Tuesday, June 8, 2010

First, no credit card debt and second, pay off non-deductible debt!

Generally the best returns are to pay off all non-deductible debt. First, credit cards, second, personal loans and third, home mortgage.

Better still, avoid credit card debt like the plague!!

Also, always save a hefty deposit on anything you might otherwise finance on a personal loan and buy what you need, not what you might like to have - saving $5000 before buying and buying a $5,000 cheaper car so you borrow $10,000 less can give you a substantial interest saving, particularly if you borrow over a shorter period (making higher repayments) as well.

Assume you have a debt of $1000.

To pay $200 of 20% non-deductible interest on a credit card debt of $1000 out of after tax earnings if you are on a 40% marginal tax rate you have to earn 333.33 (Amount to be paid divided by (100 – marginal tax rate) multiplied by 100: 200/(100-40)*100 = 333.33

To pay $150 of 15% non-deductible interest on a personal loan of $1000 (eg for a car) out of after tax earnings if you are on a 40% marginal tax rate you have to earn 250.00 (Amount to be paid divided by (100 – marginal tax rate) multiplied by 100: 150/(100-40)*100 = 250.00

To pay $100 of 10% non-deductible interest on a mortgage debt of $1000 out of after tax earnings if you are on a 40% marginal tax rate you have to earn 166.67 (Amount to be paid divided by (100 – marginal tax rate) multiplied by 100: 100/(100-40)*100 = 166.67

To pay $100 of 10% tax deductible interest on a mortgage debt of $1000 out of after tax earnings if you are on a 40% marginal tax rate you only have to earn $100.00 because you get a tax deduction and so don’t have to earn extra to pay the tax on the extra earnings.

In summary, the amount you have to earn to pay one year's interest on a $1,000 loan using the examples above is :
1. Credit card 20%: 333
2. Personal loan 15%: 250
3 Home loan 10%: 167
4. Investment loan 10%: 100

Another way of looking at this is to gross up the interest rate to a pre-tax rate:
1. credit card rate is 33.3%
2. personal loan rate is 25%
3. home loan rate is 16.7%
4. investment loan rate is 10%

So generally the greatest after tax return comes from paying off non-deductible debt, and it is worth ensuring that you have sufficient spare cash, even in very low interest paying accounts, that you never have to pay interest on your credit card.

This analysis can be complicated by taking capital gains into account on investments and depending on anticipated capital gain it might be worth using your surplus to invest in stocks rather than pay off your non-deductible home loan if the market has just fallen 50% and it has turned up and just broken through the 100 day SMA.

It may even be worth borrowing more against any “surplus” equity you have in your home to make such an investment, even though you are not paying down non-deductible debt as fast as you could.

But to keep it simple for now, first pay off all non-deductible debt, starting with your credit card, then personal loans, then home loans, and when you only have your home loan left, use an offset account so your savings are all offsetting your home loan until you need them to pay bills.

If you need to borrow using a personal loan eg for a car, make sure that your lender will allow you to pay it off faster without any additional costs. This may mean that you need to ensure that the loan is a floating rate loan. This way you can take a longer loan period to give yourself a margin of safety, but pay it off fast.

The golden rules are:

Credit Cards
No credit card debt
a) never spend on a credit card anything you can't pay off in the interest free period
b) never take a cash advance from a credit card,
c) in fact run your with a small credit balance

Debt and Investing
Pay off all non-deductible debt first

Sunday, June 6, 2010

When do I buy back in?

At the moment I am only about 30% invested in the stock market.

The question that is exercising my mind is "how will I know when to buy back in?

I am looking at using a cross of the 30 day Simple Moving Average (SMA) by the 10 day SMA from below (subject to the price being higher than the cross). The market has recently fallen up to 14% and is currently still down 10%. Unless we have a dramatic fall on Monday in response to the 3.4% fall on Wall Street S&P500 last Friday, the cross could happen this coming week.

There are risks to this approach. The risk is that the signals reverse several times without the market moving much between the crosses. That is called being whipsawn. It can cause losses and each transaction also has costs. The market is described as "trending sideways""or "in transition".

However, you need something to help you judge when to buy back in, or increase your weighting of stocks. Some would say the 200 SMA is more reliable, but you have much bigger losses in a major downturn or lost opportunities in a major upturn using such a long average.

So why would I use the 10 and 30 cross? Because it can be quite a profitable indicator. (If the market was down 25% I would likely use a much longer SMA than 30, maybe 100 - I feel that the deeper the fall, the longer the SMA for a buy signal should be to avoid whipsawing, but I have no backtesting to support this feel):

It gave a 10% rise from October 2001 to February 2002 with no whipsaws, and a 17% rise from March 2003 to March 2004 with 5 whipsaws. Using a 50 day SMA instead of a 30 day SMA would have given a 16% rise with no whipsaws and would have been a better choice on this example as the rise was gradual with 5 pullbacks. A sudden rise with no pullbacks would have been well suited to a shorter SMA like 30 Trading Days.

The chart above also shows how you can get whipsawn as the market goes through a 20% decline. If you used a 120 SMA instead of 30 you would have been whipsawn once on the way down and not at all on the way up. you would have been down 3% before your first sell signal, have lost 2% in the whipsaw and then picked up 14% for a net 9% gain compared to a zero gain over the same period if you had just continued to hold your stocks all through the period.

Here is a chart with two significant rises where there was no whipsawing using the 10 and 30 SMA cross. Note that we are down a similar amount now as was the case from both of the bottoms shown in this chart.

But what of the risks of multiple whipsaws with losses and transaction costs? Right click and open the next chart in a new window.

From Jan 91 to July 92 you would have had 7 roundtrip transactions for a total market movement of only +22%. a number of the round trips would have been loss making, reducing the 22% gain to one where on a net basis you captured only between 1/2 and 3/4 of the 22%. A 200 day SMA instead of a 30 would have given less whip sawing, but a higher first buy price, so there may not have been much benefit in using a longer SMA.

So not buying would have led to missing a profit of between 10 and 15 % in 18 months compared to being whipsawn by the 10 and 30 sma while a perfect buy at the bottom would have given 22% return - but how would you pcik the absolute bottom?

No one rings a bell at the top or bottom of the market! You have to have some basis on which to buy and sell, or adjust your portfolio weightings.

Choose the lengths of the SMA's you will use based on your own costs of transaction, loss aversion, ability to replenish funds and consider other factors as well, including fundamentals.

Before embarking on any strategy involving moving averages you should have a look at some recent work by Doug Short::



Thursday, June 3, 2010

Currency and Diversification Impacts on Investment Returns to Australian Investors

I have used the MSCI Barra performance indices (http://www.mscibarra.com/products/indices/international_equity_indices/gimi/stdindex/performance.html) for some of this article as it allows comparisons between performance measured in EUR, USD and local currency. Some charts are from the free version of Incredible Charts (http://incrediblecharts.com).

The Australian Market in AUD and USD

We know what happened with the Australian All Ordinaries from 2007 to 1 June 2010.

At the bottom of the Australian Stock Market in March 2009 the MSCI Barra index was off 53% in AUD terms from 30 October 2007.

In USD terms it was off about 77%!

The recovery in the MSCI Barra index for Australia from the 9 March 2009 bottom to 12 April 2010 was 58%!

In USD terms it was up 132%

These differences are because the AUD/USD Exchange rate was also changing over the same period. Chart courtesy of Incredible Charts free charting software.

So now we can look at the Australian Stock Market in each of AUD and USD using MSCI Barra.

The numbers above illustrate the difference that movements in the currency can have on investment returns.

Currency and Switching Asset Classes

I am now going to use the perfect example to make a point, but nobody could possibly have achieved the result so don’t think that the actual return is even remotely possible. (I will ignore dividends and interest – at 4% pa they have little effect over the time period we are considering and partially offset one another, even after tax and compounding effect.)

An Australian investor who switched from the All Ords to USD cash deposit on 30 October and then switched back to the All Ords on 9 March 2009 and then switched back to USD cash on 14 April would have :

At end October 2007 for AUD100 he would have got USD 93
At 9 March 2009 for USD93 he would have got AUD 1.56 for each USD or AUD145
As at April 14 2010 that AUD145 in the Australian Stock market since 9 March 2009 would be worth AUD229
On 14 April that AUD 229 would buy USD212 at 0.93
Today the USD212 is worth AUD256

An investor with AUD 100 in the All Ords on 30 October 2007 who has just held his investment now has AUD65

The perfect switching strategy to USD cash and back twice would give you 3.9 times as much AUD now as a mere buy and hold strategy! (But remember I said this was totally theoretical and unachievable in practice.)

There could have been additional profit if our hypothetical switching investor had moved to US 10 year bonds instead of cash. As the interest rates on US 10 year Treasury notes went lower during 2008/09 (see chart of $TNX below from StockCharts.com) the price of 10 year bonds bought in October 2007 would have increased. As rates increased in 2009/10 the price would have fallen back but as rates are still lower the price would still be higher than October 2007.

Of course it works the other way too. A US investor who held his Australian All Ords at US93 (AUD100 equivalent) on 30 October 2007, sold at the bottom on 9 March 2009 and took his funds back into USD and switched to cash would have only USD21 (AUD23 ) on 14 April 2009, compared to the Australian investor who did nothing with AUD65 – about 3 times as much as the US investor.

So the point is, if the AUD is has had large price increases compared to most currencies, maybe switching, or increasing your exposure, to those other currencies for part of your investment might make sense (and vice versa).

Similarly, if the stock market (or any other asset class) has grown very quickly for a long time, switching to, or increasing your exposure to, non-correlated assets that are at lower prices might save a significant fall in investment value if the one which has risen starts to fall.

Diversification to Non-Correlated Assets

Now imagine if our Australian Investor had 50% in USD cash and 50% in AUD shares.

At the peak he had AUD50 in shares and AUD50 (USD46.5) in cash. At the bottom of the AUD market he would have AUD23 in AUD Shares and AUD72.54 in USD Cash of USD46.5. His AUD100 is down to only AUD95.5 instead of being down to AUD47 as it would be in shares. The diversification into non-correlated asset classes has dramatically reduced the unrealised loss as at 9 March 2010.

At 14 April the position is AUD 32.5 in Shares and the USD46.5 is worth AUD50 again (by absolute coincidence of the exchange rates at 1 AUD = 0.93USD on both 30 October 2007 and 14 April 2010). Total value AUD 82.5. On this occasion the diversified investor is in front of the AUD shares only investor, but the generally expected result is that the diversified investor will have sacrificed some earnings but will have reduced volatility as shown above by the much lower fall in value of investment.


This is not a suggestion to trade, but is an introduction to three concepts:
1. Foreign currency exposure can be a good thing.
2. Considering rebalancing strategic asset allocation from time to time might be worthwhile. (called Active or Tactical Asset Allocation – these terms mean different things to different people. I am talking about 4 times a year style approach, not necessarily exactly quarterly, maybe at times of crisis in some country or region, or after a fall in stock markets in a region of more than say, 8%.)
3. Having a portfolio of non correlated assets (like USD bonds and AUD stocks) can reduce the volatility in the value of your investment and help you sleep nights.

Next Post

My next post will be on portfolio construction, risk aversion, volatility and diversification.