How to build a portfolio with inherited wealth

2021-02-02     drwealth
How to build a portfolio with inherited wealth

One of the worst effects of the 2020 pandemic is the psychological scars inflicted on market participants.

I remember in the worst depths of the pandemic when my portfolio was reeling from huge losses, I had nightmares of my late father coming home to scold me for not managing my family assets well. I even woke up with tears.

For readers, here’s some background: I managed my family assets throughout the Great Recession of 2007-2009 when my dad was still alive, a recession that is worst in terms of duration and extent of losses. My dad, a veteran who survived every recession since 1985, was never affected by his investment losses. Everything was par for the course for him. I was never scolded by my dad when I made investment mistakes which were plenty (like my disastrous buy into King Wan years ago). Overall, the portfolio did well.

So, after dreaming of my dad giving me a scolding, I decided I had enough – it was quite clear that my subconscious is rebelling against my investment decisions. I eliminated all leverage from my portfolio, basically selling enough stocks to return money owed to the broker and barely escaping a margin call.

At that time, I just needed a reboot to get clear-headed enough to navigate my way out of the crisis.

Financial experts talk about mental accounting – a psychological flaw where someone divides assets into different mental accounts. Students of finance are taught not to do this and manage their money as a whole. After 2020, I am beginning to disagree with this approach – we are human beings and not robots.

A more enlightened approach is to accept that mental accounting is part and parcel of being human.

My dad can be relatively casual with his portfolio because he earned it with his own hands. I inherited his portfolio and used it primarily to support my mum. My attitude towards this portfolio is not casual; you won’t see me chase the market’s latest buys. This week I have to tell my mum, who exhibits a lot of FOMO that we did not play with any of the meme stocks.  

Most readers earned their money from applying themselves in the workplace. I congratulate them because they don’t have the psychological baggage associated with not earning their money the old-fashioned way. So they can bet it all on Gamestop if they want to.

If you do have the First World Problem of inheriting assets like me, you may wish to segregate it from the rest of your assets, and apply the following rules when investing it in the stock market:

1 – Create a portfolio with low beta stocks

Beta is a measure of the systematic risk of the portfolio relative to the market as a whole. If your portfolio’s beta is equal to 1, it means that you have adopted the same volatility as the rest of the stock market. If you have a beta of more than 1, you are taking a more considerable risk than the rest of the stock market. If you have a beta less than one, you are taking a lower risk than the rest of the stock market.

A tool like Stocks Café can be used to calculate the beta of your overall portfolio. A screen-shot of one of my smaller portfolios is shown below:

My greater family assets portfolio is not too different from this screen-shot, which is around 0.75-0.85.

There is evidence that portfolios with lower betas tend to outperform portfolios with high betas.

Several classic defensive stocks belong to low beta portfolios. For example, Netlink NBN Trust (SGX:CJLU) has a beta of 0.37 and Keppel DC REIT (SGX: AJBU) is one REIT with the low beta at 0.36.

2 – Go for stocks that are generous with dividend payouts

Before, I’ve said that managing inter-generational wealth may entail a sense of guilt and shame in some people. One of the sources of this guilt is when you sell a stock for personal consumption. There is a sense that something is permanently lost. There is an entire academic treatise on how dividends are the equivalent of capital gains in finance, and you can synthetically build your dividends by selling stock every year.

Once again, you are not a robot governed by financial equations. Dividends in Singapore not just arrive tax-free, but you won’t incur the brokerage cost when selling stocks.

Dividends come to a convenient rescue because paying out cash is one of the signs that say that an investment is bearing fruit. After ensuring that the stock is paying real dividends from cash flow from operations, you are in essence consuming the proceeds from the business providing a service or selling a product.

Before 2019, dividends have been a decisive factor in building profitable REIT portfolios, but this strategy has not done well for the past 2-3 years. Fortunately, for folks who manage more extensive portfolios, you may not need a humungous yield to sustain your necessary expenses.

My overall portfolio yielded an annualised 6.6% in the second half of 2020. I created a core portfolio consisting of low beta, low dividend yielding counters like Keppel DC REIT and Netlink NBN Trust but I sprinkled it with some high-yielding counters like Keppel Pacific Oak REIT (current yield of 8.4% on Stocks Cafe) to boost its yields.

There’s nothing to preclude dividends making a comeback in the future and, even it doesn’t, and you will be paid while you wait.

3 – Have a preference for stocks that mean-revert

This is a more subtle quality of a stock that is difficult to filter based on traditional tools.

When a stock is mostly momentum driven, a history of upward moves will be followed by more upward motions, so a momentum-driven strategy favours these counters. An example of a momentum-driven counter is current SGX fan-favourite iFast (SGX:AIY).

The opposite of momentum-driven stocks is mean-reverting stocks. These stocks bounce back after short periods of doing poorly. (We will discuss the details on the momentum-driven and mean-reverting trades in a future article.)

A program I wrote that optimises both momentum and mean-reverting strategies for iFast would favour the momentum strategies.

As shown above, applying a momentum strategy for iFast would quintuple returns.

But, as shown below, a mean-reverting strategy would not be as profitable.

Inherited assets benefit from mean-reverting stocks as they generate dividends that can be reinvested cheaply while the stocks are down, and bounce back aggressively after the lull period is over. REITs generally exhibit mean-reversion.

If you observe Ascendas REIT (SGX:A17U), even the most profitable momentum trade strategy will underperform a simple buy and hold strategy:

But buying on dips and investing in regular intervals is a lot more rewarding for the investor.

Mean-reverting stocks may not exhibit the shock and awe of current fan-favourite stocks like iFast, but such strategies suit a long-term portfolio that is designed to generate cash flow for a loved one. Mean-reverting strategies facilitate periods of aggressive bargain hunting with dividend yields and salary payouts followed by a period of upswings.

In Conclusion

This article directly addresses the guilt and shame of inheriting money from a loved one and openly accepts the psychological burden of managing it. It does not avoid mental accounting. It provides three criteria for finding investments suitable for the placement of inherited wealth in the stock market. Stock picks should exhibit a low beta, high dividends and mean reversion over time.

Of course, this is not to dissuade a reader from investing in hot momentum-driven investments like iFast.

They can be profitably pursued with money earned within your generation.

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