Thursday, March 15, 2007

The truth about being rich

Most of us dream about becoming rich. We want to be able to afford every desire we have. i.e. wine and dine at fancy restaurants, buy that Prada bag, that pair of Ferragamo shoes and that dream house and that dream car.

But not many people get there. Somehow we are always just one step behind the Joneses (or the Queks, or the Khoos for that matter). Somehow, the next pay rise didn’t really improve our quality of life as we expected it to. Why is that so?

The truth is being rich is a relative game. You are only rich when those around you are poorer than you are.

To illustrate, 10 yrs ago if you drove a nice Civic or Sunny, you would be considered rich and successful. You are on your way to attain the 5Cs. Good job, keep it up. But today, Ah Beng drives a Civic too and you suddenly realize you are driving an Ah Beng car. And so, you must upgrade to get back into the inner circle of the rich and successful.

This is means that the standard to become rich has gone up.

In other words to reach the status of being rich is a moving target. You need to run faster, work harder, work smarter than everyone else, so that you can earn more money and join the premier league. To become rich is a rat-race and it only gets harder.

10yrs ago, if you earned $4000 a mth you will be in the top decile of Singaporean earners. Today you need to earn $7000. Even if we consider inflation is 5% per year (which is a lot, long-term average is only 3%), $4000 10yrs ago should be equivalent to only $6000 today. But if you earned $4000 in 1997 and your earnings power improved by 50% to $6000 today, you would have become poorer because you have been relegated to the 2nd decile. (You would have beaten inflation but bcos you didn’t beat the other Singaporeans who are now earning $7000, you actually become poorer.)

So that’s why we cannot stop running on that treadmill and the worse thing is, the speed keeps increasing as you run!

Now let’s suppose that we actually made it. We have managed to earn truckloads of money and kept our status in the premier league, year in year out. No sweat. In the statistics our income grew from $7000 to $20000 per mth. Woopee!

But if you think about it, we have just raised the bar for everyone else. So now Ah Beng who was earning $7000 and has only managed to up his income to $10000 has been relegated to 2nd decile. He can afford the Prada bag and the Ferragamo shoes. But now the new standard is Jimmy Choo. So too bad for Ah Beng.

This means that by becoming rich, you have just made a lot of people poorer. And that's why a lot of rich pple give back to the society (at least those who have a conscience.) Bcos they inadvertently contribute to more poor pple in the society.

Is there a solution to this rat-race? I am afraid the answer lies in the realm of enlightenment, inner peace, knowing what is enough for yourself and that kind of philosophical stuff. Not something for the aspiring rich and famous reading this blog perhaps.

See also Compound interest

Tuesday, March 06, 2007

Diversification or diworsification?

According to Markowitz (he is a Nobel Prize Winner on Portfolio Theory), diversification is the only way to achieve a higher return at the same level of risk. This actually makes more mathematical sense than common sense, and most value investors do not subscribe to this thinking. Let's try to examine whether diversification is actually diworsification.

To paraphrase the essence of Markowitz's theory, basically it means that if you are only willing to accept the risk that you will lose, say 10% of your principal, and a portfolio of stocks and bonds can give you 8% return, the only way that you can earn more than 8% is to invest in other asset classes like commodities, real estate, bonds, private equity, integrated resorts, submarine fiber optic cables and credit card points. (Ok the last 4 are not socially accepted asset classes btw)

In order to achieve the maximum positive effect of diversification, the asset classes should also move in different directions, i.e. when one goes up the other should go down. This way, say if equity markets crack, hopefully bonds or commodities will still help to offset some losses. Ok we all know that's bullshit right?

Buffett and Peter Lynch (he is a star fund manager at Fidelity some time back, quite famous too) thinks diversification is bullshit too. Lynch calls it diworsification. This is bcos all of us have limited time and resources, and it does not make sense to try to invest in as many field as possible since we can only be an expert in only a handful of them. You should bet your entire net worth only when you find a potential ten bagger (a stock that will rise 10 fold) and only if you are damn sure. This way you maximize your effort in research, make money, feel happy and can go buy that Prada bag for your wife and that Ferrari for yourself.

I kinda think that the truth is again, somewhere in between. Diversification helps to a certain extent, but not as good as what is promised by textbook, but if you don't diversify, chances are that one basket that you put all your eggs will break. (Trust me, Murphy's Law works.)

As individual investors, diversification options are actually quite limited, we do not have access to some non-conventional asset classes like commodities and private equity. Most people will have to stick with bonds, equities and cash. Even so I think there are some benefits that could be reaped. E.g. by investing in stocks in the different sectors or different countries. You don't need a 100 stock portfolio to enjoy the benefits of diversification, the textbook says 30, personally I think anything more than 5 stocks should be good enough.

Of course, when the markets correct, like last week, correlation of all kinds of asset classes that you can think of goes to 1. i.e. everything will crack together, commodities, bonds, stocks, real estate, private equity, Toto, CoE, salaries etc. And diversification fails. But by and large, diversification should help to generate a better return for the same level of risk.

See also Efficient Market Hypothesis
and What is the Stock Market

CFD Diversity

Add diversity to your stock portfolio by trading CFDs. CFDs are margined products so a trader only has to put up a fraction of the cost of the stock. A trader can profit from both rising and falling prices in value if the right choices are made. A properly placed stop loss can help to manage any risk.