Apr 242017
 

Today we’ll explore a common question I get asked all the time: What is my thought process behind leverage?

The short answer is simple. I want to make high returns without being exposed to high risk. Normally the two go hand-in-hand. But leverage allows me to separate them.

For example, a speculative marijuana stock may grow 20% to 50% a year. But it could just as easily lose half its value. The potential reward is tempting. But the high risk is not worth it.

Instead, I’m looking for a lower return, lower risk investment such as an established pipeline company known for its predictable earnings, dividend growth, large economic moat, and low stock volatility. Using historical data and fundamental analysis I may determine that there is a very high probability this stock will appreciate 4% to 10% a year. I can then apply a leverage multiplier of 5 times on this investment which means my actual expected rate of return is 20% to 50%.

In other words, I do not subject myself to the high risk that is typically associated with juicy returns. But I still get those juicy returns! Awww yeah. 😀

That’s pretty much it. The long answer requires some further explanation. Let’s start with the 3 criteria I look for before I borrow to invest.

 

The 3 fundamental rules of practicing leverage

  1. A 10+ year investment time horizon.
  2. An adequate diversification strategy.
  3. An asymmetric risk-return opportunity.

The first and second rules are straightforward. Billionaire Jeff Bezos recommends we think in 7 year terms to remain competitive. I suggest taking that up to 10 years just to be safe. 🙂 In terms of diversification it can mean more than just having stocks and bonds.

 

Seek Out Asymmetric Returns

Now comes the fun part. Rule number 3. As we all know there is no investment without risk. The third rule is about knowing which investment has a favorable risk to reward ratio. This simply means comparing the odds. For example, let’s say we are asked to roll a normal 6 sided die. If it lands on 1, 2, 3, or 4, we win $10. 🙂 But if it lands on 5 or 6, we lose $10.

So should we play? The answer is a resounding yes every time! 😀 We have a 66.7% chance (4/6) of success. So from a rational perspective this has an asymmetric probability in favor of us winning.

 

Analyzing Probable Returns with a Bell Curve

We can use a normal distribution to help identify favorable investment opportunities. In statistics, a normal (bell curve) distribution outlines all the possibilities with the most likely outcome being in the middle. The standard deviation can be used to measure the variation in a set of data. Let’s see how we can put this bell curve to use when we overlay it on top of a chart that shows how many times the stock market returned a specific amount over any 10 year period between 1916 to 2016. (source)

So over the last century, any 10 year period of investing in the S&P500 index would have returned somewhere between 6% to 11%, 40% of the time, or within 1 standard deviation of a normal distribution curve. Additionally, returns were between 3% to 14%, 72% of the time, within 2 standard deviations from the mean.

This strongly suggests that we have a 95% chance (95/100 possibilities) of making at least 3% annual return from the stock market in any given 10 year period. Pretty neat eh? 😀 Time in the market reduces risk in the market, and creates a huge asymmetric advantage to investors!

But enough theory. Let’s see this at work in a real life example.

 

Banking on Leverage

A couple of years ago I used leverage to buy RBC Royal Bank stocks. Let’s go through my thought process behind this decision.

Large cap, blue-chip dividend stocks are ideal to use leverage on. They don’t come much bluer and larger cap than RBC. It’s the largest company in the country. Plus, there’s a lion in the logo. That’s how you know it’s a top quality company. 😉

I borrowed $4,000 to buy 55 shares of TSE:RY and contributed $0 of my own money. I wrote a full analysis on RBC and explained why I thought it was a good stock to buy at the time. The reason I used leverage was because I didn’t have any cash and the investment fits my 3 rules of leverage.

  • First rule: I planned to keep RY stock for the next 10 years.
  • Second rule: I made sure RY would only be a small part of my total portfolio.
  • Third rule: RY’s P/E ratio, peg ratio, and other fundamental measurements looked appealing in 2015. The stock was expected to grow 8% to 10% a year for the foreseeable future. Historical data showed strong earnings growth and stock appreciation. RY’s dividend would be enough to cover the interest cost of the debt. Thus, this would have a favorable asymmetric risk-to-reward ratio.

My return on this investment so far, net of margin interest cost, is about 37% or $1,500. Not too shabby. 😀 But this shouldn’t be a big surprise. After all, stocks are fundamentally priced based on their earnings. And RBC has an impressive history of consistent earnings growth. Back in 2015, RY was expected to earn $7.35 per share by 2017. Fast forward to today, it appears RY may actually be on track to hit $7.40 EPS this year. We shall see.

This leveraging strategy is also recession resistant. For example, let’s say I did the exact same thing in 2007 at the peak of RY’s market capitalization, (the worst possible time to use leverage) right before the greatest recession of our generation. Yikes! Well despite the unfortunate timing, 10 years later I would still end up with a 70% positive return, net of interest expenses! This is why I am not concerned about future recessions. 😉 I know I can just hang on to RY until the stock market recovers like it always does after a major correction.

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Mar 272017
 

In a World of Abundance

Over the last couple of weeks I have indulged in many pleasant gastronomic experiences around the city. Below are some pictures of events I attended and the food I enjoyed. And here’s the kicker. 😀 Everything was free!

food events mostly found through eventbrite

 

Free Food is Everywhere 

Why would companies hold events to give away food to the public? Usually it’s because they have something to sell. Most of the presentations I attend are sponsored by financial companies that want to push their investment products. I was given wine, bread, and cheese at a Raymond James event. Private market company Pinnacle served pasta and pizza at a fancy Italian restaurant. Yum. 🙂

Even technology companies such as Realm, which develops mobile apps, gave away pizza and t-shirts. So I got a free meal that evening, and free clothing. Yay! Whenever I wear my new Realm t-shirt I’m essentially giving them free publicity.

The companies try to raise awareness for their brands, sell their services, or recruit people into their community. That’s why they host these events. I can ramble on. But enough teasing. Let me reveal how you can get free food!

Search and Execute

There are 3 steps that anyone in the developed world can use to acquire free food.

Step 1: Live in or near an urban area.
Step 2: Sign up with event management organizers.
Step 3: Search and register for upcoming local events using filters such as “free” and “food.”

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Mar 132017
 

I recently came across an informative and inspiring thread on the financial independence subreddit about additional income streams that people have. Here are some ones I thought could be relevant to people who read this blog.

Ideas for Extra Income

  • Rent your car. Turn a depreciating asset into an income stream. 🙂 “I rent my car out on Turo. It’s the AirBnb of car rentals. I live walking distance from work and rent it out all the time. I rent my Wrangler for about $50/day and have been making around $800/mo in gross margin.” ~plz_callme_swarley
  • Invest in a rental property. “I’ve got two rental properties, both I pay someone else to manage. I made 8k off of one last year and 21k off of the other one in net profit (new roofs are expensive). They’re both paid off and provide a small but steady trickle of income, I’ll probably try to save enough to get 1 more each year for the next 7-8 years.” ~SEJeff
  • Buy profitable blogs and websites. “Bought a few niche websites on Flippa, earning a little over $100 per month. Import some stuff from China and sell it on Amazon as well.” ~jb611
  • Walk other people’s dogs. “Signed up through rover.com but now my clients pay in cash to avoid extra fees. I only have 2 clients because I’m too busy to take on more. I mostly work on lunch break from my job with occasional overnight stays. Make about $300/month….I recommend signing up on Rover.com. The process takes a little effort and you need 2 references – I had my girlfriend write one and a buddy wrote the other. The site isn’t extremely easy to navigate which is partially why my clients pay me under the table now.” ~CalPolyJohn
  • Write online. “I make about $3,000/month editing Wikipedia for pay. I get my clients from https://www.buildersociety.com/, they’re great! I know a lot of other people doing this so if you want in, just start editing Wikipedia, learn the rules, and then all you need is just clients…..I can do a new page in about an afternoon and I charge $500-$1,000. It’s only 3-6 actual jobs/month. If you want to do it, make sure you spend some time editing the Encyclopedia to learn the rules.” ~TaylorSwift2015
  • Become a freelance translator. “Freelance translating (Japanese>English). Brings in $4200/month pre-tax for 50 hours/month of work…Professional (and non-professional) translators usually create profiles on both ProZ and TranslatorsCafe to look for and offer work. People with no real translation background may use a site like Gengo, whose rates are considerably lower (3 to 8 cents/word). Finally, it is also common to Google “Translation agency” and send your resume to as many translation companies as possible (rarely works, but then again you really only need 1 good client to establish yourself).” ~nakoyao
  • Monetize your lifestyle/hobbies. “I rent out my place on AirBnB when I’m travelling ($6300 in 2016). I offer private lessons as a cross-country ski instructor ($1600 this season). I host house(boat) concerts ($1-2000/event). My friend sells the overflow from my vegetable garden at the farmer’s market ($700). I take tourists out fishing/netting/ice fishing/canoeing ($3200 in 2016)” ~Holy_BatLogic
  • Teach English online. “I teach online classes for $20/hr. Just started last month, made $692 in half of February.” ~OzarkCatholic  “There are online tutoring gigs for ESL, you can get 16-20 an hour pretty easily. Check out VIPKids” ~brikky

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Feb 272017
 

New stock market highs aren’t that special. Here’s why.

Some people inaccurately believe that any time the stock market reaches a new high it must mean that we are near a peak, and it’s a sign that stock prices will probably fall soon. Many undisciplined investor may choose to pull out of the market when this happens. However doing so will almost always be the wrong decision. This is because stocks reach new highs all the time. And they usually go up even more in the following years.

This Bloomberg article explains that over the past 102 years from 1915 to 2017, the Dow Jones stock market index in the United States had hit 12 new highs every year on average. 🙂 That’s once per month. Another way to think about it is that the Dow experiences a new record high about 5% of the time. So it’s not really not that rare. 😉 The table below shows how the frequency of new highs are distributed over the decades.

If someone starts investing at age 30 and plans to live until 80, then he’ll have 50 years of time to invest in equities. Based on historical data for the Dow Jones, he will see roughly 600 new record highs during his investment duration. This is why selling stocks because we may have reached a new peak in the market is a very silly thing to do for long term investors.

Trying to sell high and buy low rarely works. Again, the facts clearly explain why this is the case. Over the same time period, (1915 to 2017), the one year average return for the Dow after it had reached an all-time high was 9%. The 3 year cumulative return was 21%, and the 5 year return was 32%. So even when stocks are at all time highs, they tend to move even higher in the years after. 😀

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Feb 202017
 

For buy and hold investors, some like to actively pick and choose individual assets to buy, while others prefer to invest in the entire market. But which is a better investment strategy? Similar to a cronut, the answer is simple, but may not be obvious.

passive vs active

Which Investment Style is Better: Passive or Active?

The Cronut is a pastry that combines together a croissant and a doughnut. It was invented by New York City pastry chef Dominique Ansel and is trademarked. You should try one if you ever visit NYC. 🙂 They cost $5 each. But you can also find cronut knockoffs in Mexico that are much cheaper than the real thing, so you don’t peso much. 😄

Anyway, why is this relevant to investing? Because much like a cronut, the better investing strategy between passive and active, is not one or the other, but both. 😀 By combining individually selected assets, and index funds into one single pot, we can create the ultimate investment portfolio. This takes advantage of low-cost index funds, while adding alpha (excess returns) in certain segments of our portfolio. 😉

So how can we implement this? First, we actively pick and choose specific investments in the areas that we have extensive knowledgeable about. Then use the passive investing method to buy index funds for all other asset classes that we have insufficient knowledge about.

For example, I selected individual farms to buy in 2012/2013 because I knew how to look at soil quality, flood risk, earnings potential, etc. Therefore, I knew how to find undervalued land. Historically speaking higher quality farms appreciate faster than lower quality ones so I made sure to only buy farms above a certain quality. Farmland funds however, invest in all quality land. As a result I have outperformed every farmland or agricultural based ETF I could find on the stock market. So within the context of this asset class, passive investing would not have done me any good.

On the other hand, when I decided to get into the United Kingdom stock market last year, I decided to buy a low-cost stock market ETF. European stocks are beyond my comfort zone. I wasn’t about to perform due diligence on all 250 stocks of the FTSE 250 index. So that’s why I invested in a broad market UK index fund instead which contains those 250 individual stocks. 🙂

This is why self knowledge is very important for investors. We should try to use our strengths and specific knowledge to produce better than average outcomes in certain types of industries or asset classes. Then we can aim for average market returns in all other areas that we do not understand. Overall, this should give us a higher investment return than either a completely passive approach (which will give us average market returns), or a completely active approach (which will most likely result in under-performing the market.)

But in order for this combined investment approach to succeed we have to know the limits of our knowledge and capabilities.

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