Finance 101: From the Simple Dollar, retirement on $1,000,000

Just a quick shout out to one of my favourite blogs, The Simple Dollar.  Yesterday’s entry on how to retire on $1 million (or if it can be done) well-illustrates the type of basic analysis underpinning retirement planning calculators everywhere.

My only caveat with the analysis, like most of these simple ones, is the sensitivity to assumptions.  This article tries several types of assumptions, which makes the thing stand out (in my opinion).  But particularly when long time periods are involved, small changes in assumptions can drastically change results.  Given we have basically no idea what the correct figures will be, caveat emptor for those placing too much reliance on one run of the ‘simulation’!

Sadly there isn’t a good fix for unknown parameters in the analysis, but rest assured I’ll let you know when I have a reliable crystal ball.

Confidence runs high; I’m Vix’ed out

Maybe I’m a one-trick pony.  I just happen to like playing the Vix – in particular, the Vix-related derivatives.  There are 2 main ways I like to do this:

1. Just short it: I take advantage of a few related characteristics to short the Vix via UVXY.  In particular, I like that UVXY is the prototype of a bad long-term buy, so I short the product using medium-dated options.  After biting my nails during the past couple months’ market volatility, this trade finally hit pay dirt.  I’m out of my latest iteration as of today, after holding about 2.5 months.
2. Spread it: when the markets get really scared, the Vix futures curve looks like the red line below (from previous post):
   

   Mmm…backwardation. Source: thinkorswim by TDAmeritrade

   Today that red curve looks much more normal, as we’re back to daily all-time highs:

   

   All back to normal. Source: thinkorswim by TDAmeritrade.

   I took off the latest iteration of this trade yesterday.  About 3 weeks of holding time.

What have I learned?  First, it’s great to learn with successful trades.  My theses were researched and executed when the time was right.  Most importantly – in my mind – is patience: at one point I was looking at some pretty solid losses on the #1 trade as the Vix kept climbing higher.  Nevertheless, that’s why I chose medium-term options to express the trade, and ensured I had a manageable maximum loss at initiation of the trade.

Trading strategy – discipline over complexity

With investing, as with life… Source: Google Images

First of all, a confession: I’m becoming a Twitter junkie.  Maybe it’s due to being alone most of the day, but the trading community on Twitter is fantastic.  So I enjoy indulging in various conversations around market events and trading philosophy.  Anyone interested can find me at @financialpiggy8

So.  One of the Twitter conversations of late has been around HFT scamming, and included some pretty senior folks in the finance space.  The worries are around what data HFTs get versus the ‘average’ guy, and what that might cost us as individual investors.  Beyond the actual data feeds, I mused on some related issues/generalities:

• Trading strategies follow Occam’s Razor: in general, simpler strategies are more robust.  At least, that’s what I have found trading at a variety of different time frames.  I think many folks unaccustomed to trading believe there’s tremendous complexity in what traders’ strategies contain.
• Key to trading = discipline: I struggle with keeping discipline.  I’m completely in agreement with several fellow traders on Twitter that espouse the less-interesting parts of being a trader.  Namely, consistency towards rules.  It’s no accident that many traders fail due to strategy neglect – trading too large/too small, ignoring entry/exit signals, etc.  The prime example of a successful trader is someone with a solid routine, hopefully with no emotions attached.  Hence the following point.
• Automated trading = automated discipline: seeing as I have pretty bad discipline (in my opinion), I outsource the discipline to my computer.  Now my weakness is pretty much limited to turning off the system when I shouldn’t (to wit: I have turned off the system far too many times; each time has been costly, in terms of missed opportunity).
• The bigger picture – why we pay financial advisors/fund managers:  people like me – interested in markets, anxious to overtrade, etc. – can also impose discipline by paying an advisor or fund manager to make all decisions.  I can say with full confidence that, for many people, the 1% charged by a financial advisor is well worth the market tracking error compared to managing/overtrading their own assets.  We can debate whether other options are a better deal here (e.g. robo-advisors charge less for the similar effect, as could diversified ETFs held forever), but the point is to stay away from self-destructive overtrading or overcomplicating matters.

In sum: the more complicated a trading strategy, likely the worse it will perform in future.  Discipline is crucial in trading, as with investing.  If you can’t keep discipline, consider hiring someone/some computer to make decisions on your behalf.

Friday reading: Andy Haldane of BoE on World Growth

I’m a big fan of Andy Haldane’s economic work.  An old favourite is his work on value investing versus momentum investing over VERY long time periods.

Anyway, his latest speech on economic growth is very interesting, well-researched, and utilises some great economic history to make a typically economist conclusion (i.e. ‘on the one hand…’).  In a testament to how visualising data can really guide opinion, I present the below from the speech:

Pretty interesting stuff. Source: BoE

Huh.  But that leads to this exciting chart (NB: note how arithmetic scale makes this much more powerful):

Whoa… Source: BoE

Happy Friday!

Greeks, Germans and Game Theory

Maybe I’m too deep in the weeds, but the whole charade between Greece, Germany and the rest of the EU seems like a case of ‘truth stranger than fiction’.  Here’s what I gather so far, mainly from reading Bloomberg and a Twitter stream full of insightful people (NB: once started with Twitter, it becomes extraordinarily addictive; not unlike financial markets):

• Greece survives due to the largesse/pleasure of creditor countries within the EU.  Remember who has the power?  If the credit tap is turned off, Greece will default.  Bank deposits have fled the country so fast, there is no chance to finance itself in Euros.  Simple as that.
• The timeline is a bit fuzzy, but seems to be end-February.  If nothing is done before then, Greece is a goner.
• If Greece defaults, the following is likely:
  • A very uncertain time, as folks attempt to figure out how an ‘orderly exit’ from the Euro could take place – there is no template, nor legislation, for how this would work.
  • Bond yields for other countries surviving on EU credit, e.g. Spain, Portugal, Italy, will likely spike higher.  Who’s to say they won’t be ejected as well?
  • I’m unsure what happens to the Euro.  I suppose it depreciates, as event risk becomes more of an issue.
• Greece’s government has the explicit (perhaps necessary and sufficient?) mandate to  exit the current bailout arrangement while maintaining Euro membership.  Though the campaign speeches said this would be easy, it’s turning out not so easy to achieve both objectives.
• In my opinion, Greece’s ace up its sleeve is Yanis Varoufakis, the Finance Minister.  He used to teach game theory, which one would assume is very useful for this type of goal achievement.  His methods have been definitely interesting to watch/read:
  • Rhetoric completely shutting down the possibility of extending the status quo.  In other words, things will definitely change.
  • Pointing out the damage a Greek exit would cause for the EU.  A sort of “don’t cut your nose to spite your face” argument.
  • Proposing relatively new financial instruments – e.g. GDP growth-linked bonds.  A good idea, but controversial for moral hazard-concerned creditors.
  • Continuous confidence in a solution which will suit Greece.  Establishing the inevitable.
• Once negotiations began, Germany’s hard-headed Finance Minister, Wolfgang Schäuble, played the ‘bad cop’ in excellent fashion.  Basically shut the door on any extension that varies the terms of the previous bailout.  Doesn’t care about fallout – he announces all is OK.
• In the middle are Michel Sapin, France’s Finance Minister, and Jeroen Dijsselbloem, the Dutch Finance Minister.  They’re obviously trying to mediate this clash of titans, hoping to navigate the two most extreme outcomes:
  • Unconditional Greece win: extremist parties in Spain and elsewhere win elections, then campaign for similar packages.
  • Unconditional German win: Greece default, with above consequences; a demonstration that budgetary discipline will be hard-met (a problem for countries like Italy and France).
• The methods used for this fight, beyond the usual meetings of ministers, is striking.  Newspapers, blogs, everything.  The term ‘Sources say…’ has been used so much, it’s incredible.  The amount of disinformation is also incredible – as if both Germany and Greece have full-time PR wonks writing increasingly provocative statements against each other.  This morning’s move in the S&P is a good example when both sides get to the rumour-mill:

Timeline: Greece is screwed. Then Greece is saved! Then Germany says ‘nein’. Source: thinkorswim by TDAmeritrade

• Where does that leave us?  The markets are still hitting all-time highs, so clearly everyone expects a last-minute deal.  Given the EU’s history, that’s probably a safe bet.  In the meantime, folks like me sit chewing fingernails – my trading system really believes in a fortuitous outcome, so I’m left hoping and praying.

In sum: I figured Greece did some sweet game theory-inspired strategising, in hopes of getting an extension under more favourable terms.  Germany has been absolutely, 100% defiant.  Though the markets are betting on a swift resolution, my stomach is more uncertain.  In the end, the Syriza guys can at least give themselves credit for using all available tools to make the best of a bad hand.

More market confusion

Yeah, this sums it up. Source: Google images.

I’m confused.  Let’s review:

• US equity markets are at all-time highs.  Europe markets are there-or-thereabouts as well.
• Bond yields are at or near all-time lows in much of the Western world.
• Commodity prices have tanked, so gas prices are low.

Despite:

• Greece, despite some excellent game theory usage, looks ever more likely to drift into capital controls at the very least, and perhaps full ejection from the Euro.
• Ukraine’s ceasefire lasted…oh…a few hours.
• US equity markets now trade somewhere around 20-21x earnings.  Well above long-run average.

In sum: these moves kinda give me the heebies.  Glad to have a system trading for me.  With the long-run portfolio, I’m slowly but surely decreasing exposure to equities.

Finance 101: follow the interest rates, or carry is king

Interest rates are all the rage these days in the media: various countries are cutting base rates to below zero (an idea once thought impossible, called ‘the zero bound’).  The latest culprits are Scandinavian countries Sweden and Denmark – their economies are closely tied with the Euro-area, so the quantitative easing from the latter increases pressure on the Scandi countries’ exporters.  Enter negative base rates.  Longer-term interest rates have fallen as well, with multiple governments now able to borrow at near-zero for 10-year loans.

With all this in mind, let’s consider the big picture, and implications for individuals.

• Definition: an interest rate is the cost to the borrower for getting money now, rather than later.  Seen from the other side, the interest rate is the return to the lender for giving up money now, rather than later.  The interest rate is an example of carry, or the return to an investor for holding an asset (in this case, a loan/bond).
• Usage: we can use the interest rate to help judge one debt versus another.
  • Borrower’s perspective: suppose you have several loans outstanding, or need to borrow, and are considering different types of loans.  Some examples, with typical interest rates are below, in descending rate order:
    • Payday loans: around 400% interest per year.  No security needed, and very short term.
    • Credit cards: around 15% interest.  No security needed, and short term (balances can be rolled forward, as long as credit card company allows).
    • Peer to peer loans: around 10-15% interest.  No security needed, and medium term (3-5 years).
    • Student loans: around 5-10% interest for Federal loans; 7-15% for private loans.  No security needed, though sort of the ultimate security: you can’t get rid of these loans through bankruptcy.  5-15 year term.
    • Home equity loans: about 6% interest.  They’re 2nd mortgages on your house. 5-15 year term.
    • Auto loans: around 4% interest.  Car title held as security; medium term (3-5 years).
    • Home mortgage: around 3-4% interest.  House title held as security; long term (15-30 years).  In the US, mortgage interest is tax-deductible at your highest marginal rate, so the effective interest rate may be much lower.
    • In sum: if I had several types of debt outstanding, I would probably pay them off in the order above.  If I needed to borrow, I’d probably borrow from the bottom up.
  • Saver’s perspective: suppose you have some cash to put to work, and are choosing between the options.  Rates help us here, as the interest rate is the maximum return you will receive on your investment.  There is a clear risk – return trade-off, though.  Anyway, in ascending order of interest rate/risk:
    • Savings account: about 0-1% interest.  Instant access, and government-insured.
    • Certificate of deposit/fixed savings: 1-2% interest.  Government-insured.  1-5 year term.
    • Government bonds (Treasuries): 0-2.5% interest.  Government-issued.  30 day-30 year term.
    • Corporate bonds: 1-6% interest.  ‘Proper’ credit risk – you may not get back what you put in.  Typical 5-year term.
    • Peer to peer lending: 5-15% interest.  Lending to ordinary folks, with no collateral.  3-5 year term.
    • In sum: pick your poison.  If you need the funds at any time (e.g. an emergency fund), better to stick with the earlier entries on the list.  If you’re looking for more risk, head on down the list.  Keep in mind rates are at all-time lows in most places, so maybe keeping with short duration (i.e. sticking with shorter-term stuff) is a safer play.

There you go.  Other types of carry (e.g. dividends, rental yield) we can pick up later.

Financial literacy and UK pension changes

The money is mine!! Source: Google images

A quick one today, versus yesterday’s rant.

There was another Dispatches episode recently discussing April 2015 changes to UK pensions policy.  For those unaware, until now UK pensioners were forced to purchase annuities with their savings (aside from a 25% lump sum, which could be taken as cash). As of April, this is no longer required: folks can use their funds as they like.

On the face of it, there seems to be no issue here.  I mean, we’re all about freedom, particularly when it comes to hard-earned savings, right?  Well… my concern here is about timing: it’s like the government just said “we know you had saved in expectation of this happening, but instead it will be that…now go!”  There was little prep time for folks to learn how to manage their own pension savings.

I may be making a mountain out of a mole hill, but the stories in the Dispatches episode, in conjunction with surveys of financial literacy such as this one give me reason for pause.  There will inevitably be several folks (such as those interviewed in the show) who decide to blow a significant portion of their now-liquid savings on new cars and such; their financial future will need to be picked up by additional state pension benefits, paid for by younger generations.  I’ve written at length about my feelings of the latter.

So what’s the solution?  To be honest, I’m torn: my libertarian side says the government had no business forcing the purchase of annuities, so this is an unambiguously good thing; my paternalist (and perhaps more realist and cynical) side thinks this will almost certainly increase the need for state pension benefits, and associated taxation.  Hum.

In sum: if you know of someone benefitting from the rule changes, please encourage him/her to seek financial advice.  Thankfully the UK government has set up the Money Advice Service…I really hope it gets used.

UK housing: Let’s choke our own people

Where can I live on my median income? Source: londonrents.org.uk

I’ve written before about my confusion/frustration/anger at the UK housing market. This view was reinforced by a recent Dispatches episode (for US readers, think 60 Minutes).  Now I could get very investigative about the issue myself – given I feel strongly about this issue, I may well in the future – but for now some thoughts from various readings/viewings/stats:

1. There seems to be an obvious market failure going on in UK housing: lack of supply. The Dispatches episode quoted the need for about 240,000 new homes each year to meet basic housing formation, with only about 100,000 being built.  The figures are the same for London, in terms of housing built as proportion required.
2. Call this a lack of understanding, but even Enzo Ferrari knew that you only needed to produce 1 unit less than demand to ensure pricing power.  This gap seems completely self-defeating for property developers.  In economics 101 terms, surely the marginal revenue isn’t maximised at this level of production; producers could still improve their (surplus) profits by producing more units.
3. Why aren’t developers producing?  It’s probably a similar situation to cities like San Francisco/NYC, whereby geographic limits constrict supply.  In London’s case, however, these limits are self-imposed: green belts keep the property available within reasonable commute contained.  Planning permission is a big issue, as well –  London is a pretty low-rise city, and though that adds to the city’s charm, it lowers the city’s residential capacity.  Developers must play expensive games with planners to build more, which probably leads to more production of expensive, high-margin housing than higher-capacity housing.
4. The influence of foreign investors.  Look, not every foreigner buying property in London is money laundering.  There are loads of folks seeing London for what it is: a supply-constricted market with lots of professionals making decent cash.  What I wonder about is buy-to-let hurdle rates: with mortgage rates at all-time lows, I suppose folks can be happy with a rental yield of 4-5% net of management fees.  That would set a cap on property prices, unless of course rents increase at a faster pace.  But if the latter occurs, who’s going to rent?  Most of London is already unaffordable.
5. What about those on the ladder?  A frequent topic of London conversation is ‘getting on the property ladder’…maybe escalator would be appropriate here.  The idea is that one just needs to buy any property, get some gains, then flip into a bigger property.  Hmm… so one just keeps doubling down in the property sector.  For those trading up the ladder – be aware that both losses and gains are magnified.  In any case, I can see how this ladder situation puts politicians in a very tight spot: their constituents probably couldn’t handle a correction in property prices, as mortgages get called in.
6. How about property tax?  The UK has a sort-of property tax, like the US: it’s called council tax.  The main difference, to me, is that the latter caps out at a pretty low level; US property tax is generally a set % of assessed value, with no cap.  Here’s an idea for the UK, which would probably be an easy redistribution from rich -> poor: take away the council tax cap.
7. What about mortgage rates?  All time lows – check.  UK mortgages primarily variable rate – check.  Affordability based upon these low rates – check.  So look out when rates rise.  Again a politically difficult situation – why would the BoE ever raise rates, as so many people would probably find housing unaffordable.

In sum: UK housing is a classic asset bubble, in my opinion.  So much unproductive investment pouring into land values.  The fact the ‘housing ladder’ is ubiquitous should be a red flag that folks buy property because it always goes up…very dangerous.  And these inflated prices mean ordinary (middle class!) workers can no longer afford to live and work in London and elsewhere.  If the UK believes in equality of opportunity (and I think we do), why do we let this transfer of wealth from the lower-paid (stuck renting) to higher-paid (buy-to-let, with homeowners sharing positive externality) happen?  Seriously?

End soapbox.

Prophetic and reasoned: hedge funds and financial complexity

OK, one more post on the book I mentioned last time.  The conclusion of this 2007 book has one of the best paragraphs I’ve read on the financial system – with the benefit of 20/20 hindsight, of course (emphasis mine):

Market crises are not born from nature. They are not transmitted by economic or natural catastrophe. The machinery of the market itself can take a small event and distort it. The more closely we try to follow the ideal, thereby adding complexity and more tightly coupling the actions of the market, the more frequently crises will occur. Attempts at that point to add safety features, to layer on regulations and safeguards, will only add to the complexity of the system and make the accidents more frequent. And when blowups happen in the future I can guarantee that the focus will be directed improperly: not at the issues of market design but at hedge funds where the events are observed. They will be implicated for the simple reason that they are engulfing more and more of the risk-taking landscape. The perception of hedge funds being what it is, they will take the blame and become subject to increased regulation. But blaming hedge funds is a little bit like The Simpsons episode in which a meteorite hits Springfield and the townspeople gather, shouting, “Let’s burn down the observatory so this never happens again!” True, the hedge funds are the institutions that have the appetite for the risk; but there is nothing inherent in hedge funds, nothing that they represent as a unified set, that makes them the singular cause of anything.

Thoughts:

• A lot of financial alchemy transforms one type of risk (e.g. liquidity risk) into another type of risk (e.g. correlation risk).  An example from 2007 was the proliferation of RMBS CDOs and their synthetic cousins: they took a simple, illiquid asset (a mortgage) and created a liquid asset with a sting in its tail (the CDO).  The latter risk wasn’t obvious until the horribleness of 2008 occurred.
• The fallout from the credit crunch/financial crisis did indeed focus on hedge funds, both the investor-funded versions and the bank-funded prop desks.  But this was misguided, in my opinion: the gains made by Paulson and others were massive, but were only a symptom of underlying issues with the US housing market.  Remember: once these liquid RMBS CDOs were widespread, and default correlation assumed constant, we believed there was no longer need for mortgage underwriting scrutiny.
• Regulators have had a field day with adding considerably more safety checks/switches since the crisis; the uncertainties around Dodd-Frank and several other pieces of legislation (e.g. how will they ever implement and police so many new rules?) may lead us back to crisis.  For example, we now have banks which have cut lending to shore up capital positions; ‘shadow banking’ to fill the gap in credit; hedge funds specifically designed to arbitrage the capital treatments of different sources of bank capital; etc.  How will it end?

In sum: in many situations, more rules may not equal better risk management.  Probably good to know for trading, as well as life in general.