Everyone investor should read this

Although this post is fully prose, please read it before you start investing. After reading it, you will be smarter than 95% of all investors. However, it is also my (albeit selfish) hope that after reading this, you should have no more need to want to read stock analysis and wanting to pick stocks. Let's start.

Liabilities and equities

When we invest, we are either investing into debt or equity. The accounting equation sums it up:

Assets = liabilities + equity

What this means is that whenever a company buys or owns something (an asset), it has to be funded by either borrowings and debt (liabilities) or by their owners (equity). Let me give you an example.

Suppose today you want to set up a durian wholesale business, you would start off by putting $20,000 into the business. This $20,000 would be used to buy $10,000 worth of durians, and the remaining $10,000 would be used for rental. This means that you now have $10,000 in inventory and $10,000 in prepaid rent (assets), and $20,000 in shareholder's equity (equity).

You go and borrow another $10,000, and this $10,000 is used as cash for daily expenses. Now your total assets become $30,000 with $10,000 in cash, $10,000 in inventory, and $10,000 in prepaid rent. On the right side of the equation, your liabilities have become $10,000 because of bank loan, and $20,000 in equity from shareholder's equity.

Liabilities and equity

When a bank lends you money, they expect to get paid for it. This is in the form of interest. When you borrow money, you need to pay interest. When you lend money, you expect to receive interest. Thus, investing in debt (or liability), you expect to receive interest.

On the other hand, if you put money into the business as an owner,  you also need to get something in return. Usually, you will expect to receive dividends. Dividends are a part of the company's earnings that is paid out to their shareholders. Apart from dividends, there is a chance that the value of your share of the company will increase, and thus you will be able to sell it at a higher price. To understand this, you have to understand the hierarchy.

Interest is always paid first before dividends. If a company has no money, it still has to pay interest on its debt but dividends are not compulsory. Thus, liabilities rank higher than equity. On the other hand, if a company does well, you can expect that there are more than enough earnings to cover for interest and dividends, and leaving behind some leftover. This leftover is also know as retained earnings, which is the net worth of the company in layman terms. If the company does well year after year, you would expect this to increase, and cause your ownership value to increase. This is how your ownership can increase. In a listed company, this is the share price.

I hope you can see now that debt has lower risk as it is higher in the hierarchy, but also has lower rewards as interest payments are fixed. The risk is low but not none because the company can still go bankrupt. The chance of going bankrupt is known as credit risk. On the other hand, equity has higher risk. There is a risk that there will be no dividends. Also, if a company does badly year after year, the net worth of the company will decrease, and thus your value of your ownership also decreases. However, the upside is unlimited because the company can be profitable forever. Thus, equity gives a higher reward because of higher risk.

Stocks and bonds

When we invest in bonds, we are investing in debt. That is, we are lending money to someone, in return, we will get back interest payments. So, when we buy a bond, we are lending money. For example, we buy a bond of $10,000 with interest of 2% and term of 5 years. We will expect to receive $200 each year for the next 5 years, and $10,000 in the 5th year. The risk is that there is non-payment of interest and principal (the original $10,000).

If we invest in equity, we are buying a share of the company. In return, we are expecting to get dividends, and possible appreciation of your shareholding. Different from bonds, there is no expected return in stocks, and it is based on estimates or predictions.

Risk and reward: unsystematic and systematic risk

I have spoken about the risk reward trade off. If you want lower risk, you have to settle for lower returns. If you want higher returns, you have to take higher risks. The risk here is systematic risk. I will explain further.

If you invest in a particular stock (let's not go into bonds for now), there are a few risks to you. One of it is company risk, whether the company might perform badly. Fortunately, this risk can be diversified away, by holding a basket of many companies. However, if you buy all companies in the property sector, then you are still exposed to industry risk. In the case where the industry does badly, you will do badly too. Fortunately as well, this risk can be diversified away too. We can buy the entire market in Singapore for instance, all the sectors included. However, smart readers will have noticed that this presents a country risk, the risk that the country's economy does not perform. Fortunately as well, this risk can be diversified away by buying all the stocks in the entire world.

If you do so, there is still another risk. This risk is called systematic risk, or undiversifiable risk. This may include a world war, global epidemic, or global recession. Unfortunately for us, there is no way of eliminating it. But, there is a way to reduce it. It is to use dollar cost averaging, in order to capitalise on market movements. For the previous risks stated such as company risk, industry risk and country risk, they are known as unsystematic risk or diversifiable risk.

Take note of this carefully. When we talk about the risk and return tradeoff, we are only talking about systematic risk, or also known as undiversifiable risk. I will give you an example. Suppose one person has 3% of unsystematic risk, and 5% of systematic risk, and his friend holds 5% of systematic risk. Both persons should expect to have the same return on their portfolio. In other words, even though the first person holds more risk, he does not get compensated for it.

Of course, besides the risk reward tradeoff, another tradeoff is also the risk-liquidity reward tradeoff. In other words, if you hold more risk and hold for a longer period of time, you will get the highest return. If you hold the same amount of risk but then cash out quickly, your returns will be expected to be lower. For now, we shall assume that we all have low liquidity, and want to hold our investments forever.

Index funds and passive investing

Since we get rewarded for holding only systematic risk, we should aim to have zero unsystematic risk. To do so, we will need to buy every stock available in the market. It might seem crazy but it is actually possible. We do so through the use of index funds. Index funds are basically funds that seek to replicate an index. An index is something like a tracker, of a basket of stocks. If it is a world index, it means that the index fund will replicate the performance of owning all the stocks in the world. To summarise, we can simply buy a world index fund.

Many people use index investing and passive investing interchangeably. However, this is not correct. Such indexes are not passive. For instance, the Straits Times Index, the index that tracks the performance of the Singapore stock market, is an active index. It is active because the 30 stocks are chosen based on the criteria such as market capitalisation, liquidity, and performance. However, most index seldom change, so in most cases, index investing is the same as passive investing as you seek to buy and hold forever.

The importance of bonds in a portfolio

By now, we have already known that bonds are less risky than stocks. However, bonds also have this risks. The risk include credit risk, currency risk, and interest rate risk. The most important of which is interest rate risk. For the explanation, you can refer to this blog post: here. In gist, when economy interest rate increases, bond prices fall, and vice versa. If you were to buy a bond index fund, the daily price (or NAV) of the fund will fluctuate. This is due to the price of the bonds adjusting due to various risks, including interest rate risk.

In theory, when the economy is doing well, optimism is high in the general public, and stocks will be at a high. What the government does it to increase interest rates in order to slow down inflation. When increase rates rise, bond price fall. Thus, you will see the first scenario where stock and bond prices are inversely related.

On the other hand, when the economy performs poorly, you can expect pessimism in the markets, and stocks will be priced lowly. The government then spurs the economy by reducing interest rates. This has the effect of increasing bond price. In this case, stock prices are low while bond prices are higher. This is the other end where stock and bond prices are inversely related.

By holding both stocks and bonds in your portfolio, the total risk in your portfolio will be reduced, due to the negative correlation between stocks and bonds. By having lesser total portfolio risk, this allows you to sleep soundly at night.

Rebalancing

Although many people are fascinated with market timing, the ability to buy at the lowest price and sell at the highest price, it is not possible. You can never predict the future and definitely not the irrationality of investors. Furthermore, research has suggested that a portfolio's performance is 90% determined by asset allocation and only 10% by market timing. It is more important to get a correct mix of stocks and bonds in your portfolio and rebalance regularly.

Suppose we have a portfolio mix of 60% stocks and 40% bonds in the beginning. At the end of 1 year, the actual composition will change, depending on how stocks and bonds perform. It might, for instance, become a mix of 70% stocks and 30% bonds, due to stocks outperforming bonds. What you have to do, is to make the mix back to 60% stocks and 40% bonds. You can do so by taking your excess money and buying bonds till the percentage of bonds become 40% or you can sell of 10% of your portfolio in stocks and purchase bonds.

I will do a more detailed blog post on how often you should rebalance, but the concept shall suffice for now.

A short parable

In a classroom of 30 students, how many students will score above the average? If you answered 15, then you are right. In the stock market, what percentage of investors will perform better than the market (the average)?

The correct answer is 50%. Only 50% will outperform the market, and 50% will underperform the market. Take note that I have excluded fees, such as transaction costs, sales load, and annual management fees. If they were to be included, the ratio changes from 50-50 to 80-20. That means, 80% of investors will underperform the market, and 20% will outperform the market.

The moral of the parable is clear. The lower your fees, the better your performance.

Some more insistent readers might ask, whether it is possible to be in the 20% of investors. Unfortunately, although not impossible, it is very difficult. Research has shown that funds which outperform the market in one year, have always tended to underperform the market in the subsequent years. It is usually better to simply stick to the market average, and minimise your costs.

Establishing the Boglehead 3-fund portfolio in Singapore

By now, you should have learnt 3 things. One, a portfolio should have both stocks and bonds. Two, you should minimise costs. Three, you should rebalance regularly.

In turn, we come to the Boglehead 3-fund portfolio, and how it can be applied to Singaporean investors. The Boglehead 3-fund portfolio is created by Bogleheads (a name index investors call themselves, named after the so-called founder of index investing John Bogle, also the founder of the low-cost index fund company Vanguard). Through the many market turmoils, the 3-fund portfolio has been proven to outperform the market on a risk-reward basis.

In the US where the 3-fund portfolio was created, the 3 funds comprised of the US stock market, the World stock market, and the US bonds market. In Singapore, this will translate to the Singapore stock market, the World stock market, and the Singapore bonds market. These are the index funds we will use.

Singapore stock market: SPDR Straits Times Index ETF
World stock market: Vanguard FTSE All-World UCITS ETF
Singapore bonds market: ABF Singapore Bond index Fund

The SPDR Straits Times Index ETF is the index fund that tracks the STI of 30 stocks in Singapore.

The Vanguard FTSE All-World UCITS ETF is the ETF that tracks to performance of all stocks in the world, and is one of the lowest cost funds out there. It also has the best tax structure for Singaporeans.

The ABF Singapore Bond index Fund is the fund that tracks the government bonds in Singapore of AAA- rated bonds. All funds can be bought on the exchange.

The more important question is the allocation. Remember this, the asset allocation is what enables you to sleep soundly at night, regardless of market turmoil. You can head to this website: here, complete the questionnaire, and obtain your desired portfolio allocation.

Out of the percentage in stocks, split them equally into the SPDR Straits Times Index ETF and the Vanguard FTSE All-World UCITS ETF. The rest goes into the ABF Singapore Bond index Fund. You can buy the in one shot, or do a dollar cost averaging over a desired time period.

For example, your desired allocation is 60% stocks and 40% bonds. You would then put 30% into the SPDR Straits Times Index ETF, 30% into the Vanguard FTSE All-World UCITS ETF, and 40% into the ABF Singapore Bond index Fund.

Suppose you have $10,000 in total to invest in one go. You would then purchase $3,000 of SPDR Straits Times Index ETF, $3,000 of Vanguard FTSE All-World UCITS ETF, and $4,000 of ABF Singapore Bond index Fund. In the case where you can't buy a round number of units (which most likely is the case), just buy the number of units rounded down to the nearest whole number.

On the other hand, you might choose to do a dollar cost averaging and put in $1,000 per month for 12 months. You would then purchase $300 of SPDR Straits Times Index ETF, $300 of Vanguard FTSE All-World UCITS ETF, and $400 of ABF Singapore Bond index Fund. Similarly, you should round the units down to the nearest whole number.

I would suggest a dollar cost averaging method whereby you channel a portion of your income to the portfolio. It will do you good in the long run. Lastly, at the end of either 1 or 2 years, you then rebalance your portfolio.

Conclusion

There is so many things to be discussed on this matter of investing, and I will be updating this post when I find suitable or interesting research being done. For now, please feel free to comment and let me know if you have any questions!
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AUTHOR
23 February 2016 at 17:49 delete

Hi there would like to check what is the code for the Vanguard fund u mentioned? Is it VWRD? In terms of tax I understand that there is withholding tax of 30%.. Isn't that very high? I have been looking for a world index fund which is low in tax but not able to find..

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23 February 2016 at 18:40 delete

Hello. Yes it is VWRD. VWRD is domiciled in Ireland and not subjected to any withholding tax. For a US domiciled international ETF, the withholding tax is 30% on dividends. For example, if the fund pays out $1 in dividends, $0.30 will be taken away. There is no such problem for the VWRD.

However, VWRD is taxed at sourced. For instance, any US based companies in VWRD will be subjected to 30% withholding tax if they pay out dividends. Since US stocks make up around 50% of the fund, I would expect around 15% of tax to be deducted at source.

Hope it clarifies.

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Anata BuBu
AUTHOR
26 February 2016 at 15:21 delete

Thanks Lazy Singaporean on your reply!

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Anata BuBu
AUTHOR
26 February 2016 at 15:22 delete

Btw would you know the dividend yield for VWRD?

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27 February 2016 at 16:35 delete

Hello Anata, hope it clarifies.

As for the dividend yield, I got it to be around 3% (2.94% to be exact) from Morningstar website. Link: http://www.morningstar.co.uk/uk/etf/snapshot/snapshot.aspx?id=0P0000WA5N&tab=3

They pay out quarterly, so should be 0.75% each quarter. Vanguard provides this information: https://www.vanguard.co.uk/documents/portal/legal/etf-distribution-schedule.pdf

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Anata BuBu
AUTHOR
1 March 2016 at 09:24 delete

Hi lazy Singaporean, thanks for the info. It is quite hard sometimes to get the information. I should build the patience like u!

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2 March 2016 at 12:43 delete

No problem. I am invested in VWRD too. Although one person is a small sample size, I will update again once I receive my dividends this year.

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