Five Cents Ten Cents

Posted: 28 Oct 2008 10:27 PM CDT

Image by for_dprefect via Flickr

DBS has announced that DBS High 5 Notes investors would be getting back the grand total of “zero” from their Lehman Brothers’ linked investment.

This is what Nassim Nicholas Taleb (NNT) in the book, “The Black Swan: Impact of the Highly Improbable,” of a black swan event. A black swan event is one which has a large impact on people, is highly unlikely to happen and in retrospectively predictable.

Looking back on the debacle, many questions relating to how such structured products were sold to investors were raised. For instance, would anyone have bought an investment that promised a potential 5% return but has a potential 100% loss?

Expected Returns

Statistically, we would do an expected returns computation:

5% x probability of credit events not happening  >= -100% x probability of credit event happening.

In practice, the computation is full of variables that we cannot predict going forward. Who would have predicted that Lehman Brothers’ would fail and fail so spectacularly? Who would have predicted the current global financial crisis when just 1-2 years ago there was talk of a “golden age” by MM Lee and “more good years” for Singapore and the world economy? Who would have predicted all this and more?

The reality facing us is that NO-ONE can predict the future with 100% accuracy. You and I live in a unpredictable world where we think we can predict the future for stock prices, economic data and GDP growth figures. Hence, analysts calls on stock price targets, stock indices and the like are educated guesses at best and shots using darts on wall charts at worst.

You guess is as good as mine seems to be a workable rule of thumb in the world of black swans.

Invest in Preparedness

Given our human wish to make sense of the world by assigning probabilities which are as accurate as pulling numbers out of the air, it is obvious that you can plan but be prepared to change your plan. You can succeed or fail at retirement planning, personal finance and being financially free depending on black swan events. I’m not advocating playing the lottery as one way to be exposed to positive black swans of a huge windfall to be financially free. Rather, I share NNT’s view to invest in preparedness rather than to follow the predictions of experts, gurus and specialists in the world of personal finance and financial freedom.

Do understand the principles of personal finance, i.e. to live within your means, to save and invest, to grow and protect your means. How you do it is really all about your own style. Knowing the broad principles gives you the framework to be prepared for your journey towards financial freedom. Applying the principles in  your own unique way makes you special.

I advocate ceaselessly to read, read and read more about personal finance and investment topics. The lessons of this current financial crisis are to some extent captured in previous excesses such as the Depression, the 80s savings and loan failures, the 90s asian financial crisis, the 00s dot.com crash. Learning about history allows us to be better prepared.

Paying off Housing Loan Early

There were discussions that I was engaged in talking about whether to pay off your housing loan. A number felt that maximum borrowing at cheap HDB concessionary loan rate of 2.5% and using the excess cash from income to invest was the way to go. Given the downward spiral of virtually all asset classes, equities, property, commodities, etc. where can one invest profitably? In the end, one still faces the unpaid housing loan even as one’s job is put at risk by the financial crisis.

Investing in preparedness meant for me to sacrifice present consumption and to put most of my spare cash and CPF monies in paying off my home early. This has opened up lifestyle choices to me that would not have been possible if I still stared at the housing loan on my residential property that could see potential depreciation in value given the overall weak market conditions.

I am in the midst of career move that I would not have dared undertaken if I had not the security of my fully-paid home behind me. I thank God that I am able to make such a move despite the current market condition.

A recent report in Singapore showed that 4 in 10 credit card holders roll over their credit card bills. This use of very expensive consumer credit is symptomatic of cash flow problems starting to permeate into individual’s payment patterns. At the rate of 24% per annum, credit card debt is crippling as it takes 3 years for your original unpaid balance to double versus your savings deposit account which takes 288 years to double at 0.25% per annum.

Protecting your backside during times of black swans

Black swans are everywhere. The problem is that we over-estimate our ability to predict them and under-estimate their impact upon us. My own conservative personal finance strategy has paid off not because I was able to predict the current financial crisis but because I was lucky enough to know that my ability to predict into the future was non-existent.

How would you go about investing in preparedness and being able to survive black swan events? Share with Panzer in the comments section.

Be well and prosper.