The Long and the Short of things

As the market currently on what seems like a day by day basis hits record highs, one has to wonder how long this record breaking bull run can last.

This chart plots the Australian All Ordinaries Index for the last 12 months (to 23 Feb 07). Apart from a couple of small blips, it's been all up hill since late September!

Now, if you're one of the increasing numbers who believes that there is only so long a run like this can go for and we're due for a correction, you might stick all of your money in cash until this correction happens.

However, investing in cash only provides you with limited returns. What would be great is benefiting from a correction when it happens. Or what if you think the market as a whole will keep going up, but think that Telstra shares are overpriced and are due to fall and want to benefit from this fall?

Well the answer is you can. You do this by "going short". There are numerous ways to go short, or sell a stock (or index) that you think will fall. You can purchase Call Options or Warrants, or sell Contracts for Difference (CFD's) or even short sell on the ASX. However, these strategies are risky, and not for the novice investor.

There are other ways to benefit from this strategy though. This involves investing in fund managers who can "go short". These are usually referred to as "Long / Short Funds". In a previous post I have written about how the after tax returns of actively managed funds often do not justify the extra risk and fees involved. However, a fund with the option to take on strategies like this can definitely provide value IF they get it right!

These types of funds are relatively new to the market. I have tried to find some returns on some tried and tested long/short funds, however they all seem to have existed for less than 12 months. Time will tell if these fund managers can predict when to go long and when to go short.

Some funds offering a long/short option are:

Acadian Australian Equity Long / Short
PM Capital Australian Share Fund
JANA Australian Share Long Short Trust
Macquarie Alpha Opportunities Fund
Perpetual Share Plus Fund

Time will tell what the success of these funds is.

It's all about time in the market AND timing the market

If you've seen a Financial Planner you are likely to have heard this one: "It's about time in the market, not timing the market". Basically this means don't worry about what the market is priced at, if its over or underpriced. This doesn't matter. Just get your money in the market for the long term and over time you will be better off than those who trade in and out trying to pick "peaks" and "troughs" in the market.

This definitely makes sense, as who can tell when the right time to invest is?

However, I have recently, as part of a Post Graduate Diploma, studied Technical Analysis. When I told my colleagues I was taking on this subject, they laughed at me. Technical Analysis goes against all the fundamentals that as a Financial Planner and Economist I should believe in. At university they talk about it like it's a black art of some sort . However, I've always been interested in charting and wanted to better understand how to analyse charts, so took on this course.

For the uninitiated, Technical Analysis involves examining price action to determine changes in the supply and demand balance. In other words, using charts to determine whether to buy or sell securities. A common misunderstanding is Technical Analysis uses past prices to predict future prices. There's definitely more to Technical Analysis than this, with Behavioural Finance a major factor in Technical Analysis.

My growing understanding of Technical Analysis, has led me to believe that Technical Analysis can be used to "Time the Market". It's definitely not foolproof, but if you pick the right triggers, you can use Technical Analysis as well as Fundamentals to invest. For example, lets say I like the fundamentals of BHP and want to buy them for the long term. I can undertake some Technical Analysis and decide that I think in the next month it will fall by 10%. Then wait around and get in at a discount to what I would get in otherwise. Obviously I could be wrong and it never reaches the low that I predict, but that's the risk you take.

I remember a client last year decided to invest $500,000 in Australian Share managed funds through his margin loan. This was in early May, 2006. If you think back a while you might remember a correction of around 10% soon after this. So within a matter of weeks, this guy's portfolio was now worth around $450,000. Now, assuming a return of 10% per annum, over 10 years, the portfolio invested prior to the correction would be worth $1,167,184, a gain of $667,184 over the period. If he had of waited a month or so, the portfolio would be worth $1,296,871, an increase of $796,871 over the period. This is a net gain of $129,687 more than the other strategy.

An extra 20% return just to pick the right time to enter the market? I'll take that thankyou!

Get rich quick - be a tight@r$e

To have $100,000 sitting in the bank, to do with what I please. That would be lovely. Unfortunately for me, I'm only a few years out of university, and whilst my savings (I like to call them investments, as I have very little in cash) are looking ok (a lot better than some my age who have fallen for the credit card and personal debt trap!), I am blessed with the ability to enjoy spending my money too much!

I found out recently that a guy who I went to uni with has just put a deposit on a unit in Sydney, using the $100,000 he saved while he was at uni.

That made me ask the question, how does someone save $100,000 while they are at uni? I remember uni days were living week to week on the few bucks I was earning working 15-20 hours in retail.

Then I remembered, while I was out partying at the local seedy uni pubs, skipping lectures for a few more beers at the on campus bar and spending my few dollars of savings on clothes and gadgets like iPods (actually in those days Minidiscs were the thing of the future... mp3 players were never going to take off), this guy was pulling a few extra shifts at work, studying hard and getting around in the same daggy clothes and a discman from 1996.

Is he happier than me, now that he has a relatively small deposit on an inner city overpriced shoebox? Who knows. I'd like to hope that smart investing over the coming years might put me in front in the long run, without having to hamper my lifestyle. Until then, I'm happy with my Minidisc player!

Seller's Remorse

Buyer's remorse, as defined by Wikipedia, is an emotional condition whereby a person feels remorse or regret after the purchase of an item. Something I quite often get after forking out for that new gadget and realising soon after that I didn't really need it.

Seller's remorse on the other hand, usually occurs when someone sells their home. The place where they have lived for a large part of their life is no longer theirs. Have they done the right thing? Who knows!

Today I had seller's remorse of another kind. In August last year I took a punt on a Uranium explorer. I didn't put a lot of money in, enough that if it went well I would be happy, but enough that if it things went belly up, I wouldn't be slitting my wrists. Well, in about 6 months, I have more than quadrupled my original investment. I didn't in my wildest dreams expect this.

I feel the Australian market as a whole has become quite overheated in recent times. The S&P ASX 200 has just cracked through 6000 points, with the All Ordinaries closely behind it. It was only late September that the market was under 5000 points. This sort of growth can't be sustainable. During this time these Uranium explorers, who are still earning no money, and are unlikely to start mining for at least another 5 years have been running hot. All purely based on speculation that Uranium is actually the Commodity of the future. Is Uranium the commodity of the future? Who knows... I'm sure the people of Chernoble would think not.

So, today, as the All S&P 200 broke through 6000 points and people starting asking the question of will we see 7000 points by year end, I did what I wasn't expecting to do so soon, I hit the sell button on my Uranium shares. I wanted to hold for 12 months to get my 50% capital gains deduction, but it looks like I'll be providing Peter Costello with a few more bucks for the next Federal Budget. As some say, "It ain't so bad having to pay tax".

Immediately after I sold it hit me. This share that I had enjoyed a wild ride on for 6 months was no longer in my possession. Those days of watching the difference in open and closing prices of over 10% are gone. What had I done??? This stock might still have a long way to run! Not only that, but I've got to hand over part of my winnings to the Government! There's no reversing a decision like this.

However, now I sit back, with the cold hard cash in my hands (well, in my bank account in 3 days anyway) and feel relieved that common sense had overcome greed. Like many of those burnt in the dot-com boom & bust that soon followed, at least I know I didn't hold too long.

Time will tell if this was the right decision. I know for sure that I will be doing something more sensible with this money, like investing in an established stock or managed fund. I will report on the progress and if I actually have made the right decision!

Property Is the Best Share Investment

The age old argument, property or shares. "You can't lose money from bricks and mortar" or "You can't sell a room of your property". Most retail investors fit into one of the two categories. I'm not going to take sides here, but I have done well out of shares (and managed funds) and have never invested in property.

Anyway, this topic isn't trying to weigh in to the debate. I want to discuss the huge advantage that property investment has over share investment. It's all to do with the ways you can borrow to invest, with the major advantage being tied to the banks' lending criteria.

Why Borrow to Invest?

Borrowing to invest involves using money that's not yours (ie, the bank's), to invest in property, shares or other investments. In Australia, interest payments are generally tax deductible and capital gains, if the asset is held for more than 12 months have a 50% discount applied to them. Therefore, by borrowing to invest, you can gain access to capital gains on money that's not really your's, whilst getting a tax deduction for your interest payments. Sounds pretty good hey? Of course, the disadvantage is that by investing with money that's not yours, if the value of the investment falls your potential losses are much higher!

Types of loans?

I'll start with property. This is a simple one. I'm going to focus on residential property, as this is what the typical 'mum and dad' will be investing in. If you want to purchase a property you go to the bank and take out a mortgage. Now there are numerous types of mortages, ones with offsets or lines of credits attached, but at the end of the day a mortgage is a mortgage. You put down a deposit. In the old days the banks required a 20% deposit for a mortgage, but competition has reduced that. From some dodgy brothers loan providers you can borrow 100% of the value of the property. Once you get below deposits of 20%, you're usually up for mortgage lenders insurance though, which protects the lender if you default on your loan.

Shares aren't as straight forward as property. There are many ways to borrow to invest in shares. These involve margin loans, protected portfolio loans, internally geared managed funds and using home equity to borrow to invest. The most common form of borrowing is the margin loan and is what I will focus on here. A margin loan shares some similarities as a home mortgage, in that you put down cash or shares as security or a 'deposit', you can then borrow to purchase shares. Generally with a margin loan, you must put down 30% deposit and can then borrow the remaining 70%. For example, lets say you have $30,000 in cash. You can use these funds to invest in BHP shares and then borrow another $70,000 and invest this. Making your entire exposure $100,000. The other point of interest with a margin loan is that if the value of your portfolio falls by a certain amount, you get hit with a margin call. A margin call requires additional funds to be deposited or shares to be sold to bring the portfolio back up the the allowed lending ratio.

Why property?

I can hear you all screaming at me now. Why buy property when it means dealing with dodgy tentants and dodgier real estate agents. Where's the liquidity? Shares provide better long term capital growth. I know, I know. It's not me who's spruiking property, its the lenders.

You see, the potential gains on something where you only have to put 10% deposit down are much greater than that where you have to put 30% deposit down.

An example will explain it better.

Lets say you've been in your professional career a few years and have $30,000 saved, currently sitting in cash. You want to invest this for the long term and seek some solid capital growth. You can deal with short term fluctuations and are not going to lose sleep at night if the value of your investment drops. Right, we've now established you're a suitable candidate for gearing (borrowing to invest).

You see the lender at your local bank. They tell you that with your $30,000, you can borrow $270,000 to invest in an investment property. Therefore having total capital of $300,000. This means you basically put down 10% and the bank lends you the other 90%.

You then see your friendly financial adviser. They tell you that with your $30,000, you can borrow only $70,000 and invest the total in shares. Therefore, you put down 30% and borrow the other 70%.

Lets say your investment property and shares average a return of 8% per annum over a 10 year period and all income is reinvested (you can't reinvest rent income I know, but we're talking hypotheticals). We will also ignore tax and interest. At the end of 10 years, your property has generated you wealth of $647,678 - $270,000 = $377,678 or a return on your original capital of 1259%! You're geared share investment has generated wealth of $215,893 - $70,000 = $145,893, a return on original capital of 486%, nowhere near that of your property.

It can be seen that the lending 'rules' on property investment make it a very attractive investment! A cheaper interest rate than a margin loan makes it look even better.

"Thats it, I'm getting rid of my shares and buying as much property as possible!"

Hang on a minute, lets be realistic here! Share investment has a lot of advantages over property investment. Firstly, my numbers are distorted, as by borrowing more, you are liable to pay more interest on your loan. I have ignored this for my example as tax deductibility of interest payments makes it a difficult calculation to make. Secondly (and this is a big one), in reality how are you going to reinvest your rental income from your investment property? Whereas its extremely simple to reinvest your dividends on your shares. Most top 200 companies have dividend reinvestment options and all managed funds certainly do. This helps to increase the compounding effect of share investment and ensures you don't just spend the money when you get it.

Shares provide a liquidity that doesn't exist in property, are easier to diversify in and require less active decision making than property. I know which one I'd rather invest in!!

Time for the lenders to get real

The major lenders still have this old time mentality that shares are risky investments and property is a risk free investment. They lend at higher ratios and charge lower interest rates than margin loans provide. My argument (and hopefully yours by now) is that shares are the less risky investment! You can easily diversify, there's liquidity and you're leaving the major decisions up to professional CEO's.

My challenge is for a lender out there to provide a facility, like a property mortgage, that allows well diversified portfolios to be geared into at high ratios, without the need for margin call for short term volatility, at an interest rate that is represented by the low long term risk of a well diversified share portfolio.

Until this day, the property investor will always have at least one argument against the share investor.