Monday, 25 May 2015

Bang for the Buck: Part 1

I've had an inclination towards personal finance, investing and trading for a while, which over time, has helped gain insights into the various characteristics, suitability and gotchas of different financial assets. When talking to people of different age-groups and life-situations, I often notice that they are very confused about how to allocate a chunk of capital, what path of money-making to choose, what instruments or assets to use and such. Through this post, I'll try to offer some classification and details, which hopefully will serve to be informational and reduce confusion. More specifically we'll look at the 2 major ways of making money: Yield and Capital Appreciation.

Disclaimer: Everything in this post is strictly for informational purposes and should not be seen as career or financial advice. If you read this and (still) do something stupid, you are on your own.

Also loosely known as income, is essentially the money/cash an asset (tangible or intangible) generates relative to its price. The asset could be a job (human-capital), where you earn a certain per hour income. Similarly, the asset could be a piece of farm-land that has a certain crop yield; real-estate that earns a certain rent; any system with an arbitrage; equity in a business that yields a certain free-cash-flow from operations. Note: I didn't say dividends because even when a company, doesn't distribute profits to share-holders as dividends, it can still re-invest it, which ultimately helps increase the asset value and thus generate more cash and we're in a loop.

For our understanding, let's say yield = cash / asset price. To have a higher yield, then, either the numerator has to go up or the denominator has to come down. Trying to predict if the numerator will go up, is a recipe for disaster, since there are way too many variables and "unknown unknowns". But Wall Street analysts actively do that (whole other discussion for another time). A much better practice is to wait until the price of an asset crashes and becomes much less than it's value, thus automatically driving up yield. This is what Uncle Warren does. More on that later.

Yield as a way to generate cash, is suitable to all age groups and doesn't have a steep learning curve. In fact, some great speculators who make money via capital appreciation, recommend allocating 90% of one's net worth to the pursuit of yield. That highlights the importance of this approach.

Capital Appreciation.
A practice where an asset is bought with an "intention" to be sold later at a higher price. (You could end up selling an asset at a higher price even in the yield method just because the yields lowered, but it wasn't your explicit intention to do so). Now since the future is rife with unknowns and unknown unknowns, it makes this method risky and requiring specialized knowledge. This is essentially speculation or sophisticated gambling where the near-certainty of yield is replaced with a probability factor. Estimating the probability to be higher or lower than 50% in itself is a herculean task somewhat, since we are trying to outsmart a lot of randomness!

When you hear about folks picking stocks, for their price is supposed to rise, or people flipping houses, for real-estate never goes down (a myth, by the way), what you are seeing is the pursuit of capital appreciation.

This method is not suitable for folks who don't have much time or willingness to do the required research to find an edge. It also needs a stomach for volatility and portfolio draw-downs (i.e decline from peak value). And yet I've seen people not just employ this method, but with 10x leverage who then ended up being indebted for the rest of their lives. If you have the time and willingness to put the hard work, this approach can be fun, engaging and help you make money in short time.

Having looked at the 2 broad categories, it would be a good time to do some myth-busting:

Myth: I hold assets for years, therefore I am an investor.
Truth: Anyone who pursues yield as a way of making money, is an investor and everybody else is a trader. Time frame has nothing to do with being an investor really. A micro-second inter-currency arbitrage exploited by a computer can be termed as an investment in a system with a variable yield. The financial world, including a lot of pundits, get this completely wrong. They want to call themselves investors, just because the term trader sometimes has a negative connotation owing to the gambling aspect.

Myth: Fixed Deposit in a bank is a great way of achieving yield.
Truth: Adjusted for inflation, the return from a fixed deposit is 0. Yes 0. Fixed deposits just help maintain the buying power of money. More on that in the next part.

Myth: Real estate prices keep rising, so flipping houses is a great strategy for capital appreciation.
Truth: Real estate prices rise only to keep up with the longer term inflation. Flipping houses can still be a great strategy, not because real-estate prices keep rising but for reasons we'll see later in this series. 

In the next part we'll closely look at instruments/vehicles like cash, bonds, real-estate, stocks, derivatives, gold, businesses, startups, jobs, their characteristics like liquidity and volatility. We'll also look at what approach is suitable for what kind of personalities, life-style, age group, with a certain amount of money.

Stay tuned.

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