Monday 29 October 2012

Real Estate Investment Trusts: An alternative to direct property investment

Over the past few months I have gone through the pros and cons of investing in real estate and how to go about buying your own investment property and then all the things you need to know about to effectively own an investment property.

In this post I will outline an alternative to direct investment property - the Real Estate Investment Trust (commonly referred to as a REIT).    I will not cover every aspect to REITs in this post however I hope o cover some of the salient features with a few to providing more detail in future posts.

What is a REIT?

Broadly speaking, a REIT is a vehicle where several investors pool funds to invest in property.  It is essentially a managed fund which invests exclusively in real estate.

Below are some of the points which commonly define REITs (although they are not necessary for something to be classified as a REIT):
  1. There are several investors (large, or listed REITS can have thousands of investors)
  2. There is usually more than one property in the REIT
  3. They are usually structured around specific types of property (e.g. office, industrial, residential, retail etc)
  4. There is a manager who takes a management fee
Beyond these general characteristics, REITs can take on so many different forms that you can basically search for and invest in exactly the type of product you are looking for - there are listed and unlisted REITs, some of which are open ended and some of which are closed.  There are also REITs focused on growth and those focused on income and heaps of other features as well.

If you are thinking about investing in a REIT - make sure you understand exactly what you are investing in because it is not as standardised as many other financial products.

Benefits of investing in a REIT

There are several benefits associated with investing in a REIT (relative to direct property investment).  These include
  • The entry costs are much lower
    • Investing in direct property costs a lot of money up front.  This includes the amount for a deposit, taxes and a certain amount to cover the interest until the property is rented out
    • REITs do not have these costs - you generally invest a minimum amount (which can be as low as $1,000) and you get the same proportionate return as everyone else
  • Your risk is spread over several assets
    • Single asset investing is inherently risky - all your eggs are essentially tied up in one basket
    • Investing in a REIT gives you exposure to the property sector but spreads your risk among several properties - see my post on diversification
  • It requires very little effort
    • Once you decide to invest, other than keeping track of the performance of the manager and whether they are doing anything particularly dumb - you do not need to do anything
Downsides to investing in a REIT

Investing in a REIT is not the golden solution to property investing (although during times when the property market is on an upswing people assume it is).  There are several risks and downsides to investing in a REIT including
  • You have to pay a management fee
    • This fee can vary quite a lot but generally you are paying 1% - 2% of the totally amount you have invested each year for the manager to manage the portfolio - this can really add up over the long run
  • You have no control over the asset or what assets are invested in
    • When you invest in property directly you have a lot of control to make sure that the property is being looked after the way you want and that you get the property you want
    • If you let someone else do this you are hoping that they will do it right
  • You do not take as great an interest in the fundamentals of the investment as you would if you were managing the asset
    • When you have an investment property you know absolutely everything there is to know about that property - the tenants, the upcoming expenditure requirements - everything
    • Although you should keep track of your REIT investments the fact is that most people trust the manager to do it right and only look at it once a year (if at all)
    • It is quite hard to know if and when things are going wrong until it is too late
Overall

I think that REITs have a place in every investor's portfolio.  They offer access to investments that would be out of the reach for normal investors (e.g. office buildings) and at various points in the cycles can be great value.

I hold both direct property and REITs.  I use REITs to hold those property forms that I am not comfortable investing on my own - that is development properties, commercial properties and retail investments.

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Friday 26 October 2012

Finding holiday accommodation - advertising websites are not always your best bet

A post today for all those who like to do weekends away (i.e. not major holidays) but always find that accommodation is the hardest thing to organise.  This post was inspired by my own experience trying to find a place to stay for a weekend away.

It is amazing how easy it is to find travel recommendations when you are going to major cities, whether you are looking to do the 5 star route or the back packer option - there are always places with reviews and comments.  It is often much harder to find recommendations for accommodation closer to home - where you live in the city and you are travelling down to a beach or holiday location or perhaps wine country for a relaxing weekend away.

I found that what I ended up doing (and taking a straw poll amongst some of my friends this is what they do too) is that they go to a dedicated vacation website, look at the options and try to get a sense of whether the location and amenities are really what you are looking for.   If you really are in a rush these websites are the best thing going around because it takes very little time to easily see what is available.

However using these websites often means that you miss many better (and cheaper) options

When I was booking a weekend trip away I thought I had looked at almost every single house that was available to rent in the location I was looking at for the dates I was interested in.  However one of my work colleagues sent to a site, that admittedly looked like it had been built using one of those auto-website builders, for a single cottage accommodation that had a better location, better amenities and a lower price than anything I had seen advertised - AND it was available.

I could not understand it until I realised that it actually was not advertised on all of those aggregation websites.  When I called to book, I asked the lady who was renting it why she didn't advertise it on those sites - surely she would get more enquiries that way.  She said that a bit risk with holiday accommodation is that you cannot check things like references and they prefer to get people through word of mouth.

So what is a better option?

I think there are several things you can do before you commit to a place advertised on one of the aggregation type websites (assuming you have time):
  1. Ask friends:  Friends and colleagues often have great recommendations of places that you would not be able to find ordinarily.  If you come with a reference people are much more willing to open their property to you
  2. Spend some time on Google:  If you are not able to find a friend who has a recommendation - a lot of these places have very basic websites on google and you can find a lot just by looking.  I did this when testing my hypothesis and a LOT of places that are much cheaper and often better suited to couples or small groups are just not advertised on the aggregation websites
Hopefully you come up with some better results that save you some money and get you a better location.  If you do I'd love to hear about it so please comment below.

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Thursday 25 October 2012

Too Big to Fail by Andrew Ross Sorkin

Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System is an in depth look at the credit crunch from the time that Bear Sterns was bought by JP Morgan (it does not cover this in any great detail) to the introduction of the bail outs for the major US Banks.

Too Big to Fail: Inside the Battle to Save Wall StreetThis book is the most in depth look at the near collapse of the financial system in America (although it briefly touches on the impacts on the international financial system) and is the most in depth look at a financial crises since the 1990's classic Barbarians at the Gate which dealt with the takeover of RJR Nabisco.  It is written in a similar fashion as well - it looks at the crises from each individual bank CEO and senior management as well as regulators and investors. 

What Sorkin has attempted to do in this book, and does so amazingly effectively, is look at the financial crisis from every viewpoint so that we the reader understand what was going through the minds of decision makers when important decisions were being made (whether they were the right or wrong ones at the time).  It was a mammoth task and one that few books previously have emulated.

The necessary trade off for the amount of detail required is that this book takes a seriously long time to read if you are following all the detail.  I like to think that I am a rather quick reader however this book took me a very very long time to finish.  I enjoyed every moment of it. 

The beauty in a book like this is that most of us know the highlights - Lehman's fails, Morgan Stanley and Goldman Sachs become bank holding companies, AIG, Fannie Mae and Freddie Mac are effectively nationalised, the banks are bailed out etc etc.  Therefore we are not reading to see what happens but rather HOW it happens.  In this way the detail is not too much - we are reading for the detail, for the thought processes and for the insights that this book gives us into the way that CEO's, regulators and law makers think.

Because this book is not pushing one point of view or another, but rather going through a series of events, and these are from the view of the professionals involved in it it may seem like it is very much pro business and does not tackle the underlying flaws in the system.  But this book is not meant to preach - it is giving insights into what actually happened - not what should have happened.

Pros
  • The level of information that author has been able to get from interviews etc is truly amazing - if you want the detail behind the effort to save Wall Street then this is the book for you
  • It is not biased at all - you actually

Wednesday 24 October 2012

What is diversification and how does it work?

In a recent post I sad that understanding the concept of risk was fundamental to understanding much of the assumptions that we make about other concepts in finance.  Today I will be discussing diversification - understanding what risk means in a financial theory perspective is important to this so I would read the old post first and come back to this post.

Overview

Intuitively most of us understand diversification - at the simplest of levels it is spreading your bets so that no one adverse event can negatively affect your outcomes.  Intuition, however, only takes us so far.  Using the definition I just gave of diversification it would suggest that this necessarily means that your potential gain from your bet is lower.

However in a financial sense this is not completely true of diversification.  In an investment sense diversification is defined as:
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

The above definition is one given on Investopedia, and whilst I have posted before on how you can never completely trust what Investopedia says - in this case they had the most concise, correct definition of diversification that I could find.

What are the key parts in that definition?
  1. Diversification will result in a higher yield AND lower risk than any individual investment in the portfolio
  2. This is only true if the returns are not perfectly correlated
Why is the definition of risk so important to understanding diversification?

If you read the above definition without truly understanding risk, in a financial sense, diversification sounds like the best thing since sliced bread.  You get higher returns and lower risk - what could anyone else possible ask for?

However if you read my post on risk you will have noticed that the problem with the financial definition of risk is that it defines risk as a deviation from the expected outcome.  This means that an investment is risky even in the unlikely scenario that all the risk is on the upside.  In this case we are not separating positive risk and negative risk.

Once we think about that we see that while diversification reduces risk, it is also reducing the positive risk in a portfolio.  That is, it is reducing the risk that your portfolio will significantly outperform what is expected.

Does this mean that the definition of diversification is wrong or bad?

No - diversification is still an important downside risk management tool.  If you go back to the intuitive definition of diversification which is that of spreading your bets so that any one adverse event doesn't overly impact your outcome then we see that diversification does this however it is not the holy grail that many make it out to be.

The intuitive definition actually falls squarely within the second important component of diversification - around that of non perfect correlation.  Most assets are not perfectly correlated (i.e. move together either upwards and downwards) however many are influenced by the same factors.  For example
  • All property valuations in a certain location will be impacted by certain events such as interest rates, availability of debt even though the individual investment propositions may be quite different
  • All airline stocks will be impacted by terrorist attacks or diseases or civil unrest overseas even though the
You do not need the stocks to be uncorrelated (i.e. not move with each other at all) or negatively correlated (i.e. one goes up when the other goes down) for your risk to be mitigated.  All that you require is that they do not move together perfectly and you get the 'spreading the bets' benefit I have described above.

Final comments

Many who are reading this who understand finance and diversification more intimately may want to point out that I have missed several points and nuances in this post.  I do not intend this to be a complete dissertation or critique on diversification - I just want those readers who hear the concepts to know what it means and some ways in which it is flawed (and also where they are correct).

If you feel I am fundamentally wrong though in any way (or would like more information) please feel free to comment below

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Monday 22 October 2012

Things to consider when investing outside your home state

To date my series of posts on investing in real estate have been centred on the assumption that when you buy your first investment property you will be buying close to home.  This is because you tend to know the areas better, know the demographics and have a sense for the rules and regulations. 

When investors start thinking about their next investment property, or one further down the track they often start thinking about investing outside their home state.  There are several reasons that you may want to consider doing this but be aware that it comes with significant draw backs and you cannot assume that because you have an effective, functioning relationship in your current property / properties that this will translate to another state.

Pros of investing outside your home state

There are several pros to investing outside your home state and most of these centre around the benefits that come from having a diversified portfolio.  I have outlined some of the benefits below:
  1. If your state is relatively expensive for property at the moment you can sometimes buy in 'slower' states which you think will recover
    • Property markets are not homogeneous and while some are growing very fast, others are slowing down or are often in slumps
    • If you are looking to buy a property you may not find value in your own state but there may be many great deals in other states
  2. It allows you to diversify state specific downturns / high rental vacancies
    • If you have multiple investment properties in one state the fact is that all of them will be affected by the same factors at the same time
    • Having properties across multiple states allows you to diversify some of this risk away, especially when the other states are driven by different sort of impacts than your own home state
Cons of investing outside your home state

There are some very clear downsides to investing outside your home state and you should think about these very carefully before investing.  Only if you are totally comfortable should you go ahead and take the plunge.  Some of the downsides and risks include:
  1. You have to start from scratch and do all your research again
    • Although the asset class is the same, fundamental things like rules, regulations, rights and obligations are often very different between states
    • Do not go into an investment in another state thinking the same rules apply!
  2.  You do not have the insights that you do in your own state
    • We all have significant insights into our own state that we don't have in other states
    • We know which areas are better and worse and which ones are desired or have the potential to be desired in the future
    • Although you can do your research in another state you just do not have that same level of inherent knowledge
  3. Searching is a time intensive process - there is a risk that you make a hasty choice because you have limited time when you travel
    • As you would know from your

Friday 19 October 2012

Cinema Membership Cards: they really do make sense

Just a quick Weekend Warrior post from me this Friday about membership cards for cinemas.  This post is mainly aimed at Australian consumers however I have no doubt that such cards and deals exist in other countries as well.

For years teenagers manning the ticket booths and candy store at cinemas had been asking me if I wanted to sign up for either the Village Movie Card or Hoyts Rewards Card.  I always used to think these were at best a pointless addition to the already overflowing number of cards that I had in my wallet.  However I must admit that recently I have really discovered how good value they really are.

Why do I think it is really worth having at least one of these cards?

I will use the Hoyts Rewards Card as an example.  It costs $10 to purchase the card and with this you get one free adult movie ticket.  Given that most adult movies are $17 - $21 depending on the movie and whether it is 3-D this is like buying a discount card which is what convinced me to buy the card in the first place.  So straight away you are getting value.

Then for every dollar you spend either on buying movie tickets or at the candy store on popcorn and drinks you accumulate more points (note that I have not worked out how the points accumulation thing works).  When you have enough points you can redeem it for a free movie.  I admit that I was very sceptical of ever being able to get a free movie out of these cards however it didn't take too long for the pimply teenager behind the counter to let me know that I had a free ticket available on my card.  This is a benefit that you really do receive.

One of the best things though, and one benefit I had no idea about when I signed up for the card, was that they have these 'movie of the week' and pre-screenings available for members only.  The movie of the week takes one movie each week and makes it $10 a ticket for members.  Again given the price of most full price tickets - this is a STEAL.  The pre-screenings are also great because you can see blockbuster movies in advance of the general release date.  This is one of the best (not often advertised) feature of the card.

Do I need to go to the movies often to make these cards worthwhile?

Not really - while I like going to the cinema to what films I am not a huge movie buff.  I may see a movie once every 3 - 4 weeks and I still find that I get great value out of the card.  If you go and see films more often then this can save you some serious money.

How do I get best value out of the cards

I found the best way to get value from the cards is to sign up for the email notifications of when the discount movies are and to book your movies through the online booking system - you can then see what rewards you are eligible for and whether it is worth seeing a different movie that week (as well as not having to wait in the line)

I also recommend having only one membership card and going to one chain of cinemas.  This is not always possible however you really do get the best value if you accumulate points only on one card.  I chose Hoyts because it is the cinema closest to me.

Do you have any other ways you save money when going out to the cinemas?  If so please post below.

Usual disclaimer: I get nothing for promoting these products - I just think they are great value

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Thursday 18 October 2012

What is the difference between bottom-up and top-down investing?

There are so many investment strategies out there that sometimes it is hard to know exactly what all of them mean, whether they can be applied in your actual personal investment portfolio or whether they should be left to the professionals.  In this post I will be covering the difference between bottom-up and top-down investing.

Defining bottom up and top down investing

The difference between these two types of investing unsurprisingly relates to what point in the investment universe you start looking.  Do you start at the bottom looking at individual stocks or so you start at the top thinking about industries and macro considerations?

Bottom up investing starts wit the hunt for cheap companies and then overlays other considerations such as the macro environment on top later.  The most important consideration to these investors is the company and stock that they are investing in which then gets context applied to it.  Most traditional value investors fall within this category.

Conversely for top down investors the context is the most important part of the equation.  They try and spot or think of the big macro trends and structural factors which will affect valuations.  Once they have researched this theory they then search for the best companies conforming to that theory.  A lot of macro and hedge fund investors use this approach - for example think about those funds that bet against housing during the GFC . they were thinking about industry considerations not about individual stocks
Why does it make a difference?

It makes a difference because it fundamentally affects how you are thinking about your investment proposition and the framing of the investment question.  The fact is that each person is different and the way they tackle this question will be highly dependent on their individual investment experiences as well as the way they think about the world.

Both approaches have their upsides and downsides (and their limitations):
  • With top down investing you are constantly going through a 'narrowing' process
    • You find a 'big picture' that you want to trade on and you keep narrowing down the options until you get to a stock and company that you like
    • This has the benefit of understanding structural reasons before you get enamoured with any stock in particular
    • The disadvantage however is that you potentially miss good deals in sectors which are not doing a lot but where a stock may be very mis-priced
  • With bottom up investing the approach is much less limiting
    • Although most people specialise in some sectors or understand some sectors better than others the fact is that bottom up investing is a lot less limiting - you are free to look for good deals everywhere
    • The disadvantage though is that you can miss potentially important structural factors which can affect the value of the stock you are investing in regardless of how good the value appears to be
Are they mutually exclusive?

While all professional money managers have a view and a style which takes primacy in their investment approach, I think that all apply both techniques in some form.  A bottom up value investor will always look at the macro considerations to see whether there is a structural reason that the stock they are looking at is so cheap while a top down macro investor will always start with their hypothesis and then look for the stock with the best value proposition which conforms to the macro idea.

These two investment approaches are not mutually exclusive however one will normally come first in an investors thinking and it really has to do with the investment approach that each individual takes.

What should you do?

So now that you know what the difference is - do I think one way is netter than another?  In all honesty I think that while it is important for professional money managers to define their thinking around these ideas, I think that the average person investing on their own behalf has only limited time each day to think of investment ideas.  

If you have an idea which gets you going you should pursue it regardless of whether you see yourself as a 'bottom up' or 'top down' investor - the fact is that your investment mentality will probably drive you to one point or the other.  The research process that you go through should automatically incorporate both concepts as I explained above.

Be aware that almost every investment book you read will push one method over the other and make it sound like the only 'correct' idea.  the reality is much more subtle than this and keeping this in mind will allow you to think about what you are reading much more critically.


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Wednesday 17 October 2012

Should I allow pets in my Investment Property

This will be a very brief post on whether a landlord should allow pets in their investment property.  Unlike things like age, gender and children, you are allowed to discriminate between tenants on the basis of pets and some day you will face the issue about whether you should allow pets in your investment property.  This post will cover the things you need to think about when deciding whether to allow pets in your investment property.

I have briefly touched on this topic before in my post on how to choose the right tenants.  You may want to have a read of that post here.

Is your property suited to pet ownership?

The first question to ask yourself is whether you are allowed to have pets on your property.  If you own the land this will never be an issue as you are the king of your castle - however if your investment property is in an apartment complex there are often rules about pets and whether they are allowed or not - do not advertise your property as allowing pets if they are not allowed.

Assuming it is allowed then it comes down to an issue of suitability.  Cats are generally easier in this sense than dogs because they take up less room and honestly are less of a mess.  Dogs require space, an enclosed area so they cannot escape and probably a bit of grass as well for all those other things. 

Check with their previous landlord about any pet damage caused

The fact is that some animals are more destructive than others and some owners are more conscientious than others when it comes to caring for your property - especially in relation to pets.  Your best bet is to call up the previous landlords when screening your tenants to find out what they were like in their previous property

Make sure you allow for and account for the pet in your lease

If you are allowing a pet on the property your lease needs several provisions
  • An extra bond specifically for pet related damage on top of the bond they are already putting in place.  There is normally strict legislation on what sort of bonds you can take from your tenant so make sure you stick to the rules
  • Provisions for cleaning when the tenants leave.  This is especially important for cats whose smell tends to linger for long after they have gone.  Put a provision in the lease that says that when they leave the property they will have it steam cleaned etc.
When you do your annual inspection CHECK for damage caused by the pet

It is better to catch issues earlier rather than later and your pet bond (described above) is more likely to cover the damage if you catch it before it gets too bad.  This comes down to being interested and involved in your property.

Finally - make sure you are comfortable with a pet being in your property

I can tell you, and other landlords can tell you, that it is not a problem having pets in your property as long as you take the right steps however if you are just not comfortable with it then they are not worth having.  If you are constantly worried about the damage that your tenants dog is going to do then you are probably going to ruin your relationship with your tenant or worry yourself unnecessarily. 

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Monday 15 October 2012

Election Cycles: Voting is about self interest

In the midst of the US election cycle combined with the early shots fired in what is looking like being a very bitter and contentious Australian election cycle in 2014 I thought I would write a post on elections, voting and self interest. 

Politics is something I find particularly interesting, however being neither particularly left-wing (due to my blue collar upbringing) nor right wing (due to my current job and position) I find myself often torn between the various political parties.  This post will not be about who I think should run different countries but rather is a collection of thoughts about why people vote the way they do and perhaps how you should think about voting.

Voting is all about self interest

I have this core belief that voting is purely about self interest.  People vote for whomever they think will give them the best possible outcome.  It is unsurprising therefore that lower income earners tend to vote for the left leaning parties and higher income earners tend to vote for the right leaning parties.

There are of course exceptions to this - a commonly used term for a high income person voting left is a 'champagne sipping leftie' being a person who votes left but would vote right if they were voting in what would be perceived to be their traditional roles.  These people are not, however, exceptions to the rule - I think they are also voting in their self interest - you just have to define self interest a little bit broader

Self interest is more than just economic self interest

If you define self interest in a purely economic sense then you are going to have outliers like the one I described above.  Self interest however, is broader than this.  I believe there is 'utility' associated with doing what one perceives as social good.  This is why we give to charity - because it makes us feel good.

A quote that sums this up best in a political sense was when Gracchus,  Roman Senator in the movie Gladiator says
I do not pretend to be a man of the people...but I do try and be a man for the people
I think that altruism hides self interest though.  If the

Friday 12 October 2012

Eating my words on Interactive Brokers

There are situations where we all have to eat our own words and this is one situation where I am having to do that.  Late last week I posted a scathing post about how long it was taking Interactive Brokers to credit my FKP rights issue shares to my account.  




As many of my regular readers would know I had already had a bad time with this particular rights issue as I went from a potential large profit to a significant loss because of the bad decisions of management whereby they gave profits that should have accrued to shareholders to their Investment Bankers, Goldman Sachs instead.  




What should have happened?

If I had invested through a broker which held shares in my own name through a regular broker instead of through a custodian type arrangement ( see summary of differences here) I would have:
  • Received my allocation under the rights issue
  • Received my overallocation of shares equivalent to 50% of the allocation above
  • Received my allocation and been able to trade shares on the date the company actually announced.
However to my eternal delight ( though as I originally posted this was significant consternation ) this is not what happened.

What actually happened?

I finally got allocated the shares just over a week late which I was originally pretty annoyed about.  However when I checked the number of shares in my account was far in excess of what I actually expected.  Below is what actually happened
  • I was allocated my shares under the rights issue a week late
  • I
    got my allocation of basic rights that I was expecting
  • Instead of a 50% over allocation of shares I got 800% over allocation
Given that the amount of money that you make on a deal like this is totally dependent on the number of shares that you are issued this gave me a HUGE windfall and at first I couldn't understand what had happened.  

The company certainly hadn't done the right thing and issued me shares at a higher level because I had complained about them as other people I know that invested through regular brokers just got the 50% over allocation as expected.  Then I realised it all came down to Interactive Brokers!

How did I get the extra shares?

Thursday 11 October 2012

Arbitrage: Movie Review

This will be the first time on this blog that I will be reviewing a movie.  Before you start to worry that I will be changing this blog into an entertainment log instead of purely a financial one have no fear - the only movies i will review are in much the same vein as the books I review - that is I will only review those with a strong financial theme or those that purport to be about finance.

Overview of arbitrage


With a name like 'arbitrage' i was hoping for great things like this movie...perhaps a look at the crazy things that happened during the GFC or the idea that you can borrow short and then lend long and earn risk free profits into eternity with the movie looking at the collapse of this system.

However it turned out that this movie had very little to do with finance even though the main character is a hedge fund manger.  The movie is actually a story of crises and how on deals with it.   The main character ( played by Richard Gere) seems to have the perfect life - he is rich, successful,has a great family ( and mistress to boot) and is selling his firm for millions of dollars to a competitor when he will be able to retire to a comfortable life.

The audience then sees cracks begin  to appear including the fact that he had cheated in his business by falsifying records and through other crooked business dealings, and he then is in a car cash which kills his mistress and threatens to ruin all his plans to save his business.


My take on this movie

This movie attempts to convey the message that

Wednesday 10 October 2012

Does it matter if my broker holds the title to my shares?

In my previous post on Interactive Brokers, I mentioned the fact that they act as custodian over my shares and that I would do a post on the upsides and downsides of holding the shares in the name of interactive brokers instead of your own.

What is the difference between holding the title to shares yourself and the broker holding title

There are several practical and legal differences in the way that shares are held.  I shall outline only a few below.  It is probably worth researching further and seeing how different brokers operate before making the decision about whether you are comfortable with it.

Practical differences in the way title is held

  • When title is held in your name the company knows that you are an investor.  When it is held through a custodian all they know is that a custodian has customers with x number of shares.  Thus all communications are with you instead of with the custodian.  You will notice that when you go through a custodian that you never receive any correspondence yourself and dividends are paid to your custodian not to your bank account.
  • The rights to participate in things such as DRP's and corporate actions are at the discretion of the custodian if they are held in their name.  This is why Interactive Brokers does not allow DRP's however it does have a system for corporate actions.  The same applies for voting.
Legal implications regarding the way shares are held
  • Custodians should hold your shares in a trust outside the business structure.  They do not own your shares and only hold them for you on trust.  However there have been examples, most recently in the GFC, of customers losing their money due to dodgy practices - see the example below
  • If your custodian is based in the US you may not be able to participate in some corporate actions.  Due to how strict the SEC is on filing requirements, a lot of companies specifically exclude US investors from participating in equity raisings and corporate actions.  You need to make sure that you are not affected by this.  Interactive Brokers tends to set up entities in various regions so it has not been a problem for me to date.


What can go wrong - A Prime Example

The collapse of many independent brokers during the GFC really brought to light the issues that can occur when you do not hold the title to your shares in your own name.  In Australia the primary example was Opes Prime, an Australian share broker which held the shares in the companies name rather than the individual investor.

When Opes collapsed in 2008 the customers expected (rightly) that their shares could simply be transferred to another broker. Instead Opes had, illegally, borrowed against these shares for their securities lending business and the lender to this business called in that collateral, sold the shares at a significant loss and the customers of the business only got back a fraction of what was rightfully theirs.

Let us be very clear from the start - what Opes did was illegal.  There should have been a trust outside the main Opes entity to hold the shares of customers as the company had no right to treat these shares as their own assets.  The customers could sue the company afterwards, however if the company is bankrupt there is little point in suing them.

What should you do IF your broker holds your shares in their name (like Interactive Brokers)

If you acknowledge the risks of investing through a broker which does not hold the shares in your name and still decide to go ahead with it (because of their low costs of trades or access to more international markets etc.) then you need to put in place risk mitigators.

You need to keep a constant look out for signs of financial stress at your broker.  You owe them no loyalty.  At the first sign that they might be in trouble it is time to abandon ship and transfer your shares to another broker (I suggest having another brokerage account) where shares are held in your name.

Set up news alerts and ALWAYS read their disclosure statements (even though it may be particularly boring).  It is not worth losing all your investment portfolio (which presumably you worked your whole life for) because you have been lazy.

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Tuesday 9 October 2012

What is Investment Risk?

This may seem lie a rather incongruous name for a post given most of us know inherently know what investment risk is.  To most of us it is the risk that we lose money.  However you may be interested to know that this is not how finance theory thinks about risk.  Indeed statements such as 'diversification is good' is based on another definition of risk altogether.

As a little bit of background as to why I am bringing this up. I was recently re-reading a book on Warren Buffet, The Essential Buffet (which I have reviewed before), and I came across a section where the author talks about how Warren Buffet uses the 'common sense' approach to risk (as I have defined it above) rather than the finance theory approach to risk.

How does financial theory define risk?

Financial theory (and trusty Investopedia) defines risk as:
The chance that an investment's actual return will be different than expected.  Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.  A high standard deviation indicates a high degree of risk
The word 'different' in the first sentence is really the key word in the whole statement.  If a return is different from expected - even if it is higher - then this is a 'risk' in financial theory.  Financial theory defines risk as a deviation from what you expect and certainty is held paramount.

Now while you may be spotting the obvious flaw in the above definition let me say first that financial markets (and people generally) pay a high price for certainty.  The more certain your return is the lower that rate of return is.  This is why government bonds have the lowest return - they are the most certain.

What is the problem with this definition

When we are brought up - risk is generally viewed as a bad thing.  The objection that Warren Buffet has to the finance definition of risk is that is views upside risk in the same way it views downside risk which to him seems nonsensical.

If we dig a little deeper into the assumptions surrounding risk (and standard deviations and statistics more generally) we see one fact that the traditional risk assumptions make that does not necessarily hold true in the real world - it assumes a normal distribution.  For all of you reaching back to your high school maths don't worry about getting out your text book - this just means that the probability of something occurring is centred around your mean with an even distribution either side of this mean.

This inherent assumption means that the probability upside risk associated with an investment is equivalent to the downside risk.  In this scenario you can see why certainty may be better and why more risk is worse.

However as I indicated above - life and financial investments are rarely normally distributed.  What Warren Buffet is trying to say is that if you can find an investment with limited downside risk and significant upside risk - then this is less risky (in a common sense approach to risk) than financial theory would generally suggest.

Why is knowing this important (and why did I bother writing a whole post on it)

The finance definition of risk is central to modern financial theory and to the way that financial products are priced and traded.  If you recognise it's short comings you can benefit by investing to take advantage of upside risk.

If you understand this definition of risk you will also understand why people say that diversification is good (I'll do a post on this very soon), why academics claim that you cannot beat the market (contrary to what some investors achieve) and how to take advantage of this for your own benefit.

You May Also Be Interested In:
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Friday 5 October 2012

Discount coupon websites are great (free) ways to save money online

This will just be a quick Friday post from me today.  I'm sure many people who shop online know this but I thought I would put up a tried and trusted way you can save a fair bit of money when shopping or buying products online.

You would have noticed that whenever you buy products or services from a website in the checkout screen there is always space for a coupon code.  If you do not buy products online often you may not realise that these coupons (and often relatively large savings that come with them) are easily available online if you search for them.

All you need to do is google the site and then "coupon code" or "discount code" and you will see a vast number of sites come up which claim to have coupon codes for that company.  Note that not all of them will work and you will often end up searching a long time for something that doesn't exist.  The following are the steps I take to get coupon codes quickly and easily:

  1. Use primarily a site you trust or have used before - it saves you going to sites that will give you nothing
    • I had retailmenot.com recommended to me by a friend who shopped online a lot and I found that they are my go to source for discount coupon codes
    • While they don't have coupon codes for everything they have a pretty good selection
    • Usual disclaimer: I'm not affiliated nor do I get anything from them when you click the link
  2. DO NOT click links that say "click through to the site to get a discount"
    • You almost NEVER get a discount this way and the website that scammed you just made a couple of dollars because they 'referred' you to a site you were already going to buy from
  3. Look for the code itself - most sites should have this displayed upfront. 
    • The "click here for code" are often gimmicks like the one described in point 2
  4. Work out which code offers you the best value
    • There are often multiple codes available which offer different deals
    • For lower priced items you're probably better off taking the flat dollar off discount but for higher priced items you may want the percentage off offer - see what works for you
  5. If the first code doesn't work try the second one
    • I've never seen a website which will only let you enter one code - try several before giving up
I hope the above tips work for you.  If you have any other sites which you use regularly I'd love to hear about them (I'm always on the hunt for bargains).

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Thursday 4 October 2012

Founders' Voting Rights decreases the value of YOUR shares

In this post I will be writing about founders’ voters rights.  This is not a concept that is present in all markets and so if you are an investor from a jurisdiction that does not have the concept of founder shares or different classes of shares then this is the post for you.  It is something that you need to consider especially if you are investing in markets such as the United States where this is relatively common.

So what are founders’ shares?

Simply put they are a different class of shares.  This necessarily involves the discussion of classes of shares.  In markets such as Australia different classes of ordinary shares do not exist.  One share is exactly the same as another and comes with the same rights, structure and benefits as any other share.

However some markets allow different classes of shares.  At the most basic level you can have, for example, one class of shares which is the equivalent of 10 of another class of shares.  You can see this with companies such as Berkshire Hathaway which has both Class A and Class B shares with the basic difference being that Class A shares are a multiple of Class B shares.  There is actually no real problem with this because it is pretty easy to value the difference in these shares and both classes of shares are tradeable.

Founders’ shares in their current form are a product of the second tech boom and started with Google’s IPO in 2004.  They create a class of shares which are held by the founder, founders or a group of insiders in the business which have super voting powers.  For example with Facebook’s recent IPO Mark Zuckerberg owns 18% of the company’s shares however controls 57% of the voting shares. 

What is the rationale behind them?

Let me say upfront that I do not buy the rationale given for founders’ shares however I will outline both what is the reasons given by the company and what I think the reasons are.

The rationale for founders’ shares or super voting shares controlled by insiders is as follows:
  • Share markets are notoriously short term driven with investors focusing on short term gains when if the business took some short term pain, in the long run shareholders and the business would be better off
  • The person or insiders that control the company and got it to the stage of being able to list is more likely to be able to take the long term view of the business and knows the best way of taking it forward (Amazon is the most cited example of this)
  • If the founder or founders are selling more than 50% of the company, it is in the interests of the whole company for the control of the company to rest with those shareholders who have the long run interests of the business in mind

Maybe I am more cynical by in my view it is more about founders wanting investors to come and board and not say anything.  It is an ego trip where the company needs shareholders but does not want their opinion because the ‘founder knows best’

Why do I have a problem with super voting shares?

There are several reasons I have a problem with them including
  1. It is paternalism gone mad.  The assumption that the founder ‘knows best’ and that I should hand over my money and stand back and not get involved is ludicrous to me
  2. It assumes that the founder will always do what is in the best interests of the business.  Often CEO’s and founders empire build.  That is they are driven by the power they wield through their corporation and not the returns they generate.  This means that they make decisions and acquisitions not based on what is best for shareholders in a returns sense.  If a founder controls the company and starts to do this there is no way they can get voted out
  3. As a shareholder you are the most subordinated interest in the company – the upside of this is that you get a say in the company.  You can vote your shares in a takeover or you can vote out the people that control the company if you do not think what they are doing is in the best interests of the company.  Super voting shares ruins this.

IF you were able to buy super voting shares on market (and thus they became a truly distinct class of shares with a different value) then you could probably value it and adjust your valuation of your own shares accordingly. 

If you are planning on buying shares in a company which has a dual class of shareholding like this make sure that you put a discount for the damage that a founder can do the company where you have no control.  The risks are high and you have limited recourse.  I would value your shares like a non voting share because effectively that is what it becomes. 

Note that there are many jurisdictions in the world where one share equals one vote.  If someone wants to control a company they need to put their money where their mouth is and have a big enough stake to be able to do so.  This aligns their interests better with that of other shareholders.

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Wednesday 3 October 2012

Interactive Brokers - The Negatives Start to Pile Up

I have previously posted on how easy it was to use the Interactive Brokers corporate actions functionality in order to participate in an equity raising (note that this equity raising was particularly annoying for me but that was the company’s fault and not Interactive Brokers).

However, there were issues with using Interactive Brokers which I highlighted at the time.  These included the following issues:
  • You had to pay and register your final decision more than a week in advance of the actual close as specified by the company
    • This is because interactive brokers acts as a custodian for your shares (there are inherent issues in this which I will post about at a later date)
    • What this means though is that you lose optionality associated with waiting until the last minute to register your interest (i.e. if you didn’t have to register in advance you could wait and see what the share price did before registering your interest)
  • You had to transfer the required funds to your Interactive Brokers account and some financial institutions limited the amount you could transfer to them to $10,000 a day
    • This is an issue because it can take a long time to transfer the funds you wish to lose and you are losing the ability to use those funds
 There were benefits though including the fact that Interactive Brokers allowed you to see all the options involved in an equity raising (whereas normally you would have to make sure you read all the fine print).

Lately though I have been coming across more issues with the biggest one being that the time it takes them to allocate you the shares is MUCH too long
  • When you participate in an equity raising you often want to flip the shares as quickly as possible.  You buy them at a depressed price and more than you actually want to hold with the idea of selling them at market price straight away
  • In the equity raising I have linked to above, FKP allotted the shares to investors on 27/9/2012 and they were tradable on 28/9/2012.  I am writing this on 2/10/2012 and I still have not yet been allotted my shares
The above point is almost a deal breaker for using Interactive Brokers.  Interactive Brokers is known around the market as the option for people who trade often and want to reduce their trade costs.  Timing for traders is important especially around strategies such as this.

I think I am going to redefine the way I use Interactive Brokers.  It still offers great trade prices for international shares and every time I buy an international share I think I shall use them because Australian brokers cost 10-20x as much.  However for Australian shares I am willing to pay significantly more to have the flexibility of DRPs (which Interactive Brokers doesn’t offer) as well as flexibility in equity raisings.

One other issue with Interactive Brokers (which I have not outlined here) is that they hold onto your shares as custodian.  This proved to be a real issue in the GFC with many people losing their shirts through no fault of their own.  I am going to dedicate a whole post to this in the near future.

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Tuesday 2 October 2012

Expenditure Tracker - September 2012


ItemSep 2012Target (new)Over/(Under)Target (old)Over/(Under)
Share Investments+$31,032+$3,100+$27,932+$3,300+$27,732
Offset Acct.-$27,048+$1,300-$28,348+$1,600-$28,648
Personal expenditure+$3,065+$2,000+$1,065+$1,500+$1,565


This is the fourth post with my reset expectations around what I can spend and save each month.  As you can see I am still not meeting my expenditure expectations however if you compare with previous expenditure trackers I am managing to slowly reduce my personal expenditure so that it does not have the same swing factor impact that it has in previous months.

Compared to August 2012, I controlled my personal expenditure relatively well and I did not have any big or unexpected expenses during the month. My credit card bill for the coming month is even lower than last month.  I'm aiming for my credit card bill to be sub $1,200 by November.  I don't think that I can achieve this over December and January due to Christmas as well as an overseas trip I have planned.

The big increase in the stock investment for this month was due to the transfer of funds into the FKP equity rights issue (and the overallocation facility I got screwed on - I have posted about this before).  As I receive the cash back from this investment the offset and share investment accounts should balance each other out again (although the spot month to month accounts may look odd).  The table to focus on would be the cumulative one (not the actual month to month one)

As mentioned in my September 2012 Net Worth post, next month I think I'm going to get a little bit more complex with the way I track my performance to include the impact of taxes (particularly capital gains taxes) because I do not wish to have big swing factors whenever I do my tax returns when in fact I have incurred taxes at much earlier dates.  The exception to this will be on the tax return I will get from my investment property as this is pretty hard to assess on a month to month basis.

On a cumulative basis my expenditure performance is as follows:


ItemJul 12 - Sep 12Target (new)Over/(Under)Jan 12 - Sep 12Target (old)Over/(Under)
Share Investments+$53,400+$9,300+$44,100+$78,209+$29,700+$48,509
Offset Acct.-$43,572+$3,900-$47,472-$49,567+$14,400-$63,967
Personal expenditure+$10,919+$6,000+$4,919+$33,091+$13,500+$19,591

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