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Business Times - 27 Nov 2010

WEALTH INSIGHTS
Manage your leverage


Excessive leverage may wipe you out early even if your original assessment of the market eventually comes true

Philip Loh
Manager of
financial services,
Great Eastern Life

I consider myself more of a speculator than a trader.

A speculator is defined as a market participant who attempts to gain from anticipated changes in the prices of financial instruments, so he works at deriving quick profits from short-term asset acquisition.

For many, speculation and trading may well mean the same thing. There is indeed only a thin line separating the two. Both may at times employ some level of leverage to magnify the gain on their positions. The difference lies mainly on the expected time frame of holding a position.

A trader, as the name suggests, may trade more frequently, while a speculator may hold on to his position for a longer period.

It is conceivable that the expected holding period of an investment may influence the level of leverage deployed, as the fluctuation of an asset class is definitely less in a day compared to, say, a month. We seldom find a market index gaining or losing more than 2 per cent a day, while it may be common for the said index to rise or fall more than 5 per cent in a single month.

Trading is not in my blood, simply because most of my investment decisions are based on logic. The classic trader mantra, on the other hand, is 'sell first, ask later'.

This means that if your investment breaks a price barrier which you had set based on certain systematic technical indicators, you react first by squaring your position or adding on to your position before asking any questions. The reason for the move is not so important to a trader as long as the trend is supported by solid volume.

Trading is also a full-time job, whereas you can dabble in speculation on an 'as-and-when' basis.

Your personal financial circumstances would also affect your effectiveness as a speculator. For me, I believe that my relatively stable and well-paying job, as well as a considerable pile of cash reserves, has allowed me to perform better when speculating. This is because I can sleep well at night, knowing that I can afford to lose all of my speculative capital without affecting my family's lifestyle.

If you plan to become a speculator, you must first be willing to risk wiping out all of your speculative capital. Therefore, the decisions you make when it seems likely that the trends that you are betting against will continue unabated and threaten to wipe out your entire capital, will usually determine your success as a speculator.

To enable you to make the 'right' decision during these moments of extreme anguish, when, for example, 30 per cent of your speculative capital has been wiped out so far, managing your pre-determined leverage level at the outset of your taking on a position is of utmost importance. After all, leverage is a double-edged sword.

Now, I have strong opinions regarding various investment themes. However, deciding on the leverage level to engage any of the themes is usually the first and most important decision that I need to make, before I start doing anything.

Why is it so important to manage your leverage? Because excessive leverage may wipe you out early even if your original assessment of the market eventually comes true. In short, the often extreme volatility of the markets is why I am strongly against excessive leveraging.

Shorting an index

For example, let us assume that immediately after the Lehman Brothers collapse, the Straits Times Index (STI) has plunged to 1,800 points, and you decide to catch the rebound by engaging a five times leverage to go long on SIMSCI futures (which track the STI quite closely).

You would have been wiped out a couple of months down the road when the STI dropped to around 1,400 points. However, if you had decided to employ just three times leverage, you would have made a whopping 160 per cent return one year later when the STI rebounded to around 2,800 points.

When the market assessment and outlook are the same, whether you end up being totally wiped out or making a killing essentially depends on the initial leverage decision you make. This is the point I want to make about being overexposed to an asset class or a market sector with high leverage. The narrower the sector that you are betting on, the more dangerous leverage will be.

It may be all right for you to use a three times leverage on the STI. However, using it on a specific stock would be a very different story.

At times, I may consider shorting an index such as the S&P or Nasdaq or STI with a two or three times leverage. However, shorting individual stocks is a 'no no' for me as the risk is simply too high, even without any leverage. The reason is that it is much easier for predatory players to manipulate a particular stock price, rather than the entire market.

And the size of the market matters as well. It is definitely easier to move the STI in a particular direction rather than the S&P, for example, which is over 20 times bigger.

For the average speculator like myself, I usually prefer some diversification with low leverage. This is because I have seen time and again investors (including myself) being right about the future performance of an asset class, but failing to convert this view into any capital gain because of poor leverage management.

Leverage is indeed a dangerous beast. It cannot make a bad investment good, but it can definitely turn a good investment bad. Worse, it will limit your staying power, and transform a temporary whipsaw into a permanent capital impairment. So when you wish to speculate, always make sure you do so with the appropriate level of leverage.

The writer is a chartered financial consultant. The views expressed are his own. Comments are welcome at www.philiploh.com/contact
Hm... personally I'm not comfortable with any kind of leverage. Earn $1, play with $1... Maybe I'm just more traditional.
All of us have to use some leverage because it is not possible to save enough to buy our home in cash - unless we are big earner.

Like a company growing its business, I believe appropriate use of debt can help a person grow his net worth. The question is what is a good debt-equity ratio, ROE, etc.

I tried to work out my household balance sheet and found that my debt to equity ratio is about 27%.
As a singaporean, 1 loan we should leverage to the maximum, it's HDB's loan, 2.6%. hehe! Big Grin

Other than that, have to be quite sure you can pay the loan back successfully!
(14-12-2010, 05:38 PM)brattzz Wrote: [ -> ]As a singaporean, 1 loan we should leverage to the maximum, it's HDB's loan, 2.6%. hehe! Big Grin

Other than that, have to be quite sure you can pay the loan back successfully!

Yes, agreed. But we should still leave a reasonable sum in our OA to fund our retirement. Problem with using OA to pay for over-priced HDB flats is that by the time you plan to retire, there's hardly anything left to retire on!
Musicwhiz Wrote:But we should still leave a reasonable sum in our OA to fund our retirement. Problem with using OA to pay for over-priced HDB flats is that by the time you plan to retire, there's hardly anything left to retire on!

Run the numbers and it will be clear that even if you do not buy ANY property, there will probably not be enough in your CPF for retirement. The reason is simple: CPF contributions are capped based on a salary of $4,500. At today's contribution rates of 35% (declining as you age) the maximum contribution is $1,575 per month.

Let's assume you are a star worker. You start work at age 25, earning $4,500 per month, and you get the maximum CPF-eligible bonus of 5 months' pay every single year until you retire at age 65. Using the current CPF allocation rates, you will accumulate:

Age 25-35: $4,500 (pay) * 35% (into CPF) * 0.6572 (into OA) * 17mths * 10 yrs = $175,965
Age 35-45: $4,500 (pay) * 35% (into CPF) * 0.6001 (into OA) * 17mths * 10 yrs = $160,677
Age 45-50: $4,500 (pay) * 35% (into CPF) * 0.5429 (into OA) * 17mths * 5 yrs = $72,681
Age 50-55: $4,500 (pay) * 29% (into CPF) * 0.4484 (into OA) * 17mths * 5 yrs = $49,739
Age 55-60: $4,500 (pay) * 20.5% (into CPF) * 0.5610 (into OA) * 17mths * 5 yrs = $43,989
Age 60-65: $4,500 (pay) * 13% (into CPF) * 0.2693 (into OA) * 17mths * 5 yrs = $13,391

Add this all up, and we get $516,442 at age 65. Assuming the CPF interest matches inflation, you have $516,442 of real spending power. Life expectancy is probably about 80, so on average you get 15 years to spend $516k or $34k per year.

Some Conclusions:

Standard of Living You were a star worker your entire 40-year career (5 months bonus every single year). Yet, your CPF money only provides ~$3,000 per month of spending power. This despite earning at least $4,500 every single month. To earn 5 months of bonus every single year, your actual pay would probably have been much higher, perhaps $10,000 or $20,000 per month. Obviously, if your retirement is funded solely by your CPF money, you are going to suffer a significant decline in your standard of living when your monthly spending power drops from $20,000 to $3,000.

Duration of Retirement 15 years is quite a short retirement. If your health is good you can easily live to 85, which means you have to spread the money over 20 years. Alternatively you might retire at 60 and die at 80, which gives the same 20 years. If you retire at 55 then you need 25 years of spending power. If you were a high-flying wage earner (which you have to be to get 5 months' bonus every year) then you probably decided to call it a day at age 50. That leaves you 30 years to spend $409k (no contributions after age 50), which works out to $13k per year, not a pleasant prospect. The earlier you retire, the less money you have, and the longer the period you have to spread the money over.

Money No Enough Without buying a property the money is already insufficient. So obviously the moment you buy even a small HDB flat, you have guaranteed that whatever is left in the OA cannot support any standard of living above starvation. And these are already using optimistic estimates for the worker ($4,500 starting pay, 5 months' bonus every year). The average worker is likely to have a far worse result, since his early years, when contribution rates are highest, are normally also his lowest-earning years. Plus, most workers don't get 5 months' bonus every year!

The inconvenient truth (to borrow from Al Gore) is that CPF money alone cannot support your retirement unless you are a high-income wage earner AND are willing to suffer a huge drop in standard of living upon retirement. I do not think there are many people who meet both these conditions. So the average person has to wake up and learn to:

a. work hard to raise wages;
b. save even harder to raise cash;
c. invest cash wisely to grow capital; and
d. reduce retirement expectations

As usual, YMMV.
Assume both Investors A and B have monthly $2015 of CPF contribution,
Investor A - 30 years, 300k loan at 2.6% interest rate. Monthly payment = $1201
Investor B - 15 years, 300k loan at 2.6% interest rate. Monthly payment = $2015
For Investor A,
Assuming the investor invests the difference of $2015-$1201 = $814 with 5% return for 30 years,
The capital with investment gain at the end of 30 years is $54081.
For investor B,
Assuming the investor invests $2015 at 5% return from 15th to 30th year,
The capital with investment gain at the end of 15 years is $43480.
So, at the end of 30 years,
Both Investors A and B had repaid the loan but Investor A is ahead by $10600.
Hi d.o.g.

I think there is probably another few hundred thousands for such a person in the CPF SA that will be available for his retirement. That should help to close the gap somewhat. However, there is still no way he can rely solely on CPF to maintain his life style after retirement.
(14-12-2010, 09:54 PM)yeokiwi Wrote: [ -> ]Assume both Investors A and B have monthly $2015 of CPF contribution,
Investor A - 30 years, 300k loan at 2.6% interest rate. Monthly payment = $1201
Investor B - 15 years, 300k loan at 2.6% interest rate. Monthly payment = $2015
For Investor A,
Assuming the investor invests the difference of $2015-$1201 = $814 with 5% return for 30 years,
The capital with investment gain at the end of 30 years is $54081.
For investor B,
Assuming the investor invests $2015 at 5% return from 15th to 30th year,
The capital with investment gain at the end of 15 years is $43480.
So, at the end of 30 years,
Both Investors A and B had repaid the loan but Investor A is ahead by $10600.

You got to multiply that (814 and 2015) by 12 to get the annual investment dollars. If we do that, then the difference between a 15-year and a 30-year loan is $127k advantage for the latter if the rate of return is 5%.

If one is totally hopeless and gets only 2.5% CPF return rate, his disadvantage is only $4k. With 3.5% for the first $20K, the disadvantage is less than $1k. These are really small amounts compared to the "liquidity" you get (oh yah, liquidity in CPF, oxymoron). The bottom line remains, do NOT rush to pay off the HDB loan. It makes no financial sense under the current interest rates.

I am ignoring the effect of inflation. If accounted, it should favor the longer loan period. I am also ignoring the way CPF accrue interest.
(14-12-2010, 10:31 PM)cif5000 Wrote: [ -> ]
(14-12-2010, 09:54 PM)yeokiwi Wrote: [ -> ]Assume both Investors A and B have monthly $2015 of CPF contribution,
Investor A - 30 years, 300k loan at 2.6% interest rate. Monthly payment = $1201
Investor B - 15 years, 300k loan at 2.6% interest rate. Monthly payment = $2015
For Investor A,
Assuming the investor invests the difference of $2015-$1201 = $814 with 5% return for 30 years,
The capital with investment gain at the end of 30 years is $54081.
For investor B,
Assuming the investor invests $2015 at 5% return from 15th to 30th year,
The capital with investment gain at the end of 15 years is $43480.
So, at the end of 30 years,
Both Investors A and B had repaid the loan but Investor A is ahead by $10600.

You got to multiply that (814 and 2015) by 12 to get the annual investment dollars. If we do that, then the difference between a 15-year and a 30-year loan is $127k advantage for the latter if the rate of return is 5%.

If one is totally hopeless and gets only 2.5% CPF return rate, his disadvantage is only $4k. With 3.5% for the first $20K, the disadvantage is less than $1k. These are really small amounts compared to the "liquidity" you get (oh yah, liquidity in CPF, oxymoron). The bottom line remains, do NOT rush to pay off the HDB loan. It makes no financial sense under the current interest rates.

I am ignoring the effect of inflation. If accounted, it should favor the longer loan period. I am also ignoring the way CPF accrue interest.

haha... thank you thank you...
I like the oxymoron part.. Tongue

Basically, I treat my CPF as my Whole Life Policy. I paid a lot of premium and I had to double up as the investment manager and if I bite the dust, my family will get the payout.


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