Archive for the ‘Non-equity assets’ Category.

 

I have a lot of time on my hands these days ! With the market at the current levels, there is not much to buy. I am in the analysis/intellectual gymnastics mode these days, analyzing companies and thinking of odd ball stuff. In continuation of that spirit, I decided to write a post on the above topic. The advantage of a blog is that you can write anything you like. It’s a different issue if others would read it or just skip it.

This is a very contentious topic. I am not discussing about real estate as an investment. The post is only about a primary home – the home in which you are likely to stay.

I have also found myself in a minority of 1 when I discuss this topic with any friends or relatives. Lets try to look at the financial aspect of this topic first and then look at the non financial or emotional aspects of buying a house.

I can summarize a few ‘accepted’ financial truths in buying a house as follows

  1. It is better to buy than rent. Money paid via rent is a sunk amount, whereas if one buys and pays an EMI, one is ‘investing’
  2. A house always appreciates in the long term. As a result it is a smart decision to ‘invest’ in a house.
  3. A house is a hard asset in comparison to financial assets which are just paper assets. So in the interest of diversification, one should buy a house.

Bebunking some myths
The problem with accepted truths is that no one wants to think about them or question them. Everyone just accepts them as absolute truths such as ‘The sun rises in the east’. I have found it easier to discuss and argue about other topics about which people don’t think they know as much (such as stocks), in comparison to real estate, where everyone thinks they are a born guru just because they bought an apartment in the last 5 years which has appreciated by x%.

Let look at each point in detail now

Buy v/s rent
This is the most irritating  argument I have heard on this topic. Everyone claims this as the truth, but I doubt if most would have actually done the calculations on a piece of paper ( I have !! yes, you cant get any more geeky than this :))

Let take an example and some cash flow numbers. Please don’t argue with me on exact numbers as they may vary a bit, but the overall conclusion will still hold. Let say you buy an apartment for 1000000 (10 lacs) for an easy round number.

A typical EMI for a 20 year loan @ 9-10%, would be in the range of 9000-10000 give or take. Additional costs of owning a house would be maintenance costs (repairs, painting etc), association fees and taxes. These are sunk cost which you need to spend to maintain the asset and no one will re-imburse you these cost when you sell the asset

EMI approximately = 11-12% of asset value. lets assume 5-6% of EMI is interest payment and rest goes to principal(varies during the tenure, but approximately 50% of the EMI is rent over the life of the loan)
Association Fees = 1% of value
Maintenance and upkeep = 1% or more
Taxes = 1% or more

Cost/ month of owning = EMI + maintenance cost + association fee + taxes
So total cash outflow  = 5-6%+1+1+1= 8-9% of asset value (without tax benefit). If one consider 30% tax benefit then the number comes to 6-7% (you can do the math)

This component of your cash flow is not adding to the asset. Interest paid or association fees don’t add to the asset. Maintenance cost is equivalent to a depreciation expense. Only the principal paid adds to the equity.

If one rents a house, one would pay the rent (typically 5-6% of asset value) and association fees.

Rental cost/month = 5-6% +1% = 6-7% of asset value

Now you can play with the numbers as you like as I have not included some numbers such as utilities which are same whether you rent or buy. In addition we can get into all kinds of variations such as renting a room or doing something of such sort, but in the end if you buy a home just large enough to live, a lot of these variations may not be feasible.

The conclusion is this – The cash outflow on an owned asset which does not add to the asset (build equity by reducing the loan principal) is quite close the total rental and other associated cash flows of renting a house.

The difference in the numbers for rent v/s buy will vary by a bit if you modify some of the EMI and rental assumptions. However the real estate market is also reasonably efficient in the long run and these numbers tend to converge over a period of time (why ? ..thats a different post)

Real estate always appreciates in the long run
Says who ? can you claim it based on some data or are you just pulling that out of your ***** ? The long term (20-30yr) data for real estate across countries and time period has shown that real estate typically provides a 1-2% excess return over inflation.

Please don’t give me this type of example to prove your point
My ________ (fill uncle, nephew etc) bought this apartment/ land in a god forsaken place and then suddenly a new company came up and the real estate doubled overnight. It is the equivalent of saying that Infosys has gone up by 100 times in the last 20 years and hence all stocks should give that returns.

Finally long run does not mean, that if you buy an over priced asset, you will not lose money. If you don’t believe it please read about the investors in the US or in japan (in the 90s).

The key conclusion is this – If you overpay for an asset, you are toast !

House is a hard asset
That does not mean anything. If one can touch or feel a house, it does not mean that it is better than any other asset from a financial standpoint. An asset is attractive if it gives a high risk adjusted return, irrespective of its form.

For example – gold was always considered a hard asset and hence highly valued in India (not in other countries). In spite of this classification, gold returned close to nothing from 1970s  till 2003. In the recent years, investors can now buy gold ETF and inspite of being a paper asset they have made good returns. The point is that the physical form of an asset does not change the characteristics of the investment. By the way, I am not justifying gold as an investment.

So should one not buy a house ?
No, the above analysis is not to arrive at that conclusion. On the contrary, one should buy a house, but for a very different set of reasons. I would say our parents got it right on this count. I would list the following reasons to buy a primary home

–        Buying a home gives one peace of mind. It is a different feeling to live one’s own house and not in a rental one. It is a very satisfying experience. I cannot describe it, but those of you who own a house would know it.
–        It is the smartest investment for a newly working professional. A lot of young people who starting working, get some cash in their bank accounts and get itchy with the cash. They go all around investing the cash in silly ways and end up losing money. In this respect, if they went and bought a house (within their means) it would be a sound investment and would also prevent them doing something foolish
–        I now get into a slightly sensitive area – If the unfortunate occurs and the main earning member were to pass away, owning your own home makes a huge difference. I can tell that from my own experience.

Conclusion
I would say the primary reason for buying a home is that it provides a roof for your family and happiness and security. The accepted truths on financial aspects are delusions which people use to justify over spending on their house – buying more than they can afford.

Final question – have you heard of anyone who used to live in 3000 sqft house in a posh locality and when his house appreciated by 200%, decided to sell the house and went to live in a village in a 500 sqft hut ? Once you and your family gets used to a lifestyle, you will never want to downgrade it !!. So next time if you are getting giddy over the appreciation of your primary home, please think about what that means, if anything. (sorry for popping that bubble 🙂 ).

 
 

Note : The position discussed in the post was closed sometime back and I do not currently hold any open positions discussed in the post

I have a confession to make – I have moved to the dark side, figuratively speaking J. I have rarely written about options and derivatives. There is a simple reason behind it. I do not have as much experience in these type of instruments.

I have been reading on these instruments for some time now and have been dabbling in them a bit for some time now. My foray into derivatives has been mainly for hedging. I still firmly believe that trying to time the market is a waste of time (atleast for me). However that does not mean that I would not like to act when I feel the market may be overvalued.

There is a difference between the two points – time v/s price based action. Let me explain – lets assume that I hold a stock, which i assume is worth 100 and is currently selling for 60. Lets also assume that everyone thinks that the market is overvalued as a whole. If I believe in timing the market, I may decide to sell the stock assuming that market is likely to correct and so will the stock. When that happens, I may buy back the stock at a lower price.

If one approaches this from a price based view point and is agnostic about the market (it may or may not drop), then one may decide to do nothing as the stock is still undervalued. If the market drops, the stock has only become cheaper and one can choose to buy more. If however the market rises, and so does the stock, then well we have a nice profit on our stock.

The benefit of the above approach is one can focus on a single variable – discount of current price from the fair value of the stock and not worry about the market level, sentiment and other such factors. Ofcourse, if you think you can predict the market levels in the short term, then dancing in and out of stocks can be profitable. I however avoid these gymnastics and keep my life simple.

So how does a derivative – a put or a call option fit into the above approach ?

There are certain points of time when one can objectively look at the market valuation and conclude that the market looks fairly overvalued. One can look at the past history of the market and arrive at a reasonable conclusion that if the PE of the market is above 25, then the forward returns are likely to be low. One could look at the data and just ignore it or alternatively try to profit from it.

During the last 1-2 month, after the market hit 16000 and higher levels, I felt that the market was getting over priced. The number of attractive opportunities were reducing and the forward returns were likely to be low. At the same time, even if the market is overvalued, it does not mean that it will drop in the next 1-2 months.

At this point of time, I decided to hedge my portfolio with the use of a put option. Let me detail my thought process and strategy behind it

Buying insurance
In buying a put, I was looking at buying insurance for my portfolio. The objective of insurance is to protect your asset at the minimum cost and not necessarily profit from it. A put option is the right, but not the obligation to sell. So if I buy a put on a stock selling at 100 with a strike price of 80, I have to pay a premium for the option. The value of the option increases as the stock price drops below the current price. If the stock drops below 80 , I am fully hedged against any further drop in the price of the stock

The price of a put option depends on 5 factors – strike price, duration, current price, interest rate and implied volatily. I cannot go into option pricing in detail here, but in simple terms – lower the strike price (below the current price), lower is the price of the put (other factors being constant)

With the above point in mind, I had make a decision based on the following factors

  • Strike price of the index put
  • Duration of the put

The Strategy
At the time of the analysis, the index was in the range of 5051-5100 and I decided to pick a strike price of 4500. The maximum duration of the put which I could pick at that time was the December contracts. The reason for picking 4500 as the strike price was due to the fact the probability of the market dropping 15% or more looked low and at the same time a higher strike price required a much higher premium.

An additional factor in buying puts was the low implied volatility (read here for more details on implied volatility). As a result, the options seemed underpriced (I have bring a value angle into it 🙂 ).

I ended up buying the December contract for 100 with a strike price of 4500.

The result
After buying the options, the market continued to rise for some time. Options are brutal instruments, also called as wasting assets. Options lose value with time (called as theta or decay). In addition, if the price move in the opposite, then loss is almost exponential.

The above situation changed in the subsequent few days and with a 10%+ drop in the market, the options were almost in the money and had more than doubled in price. The end result is that they had achieved the objective of hedging my portfolio during the market drop.

Conclusion
Am I happy with success of my options strategy ? that would mean that I would be happy on making money on my fire insurance if my house burns down. I look at options merely to hedge my portfolio against short term drops. The cost of this insurance is high (almost 10-12% per annum of principal value) and hence it would be silly to buy puts every time one felt that the market is a bit overvalued.

I would personally buy options under two scenarios
–        The market appears considerably overvalued and options are underpriced due to low volatility
–        I wish to hedge a specific stock position which I plan to sell in the next few months.

I am looking at other strategies such as covered calls, collars, butterflies, rabbits (ok I made that up) and will post if I attempt these stunts in the future and survive 🙂

 
 

I received the following comment from Raj. I am posting my response via a post. Please feel free to share your comments

Hi Rohit/Everybody,
Can we include below mentioned financial instruments in personal finance and short comments (how easy they are for new investors, who should dabble with them, pros/cons) on them:
A) Commodities
B) Gold
C) Debt instruments
D) Derivatives (options etc.)

Commodities – An easy one for me. I have zilch idea about it. Due to my mindset (value investing, looking at intrinsic value etc), I have not been able to figure out a way to invest rationally in commodities. It does not mean commodities are bad or anything. I just find them outside my scope of competence and would not recommend a new investor to dabble big time in commodities.

Gold – A subset of the above. However I am baised against gold and am a contrarian on gold. The reason for all this excitement on gold is more due to the price run up  in the recent past. Look at this chart . Over the past 20+ years, gold has barely doubled giving a return of 3.5% per annum with the entire return coming over the past 5 years. Unless you have some special insight into the demand supply scenario of gold over the next few years, I would not invest in gold based on what others are saying.

Debt instruments – my thoughts on the same here

Derivatives – A short cut to ruin if you don’t know what you are doing. I have personally started looking at these instruments and am currently in the learning phase. I am currently reading and investing in these instruments in a very small way. The idea for me is to test and learn over the next few years before I increase my commitment. This is same approach I adopted when I started investing a decade ago – learn and invest small so that early mistakes are not fatal to your networth and self confidence.

I personally consider derivatives, complex and not an easy way to make money. The upside may be high, but at the same time the risk is high (due to the inherent leverage in these instruments) especially if you are new to investing and have just started out.