Investing can appear to be a daunting challenge. But the underlying principles are very simple: buy an asset that other people need and hold onto it. It could pay you dividends (literally and metaphorically) in the years to come.

Nothing stirs more controversy in the investment world than real estate. On the one hand, it is a physical immovable asset many financial investors struggle to comprehend. On the other hand, it is intricately linked to financial assets and shares many similar features. What is an indisputable fact is that it has given birth to more billionaires (and millionaires) than any other sector.

Here we will look at the “how to” factor in real estate investment.

Why invest in real estate?

Real estate is either land or a building(s) alongside and any natural resources found there. They are physically tangible assets with inherent utility (and hence value). More importantly, land (especially residential land) has always been a scarce commodity and will become ever more valuable as urbanisation continues.

Real estate generates return in 2 forms: income (from rent) and capital appreciation (from the increase in value of the underlying asset).

A key differentiator between real estate and most financial investment instruments is the ability to leverage during the purchase. As a result, investor returns (both income and capital) can be significantly magnified, leading to exceptionally high ROI if timed correctly.

Why choose Switzerland?

Wedged between France, Germany and Italy, the Alpine nation of Switzerland is a country many have considered to be a safe haven for centuries. It is easy to see why when one considers the advantages:

• Political stability due to declared neutrality

• Peaceful existence as a sovereign nation

• Economic stability based on a developed economic model and prudent monetary/fiscal policies

• A highly sophisticated financial sector

• Advanced HDI (2nd in the world) and high standard of living

• Low correlation with the global financial market, as illustrated in Figure 1.

• A deep and special relationship with the EU and a member of the Schengen Zone

Figure 1. The CH market has shown little correlation with the global RE market during the Great Recession.

Types of real estate

Real estate encompasses a broad category of assets with myriad sub-categories and RE-derived investment products:

• Residential
  • Apartment
  • Houses
  • Holiday homes
  • Undeveloped land
• Commercial
  • Office space
  • Warehouse
  • Retail stores
  • Mixed-use spaces
• Agricultural
  • Grazing land for livestock
  • Crop land

For most of this guide, we will be talking about residential properties as an investment asset because they are most abundant, accessible and require the least specialist knowledge.

Average returns of different types of underlying properties in Switzerland

* The numbers assume no bank leverage applied

What are the key levers in real state investments?

Broadly speaking rental and property prices are dependent on two main factors: demand and supply. Put simply, if the demand for properties exceeds supply then prices will rise. If the market is flooded with unoccupied houses then prices will drop.

The supply of property is relatively fixed in the short-term (houses cannot be built overnight). In the long-term, supply is also much less elastic than demand due to zoning laws and the overall land availability. As a result, we will focus on the demand side.

Key factors influencing demand for properties:

• Population demographics: the greater the population, the higher the demand for housing (everyone needs a roof over their heads)

• Economic growth: the higher the growth, the more disposable income citizens have to play with

• Foreign direct investment (FDI): as the economy improves, its attractiveness as an investment destination not only rises in the domestic market but also to international investors. As a result, foreign capital will increase and distort the demand of the local market.

• Tourism: this is an indirect derivative of FDI. As the economy matures, it becomes increasingly attractive to visitors, who also need temporary accommodations. This adds an additional layer of demand on the market.

• Interest rate: this affects demand for housing in 2 ways. Firstly if the rate is lowered, then it makes bank deposits (the safest form of investment) less appealing. As a result, investors may deploy the cash elsewhere, channeling part of it into the housing market. Secondly, low rates lowers the cost of borrowing. As property is a leverageable asset, it means mortgage is cheaper to both prospective homeowners and investors alike, thereby increasing demand.

The different ways to invest in Swiss residential properties

Now that you are familiar with the key drivers of property prices, you may be rightly wondering: how do I gain exposure?

There are multiple ways to invest in RE, which coalesce around 2 themes: direct and indirect investment. Below is an overview.

* depends on what fraction of the asset you own

Direct investments

Evidently there are a wide array of investment options available . To determine the optimal way to invest in Switzerland there are a number of vital decisions to be made first:

Determine your objective

This is the most important question and it will cascade to all the subsequent decisions that you’ll subsequently be making: what is your aim with the investment?

There are usually 3 drivers: security of capital, appreciation of capital and the quality of income streams. They interconnect and mutually affect each other so that the increase in one will cause a deficiency in another.

For example, if you are seeking the safety of your capital, you will want to be investing in central locations where demand is high. However you’ll be in competition with many other buyers, leading to higher purchase price. As a result, the rental yield will fall.

You might wish to finance the purchase using debt, however this increases your leverage and could magnify your losses (and return, more on it later).

On the other hand, yield-hungry investors will be more willing to venture out into non-central locations and perhaps even commercial spaces which inherently possess higher yields.

Finding a balance of these 3 factors that suits your aims and financial position is a sensible first step in establishing what kind of asset suits your investment. Since it will drive most of your subsequent decisions, take your time and think it through.

Decide who will manage it

Real estate needs careful management, as it doesn’t bring returns unless it has rent-paying tenants. On top of that, real estate is a physical asset and is vulnerable to damage.

There are 2 main ways to manage properties: self-management or 3rd-party management.

Self-management is an easy and cost-effective solution as the main cost is your time. It is however impractical if you are not based close to your properties. In this case, hiring a professional 3rd-party agent might be the best option. They handle most of the daily tenancy operations, rent collection and maintenance. You should budget between 10-15% of your gross rent on agency costs.

One way to reduce management cost is to pool resources and use fractional ownership, as explained later on.

Select the asset type

Different real estate assets have vastly different return profiles. For example, most residential properties can be easily managed by the investors themselves or generic estate agents with minimal difficulties.  The low technical entry barrier inevitably increases the supplier and thus dents the yield. On the other hand, commercial properties (e.g. office space, industrial warehouses) have relatively high yield (up to 8% in most cases). Yet they require specialist management and have higher entry price tag. It makes them far less accessible and appealing to retail investors.

As a result, most references here will refer exclusively to residential properties. More specifically, given the majority of the Swiss population dwell in single or multi-family apartments, we will use these properties as the foundation. This is because by conforming to the norm, you are maximising the accessibility of the property. This reduces tenancy void periods and increase sales liquidity.

Fractional Ownership

To those who may not have the capital (or who do not feel comfortable committing large amount in one go), fractional ownership offers the ideal combination of low barrier to entry, minimal hassle and yet offering market-leading returns.

It’s a type of investment that lets you use the advantages of real estate investing without having the risks attached to managing the real estate property. This is achieved by owning a share of a property (very much like being a shareholder in a company) and letting a professional team to manage it.

Recently, a Swiss prime hotel chain, Le Bijou, pioneered a new form of fractional investing in the hospitality industry.

Typical hotel business consists of two “fractions”:

• the business of hotel operations (high value-added activity, high margin, high returns)

• real estate ownership business (low value-added activity, low margin, low returns)

So far, when investing in a hotel, an investor was forced to own both fractions. It didn’t matter if he wanted to have the exposure to the less profitable real estate ownership fraction and the related risks – there was no other option.

Le Bijou revolutionized the investment model in the hospitality business. It offers an opportunity to invest discreetly in the hotel unit setup (the franchise, interior design, and renovation, Uber-like service system, marketing) without the need to also invest in the actual apartment where the hotel unit is set up.

Thus, investors can benefit discreetly from the highly profitable fraction of the business: hotel unit operations, without locking down their capital in something that yields a much lower interest rate: ownership of the building where the unit is set up (low value-added activity).

This has transformed a traditionally capital-intensive sector into a capital-light and high-margin business, returning 14% yield to investors in the past year.

Select your location

You might have heard, a property is all about its location, location, location. A house/apartment that is close to the central business district, near convenient social amenities (e.g. nice restaurants, schools, transport hubs) and which has low crime rates will obviously be more desirable and hence more valuable than one that isn’t.

The thinking behind the real estate mantra about location is very simple:

• Humans need to work, eat, be educated and be entertained in a safe and nice environment.

• People want to achieve all of the above with minimal effort.

As a result, a property that ticks all the boxes must have the perfect location. Unfortunately most properties don’t and therefore investors need to compromise and pick what is important to them.

This circles back to the original objective of the investor. If you are buying it as your holiday home, that will also hold value over time, a residence in a resort town could prove to be a sensible choice.

If however you want your to be occupied consistently, then you need to move closer to cities and ideally buy apartments (renters rarely want to take care of outdoor spaces). Amongst renters, single professionals want to be as close to the city centre as possible whereas families are more likely to seek a quiet suburb with good transport links and easy access to schools and natural outdoor spaces like parks.

Study the area where your property will be and establish what greatest demand of the local market is.  Then, if you establish that there is a demand for properties that suit families, put yourself in their shoes. What would attract them to your property?

Are you willing to leverage?

There is an eternal debate amongst investors on the merits of leverage (using mortgage to partially fund a purchase).

Proponents believe that mortgages facilitate property ownership and can vastly improve the return on capital (you are using less than 100% capital to capture 100% of the gains) and enable you to diversify your portfolio base. Opponents argue that the opposite is also true where any losses are equally magnified.

The frustrating fact is that both sides are right!

Ultimately the decision comes down to the type of investor you are and what your risk appetite is. If you want to sleep absolutely soundly at night even when the world financial system is melting down then by all means, complete the transaction using 100% equity, if you can afford it.

However, if you want to achieve a slightly higher return, then there is no harm in introducing a small amount of mortgage into the purchase. Remember, each additional $1 of mortgage is another dollar you could invest elsewhere.

The key is to leverage in moderation. Financial leverage is just like a mechanical one. Too much stress would cause the pivot to snap. There are 2 critical ratios you need to be aware of:

1. Loan-to-value (LTV): this dictated the % of the asset value is made up of debt (rather than equity). The lower the number, the greater proportion of the asset you own, the lower the risk for banks and the better the interest rate you will receive.

2. Monthly payment: this is the amount of principal and interest you need to return to your lender each month. Since this will come out of the rent, it is obvious to state that this number should be less than your actual rent. In fact, it is advisable for the monthly mortgage payment to be no more than 50% of your total rent.

Choose your investment vehicle

Will you hold the investment under your personal name, your spouse or a non-natural person (e.g. a company or trust)? This may sound like a trivial legal formality but it has serious ramifications later down the line.

Many countries have restrictions against non-citizen investors in RE which range from additional bureaucracy, more taxation to any out-right prohibition. This could sometimes be partially mitigated by using a company registered in the host country. Yet this brings its own challenges in that mortgage lending may be difficult or expensive to obtain, not to mention the additional annual reporting requirements.

It is therefore advisable to seek appropriate legal advice before putting a name on the title deeds.

Wait and be patient

There are thousands of RE investment opportunities out there (after all nobody will refuse money). Yet finding the right one appropriate for your own circumstances may be less straightforward. Seeking the right opportunity is a lot like hunting, where you need a tremendous amount of work to prepare yourself (e.g. listing down your requirements, arranging finance, setting up legal bodies etc) in order to be ready to pull the trigger when the opportune moment arrives.

Remember, the right opportunity doesn’t present itself all too often so you need to be as ready as you can to take full advantage of them when they appear.

Indirect investments

Indirect investments is where you do not directly become the owner of the property, but instead, you become a shareholder in a company (a special purpose vehicle, SPV) which in turn owns the company on your behalf. This is a common method to pool capital together from various investors and complete a larger transaction. It allows investors to obtain institutional-level management and performance without needing to amass significant capital.

Below is a comparative overview of the key indirect investment avenues in Switzerland:

How to invest in Switzerland if you are a foreigner?

Switzerland has strict rules when it comes to foreign investments in real estate.

According to Expatica, you can purchase a property if :

• You are an EU or EFTA national with a Swiss residence permit who resides in Switzerland

• You hold a Swiss C Permit

• If you hold a Swiss B Permit, you may also purchase a property, but only to live in, not as an investment

Licensing criteria are different from canton to canton, but the preference is given to applicants looking to purchase a primary residence.

In conclusion

Switzerland offers a tremendous range of investment opportunities with a hugely diverse RE market. Its economic stability coupled with the well-developed financial system means investors will never be short of options when it comes to properties. Take your time, do your research, get a feel of the environment and you will be richly rewarded.

So you’ve finally made it: the big, fat seven-figure bank account. 1M! For those who have the privilege of seeing that balance in their account, the thrill is both exhilarating and scary. On the one hand, you are happy to be admitted to the world’s 0.6% club. On the other hand, you are now preoccupied with maintaining and growing your wealth. Understandably, managing 1 million (CHF, EUR or USD) is vastly different from managing 100K.

In this article, you will learn how to manage your 1,000,000 (CHF/EUR/USD) from someone who has had years of experience managing and growing a successful multi-million dollar personal portfolio.

See also:

• Investing 100K: Key principles, opportunities and risks overview
• Investing 200K: How to find satisfactory returns
• Low-risk investments in Switzerland: How to get above-zero returns

The philosophy of wealth

It is important to take a step back and understand what wealth is and what its limitations are.

First of all, wealth cannot buy you time or health (some may even include happiness in this bracket). These are intrinsic to the laws of physics that govern our world. No amount of money, stocks or properties can change this fact.

That being said, wealth is an important facilitator in your life. It allows you to accomplish your objectives with ease and minimal frustration, thus increasing your pleasure. It is also an enabler of interpersonal interaction which enhances your personal well-being.

When viewing wealth as a facilitator (rather than the end goal), the natural question is, “what is the end goal?” Unfortunately, there is no universal answer to this – it is as personal to every individual as a fingerprint. However, by understanding your end goal, you can better appreciate your investment objectives and thereby deploy your capital strategically.

The 4 principles of investing globally and in Switzerland

Books weighing as much as bricks have been written on this subject. There is much technical and academic literature out there, each one fiercely disagreeing with the other. We have distilled them into 4 easy-to-remember principles that are relevant across any investment scenario.

1. Don’t lose money: this is the Number 1 Rule for Warren Buffett and it’s something I hold dearly. Never invest in a venture that has a high risk of permanent capital loss. This refers to projects (or companies) with underlying structural defects that could put them out of business one day, rather than just causing temporary fluctuations in valuation. After all, any percentage gain can be temporary whereas a 100% loss is permanent.

2. Don’t forget Rule #1: the idea of never losing money is so important that it’s worth reinforcing it with a rule of its own. 

3. Slow and steady wins the day: here’s a brain teaser. Which investment will yield a greater return: 5% for 10 years, or 10% for 10 years but with a 35% market fall in the middle? Yes, you’ve guessed it correctly, a steady 5% return year on year triumphs. This is a simple mathematical reality: percentage gains and losses are not created equal. A 50% loss will require a 100% gain to return to break even. Always remember that.

4. Self-edification is the only way to survive and thrive: there might be more than a few individuals and firms out there willing to help you “manage” your wealth. The truth, however, is that nobody will place your interests closer to heart more than you will. As a result, it’s vital to educate yourself about investing so that even when you do end up entrusting your capital to a professional, you still have the know-how to keep them on their best behaviour.

The wealth playbook: How to invest 1M

Now that you are well versed with the principles of investing, it’s time to put them into practice. This playbook section will teach you how.

Purpose & Goals

It might sound cliché, but investing without a goal in mind is like sailing to an unknown destination. You won’t know when or if you’ve reached your goal. Consequently, it’s important to know what you want your portfolio to become in the future.

At the most basic level, there are 2 key functions of a portfolio:

1. To generate a sustainable and rising level of income -> this is ideal if you want to live off the passive income stream and achieve financial independence. At the 1 million level, with a 5% yield, you’ll be looking at 50K of income every year, which can propel you towards financial independence.

2. To achieve real growth in the capital value of the portfolio -> this is usually for creating a sizable lump sum for a specific future endeavour (e.g. house purchase, education).

Depending on which goal you pursue, there will be different asset allocation implications. For example, income-focused investors would allocate greater capital to income-generating assets (fixed income, dividend stocks), whereas growth-minded investors would invest in high-potential growth stocks.

Establish your time horizon

Do you want to achieve your goal in 5, 10, 20 or just 2 years? Your time horizon is critical in deciding your asset selection. Generally, the faster you want to achieve a certain goal, the greater the return needs to be and hence the higher the risk. As a result, your time horizon is directly linked to the risk you need to take on.

A good benchmark would be the long-term average return of the Swiss Market Index, which has delivered 5.82% Average Annual Total Return for the past 30 years. At this rate, your portfolio should double in value every 12 years.

The general advice at the 1M level is to just let the portfolio grow by itself, and to interfere as little as possible. This way, you can enjoy the full effect of compound growth and let time do all the hard work.

Choose the right portfolio structure

Should you invest in a tax-advantaged account, via your pension or a general investment account? These might sound trivial, but they make a real and significant difference to portfolio performance, because each will have different tax implications.

There are various tax shelter accounts (Pillar 2 and 3 accounts in Switzerland) set up by governments to encourage people to save and invest. They either have no or deferred tax liability, which will enable your portfolio to grow in a tax-free manner in the interim. Use them!

Still oblivious to the effect of taxation on your portfolio? It has been documented that even an additional 1% fee can exert a detrimental drag on long-term portfolio performance. Imagine the effect of a 25% capital gains tax!

Taxes are real expenses that act as drag on your portfolio. Having the right structure will enable your capital to grow in the most tax-efficient manner, allowing you to enjoy the maximum effect of compounding. Even a 1% saving can have a tremendous long-term effect as illustrated above, so choose wisely.

Don’t put all your eggs in one basket

The old saying “never put all your eggs in one basket” remains the key commandment in the investing world, even when investing in Swiss Francs, considered one of the world’s most stable currencies.

Diversification simply means having a selection of assets with uncorrelated risk-reward profiles. For example, adding some gold into an equity-only profile means that when equity takes a bashing, the gold should increase in value (due to its haven asset status). Research indicates that if you place 20 completely uncorrelated assets in a portfolio, then there’s little risk of long-term value erosion, because losses in one would be more than made up by gains in others.

Equally, diversification means constructing a portfolio that is wide-reaching. You may know the local Swiss market inside out, however, it will not help you if EU-Swiss relations break down and all of your assets remain in Switzerland. By investing in assets across the world, you can mitigate the risk of a specific geography.

Here are 3 easy ways to diversify your asset allocation and geography:

1. Use a multi-manager multi-asset class fund.

2. Purchase a selection of geographical and asset class specific ETFs.

3. Buy an international index fund (e.g. FTSE World Index).

Diversification reduces portfolio volatility and is essential for long-term growth.

A side effect of diversification is portfolio rebalancing. Due to constant changes in the underlying valuation of assets in a portfolio, the optimal asset allocation can never be maintained in the long-term. It is therefore important to periodically adjust (through buying and selling) to return to that optimal allocation. Due to the effort and fees that may involve, it is recommended to rebalance no more than twice a year.

Beware of fees & Costs

We saw the detrimental effect of fees on the long-term performance of a portfolio earlier: a 0.75% fee will reduce the terminal portfolio value by 17% at the end of a 20-year period. 

It goes without saying that any measures to minimise fees should be considered. Here are 3 easy-to-remember techniques:

• Use a fixed-fee platform rather than one based on the percentage of the net asset value.

• Use low-cost index funds (fees levied at no more than 0.25% per year) unless the active manager has demonstrated long-term outperformance. Remember, even that can turn sour very quickly as illustrated by Neil Woodford this year.

• Don’t overtrade – once you have invested (presumably using dollar-average), simply fire-and-forget and let the market do all the hard work.

Advisors, wealth managers or DIY?

Once you have reached the 1,000,000 mark, there will be no shortage of experts wanting a slice of your time to advise or manage your wealth. After all, money has the magnetic characteristic of attracting more money.

At some point, you will need to make a decision about the way your portfolio is managed. There are 3 main ways:

1. DIY

2. Wealth manager

3. Advisor

DIY is simple and free. You make all the investment decisions yourself and then execute. Technology has made trading so much easier that private investors today can access professional-level trading tools at a cost slightly more expensive than their morning coffee. The upside is that it is free and you will always have your own best interests at heart. However, you need to have a good understanding of the market as well as a level head, and you’ll need to devote time to your portfolio. In my opinion, it is the best portfolio management technique because nobody will place a greater interest in you than yourself.

Wealth managers, on the other hand, take over your portfolio and make all investment and trading decisions on your behalf. The upside of this arrangement is that it frees up your time and injects professional expertise into portfolio management. However, this can be an expensive approach (fees start at 1% per year) and their core incentive is really revenue maximisation for themselves rather than seeking the best performance for you.

Advisors sit somewhere in between DIY and wealth managers. They provide professional expertise to advise investors on where and how to make investments. However, the ultimate trading authority lies in the hands of investors, who can accept or disregard such advice. Advisors can be informal in the form of friends, or formal financial advisors regulated by the relevant authorities. Formal advice usually costs $200-$500 per hour. 

Always keep some powder dry

There are many qualities of Warren Buffett that contribute to his financial success. First and foremost, it is his patience and willingness to hold large amounts of cash for an extended period of time. Cash is what is known as “dry powder” in investing, because it allows you to put it to use (or “fire it”) when you need to.

Having some spare cash in your portfolio is always good because the nominal value of cash does not change and therefore it acts as a natural hedge that reduces volatility. However, the real advantage of cash comes into play during economic downturns when market fear irrationally depresses the valuation of sound and well-run businesses to below their intrinsic value. At that point, you could purchase these wonderful businesses cheaply, thereby increasing your margin of safety (and hence return). Buffett really understood the importance of this point and that’s why he aggressively bought into Goldman Sachs and Bank of America in late 2008.

Keep some powder dry as you might need it quickly (and it’s better to have it than not)!

Trust yourself & Shut out the noise

There is never a shortage of people who seek to project their opinion as loudly as possible. Unfortunately, in the digitally connected world we live in today, these opinions travel way faster than they need to, filling the time that people need to think for themselves.

My advice is to remove these distractions from your life, deploy what you have learnt about investing and listen to yourself. You understand your own circumstances better than anybody else and if that means running against the herd then do it. After all, nobody has ever lost money by not jumping onto the latest bandwagon.

Investment opportunities to consider

Now that we have a good understanding of the principles and practicalities of investing, we will look at the options available to ensure that 1M works as hard for you as it possibly can.

Here is an overview of the asset classes available to investors and their various properties.

Conclusion

1 million is a significant amount of capital, which, if invested wisely with the right objectives and time horizon, can deliver serious returns and propel you towards financial independence. As a summary, we will leave you with 3 principles that we hold dear:

• Simplicity over complexity
• Time is your best friend
• Fees kill returns

Happy investing!

“It wasn’t raining when Noah built the ark”
– Howard Ruff

We’ve been in the longest bull market in recent history with ten consecutive years of stock market growth under our belt. Since 2008, a vast number of millennial have also entered the workforce and a sizeable of them became investors themselves. We are talking about a whole generation of people who are in the market and yet have never personally experienced a market downturn. It is therefore very easy to be complacent and extrapolate the wonderful performance of the past decade infinitely into the future.

However, history tells us that market cycles are repeating themselves. External circumstances may change and yet excess greed and fear remain constant, giving rise booms and busts. It is dangerous to make linear extrapolation using past performance and expect it to continue indefinitely.

We are at a stage where “peak valuation” is in sight. What often follows is either a soft (correction) or hard (crash) landing. But a landing nevertheless. It is therefore important to take measures and actively protect your portfolio no matter what the outcome is in the next 24 months.

In this post, we will walk through:

1. Why do crises happen?
2. Evidence that the next one is imminent
3. Which assets are most at-risk?
4. What can you do to mitigate the risk?

Note: We will be mainly referring to the US and UK markets in this article as they are the major market-drivers. The Dollar is also the main international currency.

Why do crises happen?

Recessions have been making regular appearances in our economic history for a variety of reasons (e.g. economic mismanagement, wars, diseases, human greed). For the past 120 years and with the exception of the two world wars, recessions in developed economies tend to be the byproduct of the boom-bust cycle, often fuelled by easy access to capital.

The most recent downturn (the 2007-09 Great Recession) was a classic example of the credit-fuelled cycle:

• After the Dot Com Bubble, credit became readily available, reaching a peak in 2006 with subprime mortgage lending occupying 20% of total mortgage underwritten;
• Asset prices (US property price specifically but financial assets in general) became increasingly inflated and often exceeding their intrinsic value;
• This was followed by other investors entering the market in the hope of making greater returns (herd mentality), further pushing up asset price;
• When subprime borrowers started to default on their mortgages en mass, as the teaser rates expired and the monthly repayment became unaffordable;
• Lenders were suddenly faced with a book of bad loans, which led them to do 2 things:
  • Repossess these properties en mass: this led to a sudden increase in property supply without matching demand, cause a drastic fall in the US property price;
  • Tighten lending criteria across the board: often indiscriminately, which starved companies off capital and suffocating growth
• The economic outlook suddenly became less positive than before, which caused investors to revalue their investment and started selling their holdings;
• As selling continued, it became a self-fulfilling prophecy (due to herd mentality) and snowballed into a financial market crash.

In the aftermath of the Great Recession, the 3 most important central banks in the world (Federal Reserves, Bank of England, European Central Bank) deployed 2 key tools to stimulate the stalling economic growth:

1. Quantitative easing (QE): the creation of “cash” by central banks to purchase financial assets, increasing their price levels and maintain market confidence
2. Slashing interest rates: this lowered the cost of borrowing to encourage investors to take out debt capital and put them into productive use

How QE interacts with interest rates to stimulate growth? Source: BBC

The evidence: why the next financial crisis may be around the corner?

These 2 policies significantly increased the total liquidity in what was previously a stalling market. They were unarguably instrumental in the rapid economic recovery that followed suit. However, both instruments also led to a rapid increase (or recovery) in asset price across the spectrum because:

• Significant demand-side pressure through QE
• Negligible cost of borrowing (real interest rate was negative when compared to inflation in most developed markets), which further fuelled appetite for asset acquisition and exerted demand side pressure

As a result of over a decade of QE and low rates, most stock indices in developed markets have seen a rapid increase in valuation. This resulted in these assets being in a state of full price: intrinsic value plus market premium.

• S&P500 index gained 260% between January 2009 and January 2019;
• The Central London Property Index increased by over 100% between the trough in December 2008 and December 2017;
• The Swiss Private Property Index displayed a steady performance between December 2008 and December 2016, increasing by 40%.

The sustainability of such valuation relies on the presence of 2 premises:

1. An abundance of liquidity in the market (either through QE or low rate)
2. Continued growth expectations

However recently there are signs that both factors are waning in today’s market, making the stock market valuation increasingly perilous.

The two factors that will lead to the financial downturn in 2020

There are 2 streams of headwind facing most developed economies, which are threatening the growth that we’ve enjoyed in the past decade:

a) End of QE and rising interest rates
b) Inequality and the rise of social-political instability

Let’s explore these two points in-depth.

a) Rising interest rates and the eventual reversion to the mean in asset prices

At a simplistic level, when the debt/GDP ratio exceeds a certain point (between 100-200% depending on the country, the governor of the central bank and the macroeconomic climate), central banks tend to start tightening monetary policies in the form of raising the base interest rate. They will also start to impose stricter criteria on bank lending (e.g. which sector, what LTV ratio, etc), usually in the form of more stringent stress tests.

There are 4 key rationales behind tightening monetary policies:

1. Central banks aim to keep inflation low: when economic growth gathers momentum, price level tends to increase, which leads to inflation. The base interest rate becomes the primary regulator as it cools down economic growth and central banks will have to bring it up in order to manage inflation.
2. Controlled deleveraging: when the total debt within an economy exceeds a certain threshold, a large amount of the GDP will go towards interest payment, which is not the most productive use of capital. When companies pay an increasingly large amount of their profit to debt interests, it means lost investment in their employees (through training or better remuneration, which can be ultimately consumed to enhance growth) and lower tax revenue. Both are bad for economic growth.
3. Central banks want to create an environment for greater capital allocation efficiency: linked to #2, a blanket low rate across all borrowing may not be channelling capital into the most productive sector, therefore by imposing more stringent/selective lending criteria, central banks can attempt to direct capital into the desired sectors.
4. Central banks want to decelerate growth to prevent huge overheating, what will lead to even worse crises: investors believe that markets get nervous when the debt-to-GDP ratio exceeds a certain threshold and will automatically push up the cost of borrowing for governments, therefore central bankers would like to proactively decelerate growth to prevent overheating and enhance confidence.

The interest rate has historically moved in line with the debt-to-GDP ratio until recently
Source: ResearchGate

The overall effect is that at debt capital will become more expensive and difficult to access. The immediate impact would be a decrease in demand for financial and real assets, leading to a drop in their prices. If this is mishandled, it can lead to a vicious cycle where:

1. Asset price decreases, leading to a drop in valuation;
2. Debt-to-equity ceiling becomes breached, leading to less credit being available;
3. Investment falls and income (profit) drops;
4. Business becomes less valuable due to lower profitability, leading to a further drop in valuation;
5. When magnified across the entire economy, growth stalls.

b) Inequality and the rise of social-political instability lead to the rise of populism and eventually to a greater economic downfall

The rapid asset price appreciation as a result of central bank policies had the unintended consequence of exacerbating economic inequality across developed economies. Three pillars contributed equally to this:

• Increased asset price (induced by these policies) benefitted people with assets -> this meant the wealth gap between those with assets and those without were widened;
• Increased asset price also made assets less affordable, thereby decreasing the probability of people without assets of ever acquiring them -> people already with assets could acquire them and end up with more assets -> wealth gap further widened;
• Interest rate cut makes the cost of asset acquisition much lower than before. Borrowing at low rates became only accessible to people who already possessed assets.

So the poor become poorer, while the rich (who owned assets that went up) become richer.

“We have to be concerned about the wealth gap and the consequences geopolitically”, Ray Dalio

The link between rising inequality, growing social cohesion and by extension, political instability has been well-documented. Inequality fuels populism as we have seen with Brexit, the election of Trump, Salvini and the rise of AfD in Germany. Populist policies had historically been a headwind to long-term economic growth and therefore this decreases investors’ confidence in the future prospect of the global economy.

What will happen to your portfolio when the next tsunami hits?

Let’s assume that you find yourself in the midst of the next market downturn. What’s going to happen? What does it feel like? How will you react?

Let’s consider a hypothetical chain of events that might unfold in the foreseeable future:

• After 2 years of chaotic negotiation, the UK crashed out of the EU without a withdrawal agreement, sending its entire economy into uncharted waters.
• Sterling hit a 30-year low against dollars.
• Protests in the street led to the resignation of Prime Minister May and a general election was held, leading to Jeremy Corbyn, a staunch socialist, being elected.
• Business confidence plummeted as a result and corporate investment fell.
• Amidst the chaotic political scene, much of the EU derivative contracts underwritten in London became legally unenforceable, causing massive losses to holders.
• Market confidence plunged and the FTSE 100 was is down by 15% at the end of the week and 30% by month.
• The UK economy suffered a sudden slowdown and was manifested across the EU due to the strong trading relationship historically.
• The slowdown in the EU, in turn, spread across its own trading partners around the globe.
• Investors began to cast doubt about the health of the global economy and major indices suffer dramatic falls and are down by 25% by the end of the month.

In this hypothetical case, here is the potential impact to your $100,000 portfolio, which is made of geographically and sectorally diversified ETFs, comprised of the classic 60-40 equity and bond combination:

• The equity portion of your portfolio will drop by 25% from $60,000 to $45,000;
• The bond portion will more resilient but can still drop by 15% from $34,000;
• As a result, your portfolio will now be worth $79,000, suffering a 21% depreciation
• Corporate earnings may be slashed during a downturn, directly impacting dividend payout. It is entirely feasible to see a more than 15% drop in the dividend growth rate.

These are real and nominal losses in income and valuation respectively, which can affect investor psychology profoundly and cause them to panic sell, that in turn, exacerbate the drop in the market.

What can you do to insulate your portfolio now?

The easiest way to preserve your portfolio value during a downturn is to diversify your risk concentration before the market fully appreciates the risk.

Looking across the risk spectrum, in an ideal world, we need an asset that fulfills the following 2 criteria:

• Located in a jurisdiction with high political, economic and legal stability as well as a favourable business environment. These factors are important for value preservation;
• Capable of stable and increasing income generation, which will enable value enhancement.

Swiss real estate immediately springs to mind.

As a nation, Switzerland is blessed with some advantageous characteristics:

• It is a small, stable and neutral country;
• It hosts a highly advanced economy;
• As a nation that enjoys strong bilateral ties with the EU and accepts freedom of movement, it is enjoying above-average population growth;
• Total tourist arrival per year has been increasing consistently at 3% per year, even during the Great Recession.
• The supply of properties is relatively inelastic (limited stock availability), therefore the average nightly rate will increase when faced with rising demand, enabling increasing income potential.

The Swiss property market has historically enjoyed balanced growth. Lately, it has seen a more aggressive trajectory due to the factors outlined above. Equally due to the strong demand-side support, the property price has remained stable, even during the Great Recession, which makes it an attractive hedge against market volatility elsewhere.

Looking at the historical performance data, the return and volatility of a mixed-class portfolio (with cash, equity, and bond) with or without a Swiss real estate component differ significantly. What it emphasizes is the hedging role the property plays in the portfolio: it reduces the amount of risk for a given level of return (the flip side of the coin is that it enhances the return at a given risk level). This is because research has demonstrated that Swiss real estates show little correlation (0.1) with other major assets, making it an ideal risk hedge. It also means that in the event of major market price movement, the value of your portfolio will remain relatively constant due to the value-preservation nature of holding Swiss real estate.

How do I get exposure to the Swiss property market?

There are a few different approaches and the exact methodology depends on investors’ personal preference and circumstances.

Conclusion

We have enjoyed been enjoying a decade of extraordinary returns on the financial market. Such a long period of stability can often cloud our judgement and make us believe that this is the norm. Yet history tells us that this is far from the truth. The financial market is volatile and there are warning signs across the spectrum that a downturn might be around the corner. Fortunately, there are numerous options available to investors in today’s market to facilitate risk reduction whilst enjoying balanced return on their capital.

Source: the article was originally published at Starwerk.ch

You’ve done the hard work and built up a sizeable portfolio. Now, where should you invest your hard-earned cash so it keeps working hard for you?

One of the perpetual problems facing investors today is the ability to find assets with decent risk-adjusted returns without exposing yourself to the risk of permanent capital loss. The smaller is the portfolio, the harder is it to achieve reasonable returns with acceptable risk.

At this range, the amount of investable capital is significant enough to hurt investors in the event of a loss. The capital is likely to be the result of years of saving and frugal living. However, at this level, the cost of seeking professional investment advice can appear exorbitant (up to 3% of the total portfolio level). Investors are essentially stuck.

See also:

• Investing 1M: Key principles, opportunities and risks overview
• Investing 200K: How to find satisfactory returns
• Low-risk investments in Switzerland: How to get above-zero returns

Low-risk investing in Switzerland is difficult

It is worth going back to square one and to consider the purpose of investment: investing is to maximize real return whilst minimizing the chance of permanent capital loss.

Real returns mean that the financial gains derived from the asset (in the form of income yield and capital appreciation) must exceed the rate of inflation. This will lead to an enhancement in purchasing power.

Permanent capital loss is usually a result of failing to account for the risk of a particular asset, thus leading to the inability to recoup the initial capital outlay within a reasonable timeframe.

I have a rather extreme personal example.

Three years ago, I invested some spare cash into a startup company which promised to revolutionise the realty agency model. Looking at industry comparables, if it could achieve half of the scale its transatlantic competitor did then it would have delivered a 15x return on my capital.

Unfortunately, things didn’t quite work out that way. A few days ago, I received an email from the management informing me that the company had entered into administrations and it’s unlikely that investors would be able to recoup any of its investment.

Thankfully I only put in some pocket money so no hard feelings. However, this is a clear illustration of the return-capital loss paradox. Whilst the upside of this asset may be huge, it is underpinned by 2 critical risk factors:

• Capital risk: the asset in question was equity (shares) in a startup company. In the event of bankruptcy (whose probability is quite high), shareholders are last in line to receive a payout, if any.
• Liquidity risk: the shares in the company are not publicly traded. As a result, it is incredibly difficult to turn it into cash within a short time without suffering a significant loss of value, because not many people have the skills to value, let alone the risk appetite to purchase.

Investors today are confounded with these 2 critical risks. Additionally, not many possess the know-how to accurately gauge the risk-return trade-off. Consequently, this often led to poor investment decisions being made, based on gut instinct and information asymmetry.

Low-risk investment options overview

Suppose you have a 50,000 EUR/CHF/USD cash portfolio, saved over from many years. What are your realistic asset choices for investment?

There are 3 broad asset classes available today:

• Cash
• Bond
• Equity

Risk reward ratio across different asset classes

Comparison of different asset classes by returns and risks

As the above chart illustrates, cash and cash-like assets tend to have low return coupled with fewer risks and higher liquidity. On the other end of the spectrum, equities have high growth rate and above-inflation dividend yield. However this is counterbalanced by increased volatility and risk of capital loss.

Bonds, however, combine the above-cash return with a much lower risk profile. This makes bonds an ideal middle ground for investors with low risk appetite.

Real estate bonds become attractive under the current climate

Bond is derived from the English word “to bind”, which creates a binding instrument for one party to pay another. In the modern financial world, a bond represents an obligation for the borrower to pay the lender under terms stipulated on the bond instrument.

Here are some of the key characteristics of modern bonds:

• They do not represent ownership, but merely for the borrower to pay the lender under a specific set of conditions defined by the bond;
• They provide a fixed rate of return in the form of coupon payment (i.e. interest) to investors at regular intervals;
• Capital is redeemed at the end of the term;
• Bonds can be secured against certain assets (collaterals) but don’t necessarily have to be;
• In the event of default (borrower failing to observe the conditions of the bond), the lender has the right to seize assets and liquidate them to recoup the capital and interests, before any shareholders.

There are 2 ways to earn returns when it comes to bond investing:

1. Coupon payment: each bond has a set interest rate (called coupon) that is paid out at regular intervals (monthly, quarterly or annually). This is the primary way and that’s why bonds are often called fixed income investment.
2. Capital price appreciation: bonds represents an obligation between the borrower and the lender. Each bond is sold and redeemed at the face value of the bond (aka par value, usually in 100 EUR/CHF increments). It is possible, under certain situations (e.g. changing interest rate, alteration in the financial health of the issuer) for the market value to deviate from the par/face value so that you can buy it at a low price and sell it at a higher one later. In fact, just the US bond market size alone is larger than the entire global equity market combined together. However, these are highly specialized situations and retail investors tend not to personally trade bonds too often.

Bondholders have a preference over shareholders, which is manifested in 2 forms:

• Regular and uninterrupted interest payment (whereas equity dividend is an option rather than obligation);
• Liquidation preference over shareholders in the event of default.

These 2 features enable bonds to carry a different risk profile versus equity:

• Equity valuation is a product of expectation on current and future profitability;
• Bond price is more dependent on the strength of the balance sheet and the current cash flow of the business

Given that balance sheet and cash flow are much easier to measure than future profitability, bonds tend to be less volatile and are perceived to be a lower risk asset class than equity.

The special case of Swiss property-backed bonds

Until recently, property and bonds were two words only institutional investors had the privilege to be associated with. These were mega-deals that had an entry ticket in the millions of $, which were simply out of reach for most retail investors.

Yet due to lowering costs of transaction, securitisation and funding, thanks largely to technological advancement, these entry barriers are beginning to be broken down.

It is now possible to:

• Establish a limited company (special purpose vehicle or SPV) in a respectable jurisdiction within a few hours;
• Use the SPV to issue shares and bonds to potential investors to fund the purchase of a property;
• Buy properties, receive rental income and sales proceed using that SPV.

This has enabled the securitisation of the property market and thus vastly opened its access to retail investors. Investing 1 million EUR/CHF in an apartment may sound like a lot, yet when it is broken down to 10,000 shares valued at 100 EUR/CHF each, suddenly most mortal souls can start building their own property empires.

Hence we come to property-backed bonds.

An SPV that holds and lets put a property is just like any other businesses, which owns assets to generate revenues, costs for operating and financing of these assets and hopefully, it will make a profit at the end of the day.

To acquire these assets (i.e. properties), its shareholders can decide to partly fund it themselves (through equity) and partly issue bonds to borrow money from investors. They then pay out a fraction of the rental income to bondholders as coupon payment and retain the rest as profit. This way, shareholders do not have to commit a huge upfront capital payment for the project, which lowers their financial risk.

It’s a pretty sweet deal for bondholders too:

• They receive a regular and predictable return on their capital without fail -> currently yields around 3.5-5%, which is inflation-busting;
• Due to the securitisation nature of the product, the minimum investment level can start from as low as 10,000 EUR/CHF -> this significantly lowers the barrier of entry and opens up to many retail investors;
• It provides an easy and efficient manner for investors to diversify the location and class of their asset base, due to the lower entry barrier;
• Bonds are secured against the property, which means in the event of default, bondholders have the right to seize the house from shareholders and auction it off. They will be entitled to the proceeds first;
• The amount of bond as a % of the house value (loan to value ratio) is kept at a sensible level (60%), which means the property can withstand a 40% drop in market value without affecting the capital security if bondholders.

The only potential drawback between a bond of this nature versus publicly traded equities or bonds is liquidity. In other words, the ability to turn the investment into cash quickly without value erosion. Given such bonds tend to be privately issued and subscribed, the expectation is that they would be held to maturity. As a result, no markets exist for the trading of such instruments and therefore the liquidity risk is high.

In conclusion

The array of investment options available to today’s investors can indeed be confusing. However, when pierced through the haze, it is easy to see that bonds secured against valuable collaterals offer the perfect combination of inflation-adjust return and low risk to the capital.

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