STI Review 2012 Oct and Guide 2 to Investing Plan A and Plan B

Here is the second action plan continued from previous post.

2. Another Plan A: Enter a 'not cheap' market now with a diversified portfolio.

What if you don't want to risk missing the boat and for some reason you have to start investing now, even when the market is 'not cheap'?

I know the feeling, been there myself also. When I started my diversified passive portfolio, no time seems like a good time to start - when there is a cheap asset, there may also be an expensive asset. The best time to start a portfolio is at the bottom of a recession, when many investment assets are very cheap and people are staying away from these assets like they are smelly tofu. I'll say the smellier the smelly tofu, the better it is eat. So learn to eat smelly tofu already...haha.

That said, I think only experienced investor will have the guts and know-how to start investing at market bottoms. So back to the question of new investor, what to start investing in when market is 'not cheap'. In my opinion, when stock market is 'not cheap', it is better to start a diversified portfolio.

By diversified I mean besides buying stocks, buy also Singapore government bonds. The way it works is government bonds price will move in opposite direction to stock market price. If stocks are 'expected to rise' for long period, bonds price will drop as people leave bonds to chase better returns in stocks. On the contrary, if stock prices are 'expected to fall for long period', people will drop stocks and run to bonds for the relatively safer and consistent yield.

Now if you have both stocks and bonds when market is 'not cheap' this is what is going to happen usually. If bet correctly and stock market goes up, stock price will normally rise faster than bond price drop, hence you will still make a net profit. If bet incorrectly and stock price drops, bond price will rise and offset some or most of the big drop in stock prices, therefore your net loss will be lesser than the average stock market loss, hence making your lesser loss more bearable. At the bottom turning point of market, or when stock price has been at or below 200MA for a long while and there may be price divergence with MACD again, perhaps that will be a good time to sell off some or most of your profitable bonds and buy into cheaper stocks.

This way, if you win you won’t win too much but at least as a new investor in a 'not cheap' market, having some win is better than facing potential big loss. If you lose, it will be more bearable as your total loss is lower compared to the average stock market loss, and you may also take some comfort at watching how the bond keep growing when stock prices are dropping. And even if you lose, you will still have a 2nd chance to sell the profiting bonds to buy cheap stocks later on, hence making back the loss faster than if you were to buy only stocks at possible height of market.

Having a diversified stock and bond portfolio is a way to reduce 'volatility' in a portfolio, meaning reducing the potential loss (and gain) in a portfolio. Avoiding big loss is important for new investors so that new investor will not panic, cut loss, and throw away the investment strategy. A diversified stock bond portfolio, rebalanced yearly, has practically the same returns as a stock index portfolio over the long run, so stock/bond portfolio is not missing out on much while enjoying lower volatility. So how to start a stock bond portfolio? There are 3 things to decide: asset allocation ratio, which particular stock to buy, and time to rebalance.

 

First thing, about allocation ratio. If you are conservative investor who do not like large losses, use 50% stock and 50% bond, which will offer lesser potential loss and more stable portfolio returns. If you are young and aggressive investor, or with high stream of future cash income, use 70% stock and 30% bonds (or 80% stock and 20% bond if you have very high stream of cash income), which will offer more stock returns and also potentially higher stock loss - higher stock loss may be alright if you have future high streams of cash income which allows you to average down on stock all the while when the market is falling.

Second thing, about what particular assets to buy. For bonds, I would say get 30 year Singapore Government Bond only. Choosing only local bond to avoid currency risk. Choosing government bond instead of municipal and corporate bonds to avoid default risk during bad economic times, and Singapore Government bond is rated AAA, so why not? Choosing 30 year long bonds instead of 10 year medium bonds or 2 year short bonds, because 30 year bonds is more volatile than short or mid-term bonds. In recession, higher volatility of 30 year long bond will allow this bond price to spike up more and greatly offset potential drops in stock price. If stock goes up instead, this long bond will drop faster also than short or medium term bonds. This is ok because normally, historically and practically speaking, stocks will rise faster than drops in this bond, which will still allow net profits for stock bond portfolio. About interest rate risk for bonds, long term 30 year bond price are also negatively affected by rising interest rate, more so than short term adn mid term bonds. In the next couple of years, I do not foresee risk of rise of interest rate, since U.S. central bank is committed to maintaining interest rate low till 2015 and Singapore government will likely follow suit. The European situation will also take some more years to resolve till it does not negatively impact on global economy.. Even if interest rates rise in future, if you are a long term diversified portfolio investor, it will still be good to be consistent and hold on to 30year long bond for the long term volatility protection. Consistent strategy is key for diversified portfolio investing. 

Third thing, what is rebalancing and when to do it. If you invest in such stock bond portfolio for long term, then some time after you start the portfolio, stock and bond prices will change and the stock bond allocation ratio will change accordingly. Let's say after one year, a 50/50 stock bond portfolio becomes 60/40, meaning stock has had a good run and overtake bond price drop. So at end of the year, sell stock to buy bonds, or top up with fresh cash on new bonds, to get back to 50/50 allocation. In this way, you are forcing yourself to mechanically sell for profits and buy assets when they are cheap. This is called rebalancing, and is preferably done every year, or sometimes every quarter or even month, depending on the optimal commission costs and availability of fresh funds. You may say you are missing out on stock profit by selling stocks every year, but if there is a sudden stock market correction, teh 50% bonds is there to ensure you keep most of your profits instead of throwing profits back to the market.

If you are looking to implement a more diversified long term portfolio now or in future, you can check out the Permanent Portfolio passive investing strategy which holds stock index fund, government long bond, gold and cash. Permanent Portfolio is an unconventional strategy offering even lower volability while offering similar long term returns to sotck index fund.There are also other mroe conventional passive portfolio strategies available too under different names. Also, stock and bond portfolio like this are not unique, it is the basic building block of many fund managers and their diversified investment and retirement funds. So you can also choose to maintain a simple diversified passive portfolio for yourself one day if your investment needs change and you become more risk adverse.

Continue to read Part 3 using below link.
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Part 1 of Article - Guide 1 to Investing Plan A and Plan B
Part 3 of Article - Guide 3 to Investing Plan A and Plan B