Simple Pound

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Thanks to Rob @ Money Watch I didn’t miss this comprehensive overview of the credit crunch by the BBC. It is essentially a collection of key graphs to represent the economic changes in the last 12 months and I wanted to cherry-pick my favourites to share with you - but not necessarily because I agree with the message they are intending to bring across (hence the question mark in the title…)

Let’s start with a picture highlighting the key changes in our economy since the start of the credit crunch. The message is clear - petrol and food, two essential cost factors in nearly every household, have increased significantly in price over the last twelve months while the value of our homes has been eroded by approximately 4.4%.

With the rise in petrol prices come further cost increases in related fields such as energy or holidays (think airfares…). But did anyone ever stop to think that this has actually nothing to do with the credit crunch per se? Through an unfortunate coincidence we see a boom in commodities prices at the same time as our economy is already suffering from the aftermath of the subprime crisis - yet that doesn’t mean one caused the other.

Similarly, the food inflation we witnessed in the last couple of months originated in the commodities boom that saw prices in wheat and other agricultural produce reach heights of unprecedented nature. I agree that it has been rather extreme and that certain products seem to have been increasing at the rate of a penny a day, nevertheless that doesn’t automatically mean it’s a direct cause of the credit crisis.

More importantly I’m starting to wonder whether conditions like this couldn’t have been avoided if only people/businesses would have appropriately used hedging. Only today I read that South West Airlines still bought its fuel for $26 a barrel at a time when the market price had reached $80 (slightly old example, but it illustrates my point). How come the likes of Tesco’s, Sainsbury’s or Marks & Spencer’s didn’t come up with a clever idea like that? After all, hedging was introduced for companies to sell their risk in exchange for a small premium and stable input prices.

Before I rant even further, let’s move on to the last category in the summary picture: housing. If you have been reading this blog for longer than just a few days, you will know that I join forces with all the other people struggling to get their foot on the housing ladder and hence eagerly awaiting a double-digit drop in house prices. I totally emphasise with anyone who is worried about negative equity but if you are living in your house because it is your home then you have almost no reason to be overly worried. Hopefully nobody will be forcing you to sell any time soon, hence you can simply wait it out and I’m certain that we will see prices returning to their historic levels (with the only difference that hopefully a few more first-time buyers will have joined the ranks of home owners). And even if you are looking to sell and for whatever reason you cannot wait a few more months or a year until you do so, there are a one-hundred and one things you can do to enhance the value of your home.

In any case, my actual point was related to the graph below. After you got over the fact that house prices have officially been falling since April, have a closer look at the second graph with details of house prices over the last 10 years. Note that it charts the annual change in house prices - that means, as long as the graph runs above the 0 line, your home will have increased in value. Looking at your portfolio or pension account - how many investments can you quote that haven’t fallen in value once over the last 10 years? I doubt there will be many.

What I’m trying to say is that a house purchase has always been a good and solid investment with annual returns of anywhere up to nearly 30%. Now, for the first time in over 10 years we’ve seen a careful reversal of this trend and the world is in panic. As I said before, I totally emphasise with people worried about negative equity, especially as a house purchase is such a major investment, maybe the biggest one many of us will make in our life. However, that put aside, any investment bears the risk of losing as well as gaining in value. Why should property be different?

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Admittedly, it’s been getting very quiet on the blog front and you’ve all heard the excuses of working late and being busy, so I won’t bore you for very long before moving on to more interesting stuff. But can I just say that I also walked 20 miles for charity and that took away some blogging time! I bet that’s a new one for most of you…

Anyway, as I promised in my last post (yes it’s been a while) I have had an idea about a series of posts that might be of interest to you, especially if you really really like numbers (like I do). While reallocating my pension across several funds, I kept wondering how to best measure how well (or badly) my choices were performing compared to the market in general. For a start I have split money fairly evenly across index funds and actively managed funds in a way that will hopefully allow me to compare apples with apples - i.e. simply speaking, for each asset class I have picked an index fund as well as an actively managed fund to compare their performance against each other.

Somehow, that didn’t seem good enough and so I did some research on what else I could do. As I said, I like Maths and numbers because they have an inherent logic and beauty… great, now I sound like a total geek. Or idiot. Your choice

Hence, here’s my line-up of posts that will hopefully appear throughout June and July (bear with me as I’m also going on holiday in three days). I’m not going to explain much (or anything) at this stage, because otherwise there’s not much point in writing separate posts about each. I simply hope you’ll be excited to read what’s coming up and all the things you might be able to learn soon(ish).

1. Post : The Basics
- arithmetic mean (average loss, average gain)
- geometric mean
- frequency distribution
- maximum value
- minimum value
- positive # of years / months / weeks
- negative # of years / months / weeks

2. Post : Risk
- VAR: value at risk
- M-squared

3. Post : Statistics
- standard deviation
- semi-variance (semi-deviation)
- downside variance
- below-target probability

4. Post : All About Interaction
- covariance: degree of variability of returns between two assets
- correlation coefficient
- units of annual return per unit of std. dev.
- expected final value of $1.00 / £1.00

5. Post : First lesson in Greek
- beta coefficient or an assets’ degree of responsiveness to market movements

6. Post : Advanced Greek
- alpha or superior returns

7. Post : More Jargon
- sharpe ratio

Some of these will be rather obvious, or aren’t even really mathematical but I thought they were nevertheless useful when analysing your portfolio. I’m going to try my best to explain even the more complex concepts in a straight-forward way that will make you (and me) understand why exactly a particular formula might in fact be useful.

Knowing myself, all of the above will eventually end up in a big spreadsheet, which I naturally will also make available to you so you don’t have to play with Excel for hours to get it all onto one page (surprisingly enough not everyone finds that sort of stuff fascinating).

I’m getting rather excited while writing this, so hopefully my energy won’t be wasted and you’ll enjoy it as well! Let me know if you think I’ve omitted anything absolutely obvious that shouldn’t be missing from a series of posts on portfolio calculations.

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A year ago I wrote about Zopa, a (then) new loan concept that wanted to bring people together in order to facilitate a lending and borrowing market that wouldn’t require banks. The concept is remarkably easy - on the one hand we have people with spare cash looking for a good and (reasonably) safe return while at the same time we have people out there who are looking for some spare cash (i.e. a loan). Why not make these people talk directly, instead of forcing the former group to deposit their savings into a bank account with a mediocre interest rate and subject the latter to bank’s exorbitant fees (exceptions apply)?

After I had been watching the Zopa site grow for quite some time, I decided that it was time to join the fun and have a go at it myself. With the house purchase one of my major short-term goals at the minute, I didn’t want to tie up a lot of capital for a long time, hence the amounts I’m allowing myself to use at Zopa are fairly small (£ 25 in total at the minute, increasing by about £ 10 a month). Nevertheless I figured I had seen enough to share my experience with the site so far…

Signing up: Ideally this should have been a fairly easy process, especially since I was intending to become a lender, not borrower. However, due to money laundering regulations Zopa is still required to verify your identity and address. Since we’ve moved to our current flat only a few months ago, this identity check could not be carried out online and I had to submit the usual proof of identity and address documentation. This is nothing unique to Zopa and I’ve encountered the same issue several times before with banks, credit card and loan companies. In the end it took only 2 days for them to process my documents and I could sign up successfully! Overall impression: good.

Customer Service: Apart from the registering process I’ve had several other encounters with the Customer Service department relating simple queries as well as a functionality problem at one point. The usual way of contacting them is by sending an email and the response time is always within the promised 1 - 2 business days. All requests were dealt with swiftly and the team is very helpful and always friendly. Overall impression: excellent.

Transferring money: There are three major ways you can transfer money into your Zopa account: Debit card by phone (for instant transferral) or online (for transferral within the same business day), standing order (similar to the way you’d set up the standing order for a savings account) or by bank transfer (longest of all methods as it takes about 3 days to reach your account). With either option you will receive a confirmation email when your funds reach the account and are ready to be used. To transfer money out, you will need to have your bank account confirmed with Zopa. To do that, you simply need to transfer £1 by bank transfer once for them to be able to verify the account belongs to you. At this stage, you cannot transfer the money in your Zopa account to anybody else but yourself. Overall impression: very good.

Lending in Zopa Markets: With Zopa you have two major lending options - Markets
or Listings. If you allocate your money to the Markets section, most of the work matching your lending offer with a borrower request will be done behind the scenes for you. You merely see your money moving between the stages of being offered (currently available), processing (matched to a borrower, loan verification in progress), lent out and late payments (hopefully very few in the latter category). To determine your rate of return you can either give Zopa your desired rate of return and the longest amount of time you’re willing to tie up your capital or you can fine tune your offer by indicating an exact rate of return per market segment. These segments are determined by the borrowers credit rating and the duration of the loan and range from A* for 12 months to C for 60 months. Zopa is helping you to offer realistic rates by quoting you a range of rates that other lenders are offering.

My experience with the Markets section is thoroughly positive. I’ve got all my lending offers at the higher end of the market range and yet I find that my available money is usually processing within a time span of about 2 days. I’ve only had one slight hiccup so far that was explained to me and hence resolved by the Customer Service team within 2 days (my Zopa account contained a little less than the shown £ 10 due to the Zopa fees being earmarked but not deducted every month). Overall impression: good

Lending on Zopa Listings: Zopa Listings are essentially an eBay-like reverse auction system where borrowers advertise their borrowing needs together with an explanation of their finances and lenders can quote how much they’d be willing to lend to this one borrower and at which rate. All quotes get aggregated throughout the duration of the listing. When the borrower’s desired loan amount has been reached (i.e. funding is at 100%), lenders can continue to quote and hence will start outbidding each other with lower rates. Eventually only the minimum number of lenders with the lowest rates will be kept in the listing and hence will be able to lend their money to the borrower. The advantage of the Listings is that you might be able to get a higher rate than you’ve quoted in the Markets section by bidding at the last minute - similarly to how you can get a bargain at eBay through sniping (or old-fashioned pressing of refresh and bidding on the last second).

I’ve only (actively) participated in one Listing so far which ended at 4.20am in the morning. I waited to submit my quote until half past midnight and went to bed hoping lots of people would have already done the same. By the time I submitted my quote, I was about 50 offers (out of 130) away from being excluded so I felt pretty safe and happy as I had a good impression of the borrower. Unfortunately I was out-bid just 15 minutes before the end of the Listing… In any case, the entire process was certainly exciting and I’m intending to look out for other Listings as soon as I fund my Zopa account with more money (waiting for the paycheck, anyone?). Overall impression: excellent

Total verdict: For me, Zopa turned out to be everything I expected and wanted it to be. Obviously I can’t really comment on the bad loan rate at this stage, but then I don’t think it is a major part of evaluating Zopa itself. Every lender can adjust the risk he or she is willing to take by only offering money in certain (high-quality) markets or reducing the term of the loan they’re happy to accept. I believe that people might be less likely to default on their loans when they know that they owe their money to individual people, not big face-less institutions - if you had the choice, whom would you pay back first? Your neighbour or the bank? I might be wrong, but this is what I would like to believe and Zopa’s low bad-loan quota might prove just that.

If you’re intrigued by the concept and would like to explore alternative ways of making money / earning a return on investments, I urge you to give this a go. Sign up here to get £30 when you start lending (minimum amount applies) and become part of the Zopa Community. Trust me, it’s fun!

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I have recently come across the Zopa website, which claims to connect lenders and borrowers without involving banks - thus guaranteeing both parties better rates. The whole site is built around a community of people either willing to lend or people seeking to borrow money - from each other directly, rather than going to their local bank and thus making these institutions even richer than they already are.

And it seems to work as they are quoting quite competitive rates of 5.95% APR for a £5000 loan over 36 months, while promising lenders an average of 6.75% pa for their money (after bad debt and fee, before tax). Since I am not planning to take out a loan very soon, I was more interested in the lender aspect of this. It is essentially a bond based on an individual (and his credit rating) rather than a government or corporation - only with a much better return.

And here’s how it works: If you decide you have got some money left over that you wish to temporarily make available to someone else, you create an account with Zopa and transfer your money in, specifying which credit rating you will accept and for how long you want to lend the money. Their credit scores range from A* (very reliable) to C (still reliable, but less credit history - e.g. a student), which is based on an extensive identity-, credit- and risk-check. According to them, a person with a credit rating of “C” is still more creditworthy than the majority of the population. Well, that sounds good, but is obviously very difficult to prove…

The interest you get for your money depends upon the duration you’re intending to lend money and the people you’re happy to lend to. Since the website essentially functions like a market, the actual interest rate you are receiving will be based on supply and demand. So in order to get a decent return, you should put down your money for as long as possible (5 years) and ideally to C-rated people, because for these categories demand will potentially be highest. Obviously decisions like that depend upon you’re own risk attitude!

There is no lower limit for how much money you can put in the Zopa account - people start at sums of £10 or use Zopa as a regular savings account and make small monthly contributions. In most cases you won’t be lending to a single person, but your money will be spread across various people seeking a loan. This is an in-build protection mechanism based upon the wisdom that diversification limits risk. And if the conditions of your lending aren’t appealing to anyone in the market-place (for instance, your lending period is too short), you will still earn 4.5% interest on the money in the Zopa account - which is more than I am making with my savings at the moment!

As I said at the beginning, I’m beginning to really like this idea. Especially since you will know where your money is going and in most cases people also share what they are using the money for. In short this means that whenever you decide not to spend your money but put it in your Zopa account, you could potentially help fulfilling someone else’s dream!

Head over to their website for more information! And please, if you’ve had any experience with Zopa at all, leave a comment and have the rest of us benefit from your knowledge!

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There are tons of possibilities out there to invest and hopefully grow your money and the current obsession with derivatives certainly doesn’t limit that choice. Personally, I will stay away from derivatives until I can be sure that I understand what’s going on.

But let’s start with the basics and give you an overview of the most common investment choices. There’s on simple rule that applies to all of them: More risk, higher return. Whether you decide to keep your money under your mattress (and thus effectively lose money due to inflation) or invest it in a small start-up company depends entirely on you and your risk attitude.

A rule of thumb that is commonly used to determine the ratio of bonds and stocks in your portfolio is 120 - age. This is the proportion you should invest in equity (i.e. shares, equity-based funds, index funds etc.) and reflects the time you have left until you retire (if you are retiring in 5 years you will mind if your portfolio drops by 20% whereas if you have 40 years left you know you have plenty of time to make up for it). In my case this would be 120 - 20 = 100% in stocks, which is what I intend to do - after I’ve got some money sitting in a savings account with a sign round its neck saying “emergency fund”. At which point I can probably already invest 1% in debt-based securities (bonds…)

I intend to break up this post into smaller chunks which should hopefully assure that (a) you don’t fall asleep, (b) you can look up the things you don’t know and (c) I don’t have too many good reasons to procrastinate from doing my revision.

So here we go with probably the most obvious choice: Shares.

Buying shares in a company effectively means you’re buying a tiny part of that company and thus have a right to have your share of their profits. Now with hundreds of thousands (or even millions, depending on the size of the company) of shares in issue this mostly boils down to a few pence per share. The profit is distributed to the shareholders (that is you) through dividend payments. Having said that, there are some companies who are not making any dividend payments but instead are using the profits to re-invest and grow the company. Depending on whether you want a solid income stream or growth from a share, you will have to make your choice.

The former group of shares is often classified as income shares, because they provide guaranteed income on a (semi-)annual basis. These companies are usually large firms whose demand doesn’t depend on economic conditions (utilities or pharmaceuticals come to mind) and you thus distribute their cash reserves to the shareholders. Likewise, these companies usually have a phenomenal market capitalisation (= share price x number of shares), which means that buy and sell transaction don’t affect the share price as much (Microsoft currently has a market cap of $280 billion). This however also implies that the share won’t grow as fast as a smaller share could. In short: the dividend payments are intended to make up for the lack of growth that can be expected.

Therefore, many of the companies classified as growth shares won’t belong to the category of dividend-paying companies (as with everything this is not a black-and-white decision - dividend policies can change and growth shares can also pay the odd dividend, but I’m talking stereotypes here…). These companies usually belong to more volatile market sectors (media, technology) and use all profits that are left over (after interest payments and tax) to fund further investments and thus grow the company. This will (hopefully) be reflected in future income statements (i.e. future profits) which in turn will help convince further investors to join the group of shareholders. Because these companies are usually smaller than income companies they are subject to greater share price movements - and as long as those are in the “right” direction, investors will make money through the increase in value of their shares.

Both income and growth shares belong to the category of common stock, which means that you invest in the ownership (equity) of a company and are allowed to vote for the board of directors every year - who are supposed to represent and act in the shareholders’ best interests. This, however, also means that in case of bankruptcy your claims towards the liquidated assets of the company are subordinated to preferred stockholders.

Owners of preferred stock are owning a part of the company in the same way that owners of common stock do, but with the major difference that dividends paid to preferred stockholders are usually fixed and paid out before the dividends to common stockholders whose dividends are variable (if paid at all). While this promises greater security, the old trade-off kicks in that determines “where there’s lower risk there must be lower return”: preferred stockholders don’t benefit from any growth in profits in much the same way as they don’t lose when profits plummet (as long as the company remains profitable - if it doesn’t, dividends are usually accumulated over time and paid as soon as profits allow).

This was surely a fairly lengthy introduction to the concepts, but I hope it was nevertheless helpful. If you want to read even more about shares and share categories now, I recommend you start here and here.

Read part 2 of “Investment Choices” on exchange traded funds >>

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