Business

Keep your eyes on the goal

The Sterling Report

By Toni-Ann Neita-Elliott

Sunday, July 22, 2018

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In honour of the recently concluded World Cup (Vive la France!), I thought I would share a story to remind you to keep your eyes on the goal as an investor.

In 2015 Mr Green had $3 million to invest and wanted to earn better interest than his bank was offering. So instead of lodging the money in his bank account, he bought a Toyota Corolla for $3 million, and entered into a contract with Cantor General Ltd to rent the car from him for seven years at $450,000 per year.

This would work out to 15 per cent interest on his investment per year, but he had to pay some upfront one-time costs when he purchased the car and so he had actually spent $3.1 million for the car even though it was only valued at $3 million. This reduced his real return on his investment over the seven years to around 14.5 per cent per year but he was happy with this return.

It is now 2018 and he has done a valuation of the car and finds that due to changes in import policies and taxation the car has actually gone up slightly in value but the market value of the car is expected to go down over the next four years and so it will be worth less than it is worth now when the seven-year contract comes to an end.

Should he take advantage of the temporary appreciation in the value of the car, especially since he knows it will depreciate in value in the years to come? Is he losing by not selling now since he knows he will end up selling it at the end of the contract at a lower price?

Of course, it makes sense to sell his asset at a higher price than a lower price but he also needs to consider the future rental income he is giving up and if the money he gets now from the sale of the car can be reinvested in some other venture that will make up for the income he is foregoing.

He reminds himself that he will continue to earn the 15 per cent income for four more years irrespective of how low the value of the car falls, and that he didn't buy the car with the expectation to sell it to make a profit. He purchased the car and rented it out in order to earn higher interest than what he would have earned in a bank. That was his investment goal and he has certainly achieved that objective and will continue to do so until the end of the contract.

However, he does the math and decides that he would be slightly better off if he takes the capital gain on the car by selling it now. He must now reinvest the funds by replacing the car he has sold with one that will earn the same or more than he has given up in future rental income, since his goal is income.

He searches the market and finds that car prices are higher than when he had bought the Corolla in 2015, and ends up having to buy a smaller car. Nevertheless, he lucks out and is able to find someone willing to rent the car for the same yearly rental as Cantor General Ltd had been paying for the Corolla.

However, as time passes he realises that the replacement car is depreciating in value much faster than the previous one and that the new car is not as reliable as the car he sold and he ends up incurring a lot more in maintenance costs.

And then the worse thing happens… the car breaks down and is unable to be repaired. Mr Green finds that he is now without his monthly income stream and without an asset! The other car had served him so well and not given him any trouble. It had been a source of reliable income, just as he had wanted, but he had lost sight of his investment goal and tried to make a short-term profit and gave up sure for unsure.

This is a hopefully relatable story that can be likened to investing in bonds.

Plain vanilla fixed-rate bonds pay a fixed rate of interest per year until maturity, irrespective of changes in the price/value of the bond over its life; just as how the Corolla was bringing in a fixed annual income, even though the value of the car was changing over time.

So even if the value of your bond is going down, you will still get your fixed interest payments until the bond matures. The day you buy the bond, you'll know exactly how much money your investment will make.

This is the “buy to hold” strategy.

Some investors, however, buy their bonds to trade. They buy a bond with the hope that its price will go up and they can sell it at a profit.

This story was a cautionary tale about losing sight of one's investment goal. Mr Green had bought the car for its rental income but decided to sell it to take advantage of the increase in its value, which is similar to an investor taking the capital gains on his bond when the price goes up. But when trying to reinvest the sale proceeds he was faced with a market whose prices had gone up and had to buy a smaller car. This is the “reinvestment risk” that investors may face.

And then poor Mr Green ended up with a car that gave trouble and eventually broke down. This is like selling your stable bond and ending up in a more volatile bond that eventually defaults!

The lesson here is to know what your investment goal is when buying a bond and not lose sight of that. This, of course, does not mean that changes in the market or in your personal circumstances may not warrant a change in strategy, but the key is not to lose sight of why you made the investment in the first place and to assess if it is meeting your needs (or not) before making a decision to change your strategy.

Toni-Ann Neita-Elliott is the AVP, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm .

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