression, and who inspired many post-Keynesian economists in later years. He observed that the prices of all things tumbled during the great depression, 43% to be exact, and that had a devastating impact on firms. See a stylized example of a surviving firm below.

Irving Fisher’s debt-deflation theory of the great depression

The firm had $100 in assets on its balance sheet. On the liability side, it had $50 in debt so its capital or owners’ equity was $50. Once the gross price level P fell by 43%, the firm’s assets were reduced to 57, its debt remained at $50, thus its capital or the owners’ equity dwindled to only $7. That’s a devastating 86% loss. The simple example isn’t just an unrealistic example. During the Great Depression, the S&P 500 actually did fall by 87%!

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For the final article of this macroeconomics series, I want to write about something that is much more relevant to your financial wellbeing, whether you are a wage earner or business owner. That is, what would happen if the dollar loses its status as the predominant reserve currency?

The Quantity Theory of Money states:

M/P = kY where

M is the total money supply, P is the gross price level, and kY can be interpreted as the demand for money.

If the dollar loses its “gold” status, central banks around the world will need much fewer dollars and the demand kY for the dollar will drop. To balance this out, either the gross price level P will increase, or the total money supply M will have to be reduced. To put it in layman’s terms, we will get hyper inflation and hyper interest rates, the latter to reduce the money supply.

Let’s look at a historical precedence. See the chart below

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“Why are so many countries lending to the US for negative real interest?” Professor Sussman opened the floor for debate at our Oxford macroeconomics class. In totality, foreign countries own $6.2T of US debt. The chart below shows the countries that lend to the US.

In the previous three articles, I wrote about The Gold StandardThe Fiat Money andThe National Saving Shortage respectively. I hope I explained that the trade deficit is recycling of foreign savings for US private investments. And as long as we are paying negative real interest on our national debt, It’s not a problem, but a win to be able to keep borrowing. What I did not explain is why foreign countries would lend to us at negative real interest, and this is exactly what the professor asked in class and what I hope to explain with this article.

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In macroeconomics, there is the balance of payments (BOP) identity …

Imports – Exports = Investments – Savings

This formula is called an identity, not a theory, because it is as true as 1+1=2. The identity basically says if a country imports more than it exports, that is, having a trade deficit, it is because the country does not have enough savings for its investments. (The chart below shows the saving rate of the US in the last few years.) The intuition is this. Foreign countries only have two ways to spend the money they earned from exporting to us, they can either buy our products, or they can lend the money to us. If we have a national saving shortage, we need them to lend us the money, not buy our products. This creates a trade deficit.

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On August 15th, 1971, President Nixon announced that the US would no longer redeem US dollars for gold, thus formally ending the gold standard. During the gold standard, the dollar bill was a certificate of deposit of gold which was redeemable to the bearer on demand. Post-gold standard, the dollar bill is pure paper money, what the academics call fiat money. Read my previous article The Gold Standard.

One immediate consequence was that the government could now issue money at will. And indeed, since 1975, the US has increased the money supply tenfold. As you can see from the chart below, the money printing accelerated in 2009, after the Great Recession. With this level of money printing, we actually need a lot of cheap imports to keep inflation at bay or else there would be too much money chasing too few goods.

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The Trade Deficit: Who Is The Winner?

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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