Invest Outside the Box

Understanding Different Asset Classes and Strategies

Tariq Dennison

• Publisher: Palgrave Macmillan
• Year: 2018
• ISBN:
  9789811303722
• Topic: Business
• Subtopic: Financial Services
• Index: Business

This book is a practical and concise guide to major asset classes, investment strategies, and foreign markets. For investors familiar with one "box" of investments, this book serves as a non-technical introduction to other "boxes" worth diversifying into, such as bonds, real estate, private equity, cryptocurrencies, and Chinese A-shares. Readers with no prior finance background will find this book an accessible entry point to investing. Written by a practitioner, this volume can serve as course material for introductory investing classes or as an on-the-job guidebook for professionals and practicing investors.

Part I

Asset Classes: The “What” Box

The most obvious box classifying an investment is what type of asset the money is being invested in, whether a bank deposit, bond, rental property, stock, foreign currency, or alternative asset like gold, art, or hedge funds. These “asset class” may be the first dimension on where to put money, and generally one of the most natural for investors to think of diversifying between, though in many ways still define how each investment is sold and by whom.

© The Author(s) 2018

Tariq DennisonInvest Outside the Boxhttps://doi.org/10.1007/978-981-13-0372-2_1

Begin Abstract

1. Cash, Bank Deposits, and Interest Rates

Tariq Dennison¹

(1)

GFM Asset Management, Hong Kong, Hong Kong

Tariq Dennison

End Abstract

Before even beginning to look at buying a stock, bond, or building, an investor is likely to start by depositing money in a bank account. Bank deposits are not so much an investment themselves but rather a convenient place to store money and a platform for using the bank’s services to transfer some of that money to other accounts. Usually, a depositor would have to pay a company for storage and other services to take care of personal belongings and valuables, but banks are allowed to invest the money deposited with them into bonds and loans (described in the next chapter), passing on part of the interest from those investments to the customer and keeping the rest as their service fee (rather having to charge direct fees for all of their services). As of 2018, banks and bank deposits are still the main way money moves around from business to business worldwide, and in fast-growing, recently poor countries like China, many first-generation bank customers are switching from banknotes and paper checks to paperless payment systems that move money electronically between bank accounts (like Alipay and WeChat Pay). Over the next decade, there is likely to be a rise in “e-cash” transactions using cryptocurrencies and blockchain technology (described in Chap. 9) and replacing the need for banks to serve as fee-taking and risk-taking intermediaries for the basic functions of storing and transferring money.

1.1 What Are the Different Types of Bank Deposits?

The simplest bank deposits are ones that allow money to be withdrawn at any time “on demand”, and so are called “demand deposits”. These accounts are generally called “checking” or “savings” accounts and are often treated as “cash equivalents”, since the customer should be able to withdraw or send out cash from these accounts within a day or two without penalty. These accounts generally pay the lowest rates of interest (if they pay interest at all), since they give the bank the least amount of flexibility to invest that money in longer-term, higher interest bonds or loans, and this lower interest should be viewed as the cost of having that cash available on demand for your immediate use.

Banks also offer “time deposits ” or “term deposits ”, where the depositor agrees to leave a sum of money on deposit for a fixed period of time (say one month, three months, or one year or longer) in exchange for a higher rate of interest, often with a pre-set penalty if the deposit is “broken” or withdrawn before this time period is over. Time deposits can be thought of as an entry-level form of bond investment, and can sometimes pay even higher yields than bonds, as banks often have access to investments most individual depositors so far do not.

1.2 Why Keep Money in Bank Deposits?

In exchange for the lower rate of interest on bank deposits, some of the services and conveniences one should expect from a bank include:

• access to deposit or withdraw cash at branches or automated teller machines (ATMs),
• transferring money to others via check or wire transfer,
• debit cards (for spending directly from the account, using credit card networks),
• currency conversion, and
• bank statements (sometimes used as proof of address or income)

As mentioned earlier, these basic features and services of bank accounts may increasingly be replaced by blockchain technologies (described in more detail in Chap. 9) over the coming decade or two, but as of 2018, the most basic form of savings and wealth is still “money in the bank”.

1.3 How Most Money Today Is a Form of Bank Deposit

Accounting 101 teaches that modern money, in the form of bills of cash in a wallet, or cash on deposit at a bank, is a form of debt by a bank to a bearer. Dollar bills, also known as banknotes, are basically a promise by a bank to pay the bearer the face value on demand, as illustrated in Figs. 1.1 and 1.2. This is a historical relic of earlier paper money, which could be redeemed on demand for the face value of gold or silver (precious metals will be introduced in Chap. 6).

Fig. 1.1

Series of 1914 US$100 bill, example of an early “Federal Reserve Note”

Authorized by the Federal Reserve Act of December 23, 1913, still contains the language “will pay to the bearer on demand” not printed on the 2013 series of US dollar bills. (Photo source: uscurrency.​gov; https://​www.​uscurrency.​gov/​security/​100-security-features-1914-%E2%80%93-1990)

Fig. 1.2

GB £100 banknote issued by the retail bank Royal Bank of Scotland plc

Legal tender British pound notes by two other retail banks in Scotland, and by four other retail banks in Northern Ireland, as opposed to by the Bank of England (the central bank) in England, or directly by HM treasury in the crown colonies of Guernsey, Jersey, and Isle of Man. (Photo source: RBS https://​www.​rbs.​com/​heritage/​subjects/​our-banknotes/​current-issue-notes.​html)

When a dollar bill is deposited at a bank, the deposit becomes a debt where the bank is obligated to pay back that dollar on demand, plus interest if the account is interest bearing. The interest rates banks pay can often be adjusted daily relative to prevailing overnight interest rates driven by central banks, or what rates the bank can earn in the market and feels the need to pass on to prevent you from transferring your deposit to another bank. The next section, as well as the following chapter on bonds, describes in more detail how interest rates are driven up and down through economic and market factors.

Banks make their money by borrowing money via deposits at relatively low interest rates and then lending it out to individuals, businesses, and other borrowers at relatively high interest rates. The business model of a bank has been summarized by numbers like “3-6-3” for a bank that pays 3% interest on its deposits, charging 6% on loans, with the bankers having the goal to finish their office work and get out to the golf course by 3 pm. In the second decade of the twenty-first century, when interest rates have been lower and bankers have felt more pressure to work later to keep their jobs, “3-6-3” might be said to have been replaced by “0-3-6”, but the simplicity of banks’ business models remains the same.

Unlike the deposit side, the loan that banks invest in are usually not payable on demand back to the bank, so the bank needs to keep a certain percentage of your deposit in reserve with the hope that no more than that percentage of their deposits will be withdrawn before the loans are paid back. One of the major roles of central banks like the Federal Reserve and Bank of England is to loan banks the difference if withdrawals ever do exceed the amount held in reserve, but these loans usually charge significantly higher rates of interest than the bank would have to pay on deposits. So one main job of a bank is to keep the balance between deposits, withdrawals, loans, and reserves as tight as possible to maximize profits (called “net interest margin”, before subtracting what they pay for their staff, branches, taxes, and other expenses). As a simple illustration, below is a sample balance sheet and income statement for a simple bank funded with $100 of equity capital and $900 in customer deposits, which it uses to make $900 in long-term loans (on which it can earn a higher rate of interest) and $100 in short-term loans (which pay the bank less interest and are paid back quickly enough to provide liquidity for the percentage of depositors wishing to withdraw their funds at the end of the period) (Fig. 1.3):

Fig. 1.3

Balance sheet and income statement for a simple sample bank’s first year equity, deposits, assets and income

The $100 in capital serves as a buffer against the first $100 in losses of principal the bank may suffer on its loan investments before the depositors are at risk of the bank rupturing (the origin of the term “bankrupt”) and not being able to redeem 100% of the money deposited on demand. Depositors generally have the expectation of being able to withdraw 100% of their money from the bank without having to worry about the capital ratios or loan losses on their bank’s balance sheet, so this assurance is provided in many banking jurisdictions by bank regulations (often domestic central banks, who have harmonized capital requirement standards in a series of voluntary frameworks so far known as Basel I, Basel II, and Basel III) and reinforced by deposit insurance schemes (e.g. FDIC and NCUA in the United States, CDIC in Canada, FSCS in the United Kingdom, and SDIC in Singapore). These regulators and deposit insurers set the minimum capital ratio requirements (and so the maximum amount of deposits as a multiple of this capital) for banks which limit the amount of risk banks can take in search of profits while keeping deposits safe enough.

The primary objective of commercial banks is to maximize its profitability, which can be measured by this return on equity (ROE) rate to its shareholders (described in more detail in Chap. 4 on equity investing), but must be accomplished by maximizing value to its customers on both ends: depositors willing to accept lower rates in exchange for service, versus creditworthy borrowers able to pay substantially higher rates on loans. Most central banks, unlike commercial banks, have policy objectives centered around macroeconomic goals like maximizing economic growth, maximizing employment, or maintaining stable prices, all unrelated to any objective of maximizing ROE, but both commercial banks and central banks remain focused on one of the most important financial variables described in this book that underlie a large percentage of investment choices across all asset classes: the rate banks pay on deposits.

1.4 What Determines the Rate of Interest Banks Pay on Deposits

Like any other market governed by supply and demand, prices drive and are driven by how willing customers are to deposit more money at a bank versus how motivated banks are to pay higher rates interest to draw more deposits. Banks would maximize their ROE by paying as low an interest rate on deposits as they can to lure enough of a multiple of their equity capital needed to make all the loans they can make at as high a rate as they can find enough qualified lenders to borrow at.

Banks cannot simply set interest rates at whatever level they wish but rather are like oil and sugar companies in having the prices of their primary commodity (which for banks is the cost of borrowing or lending money, priced as an interest rate) determined by larger economic forces. The next chapter describes the multi-trillion d...

Table of contents

• Cover
• Front Matter
• Part I
• Part II
• Part III
• Back Matter