Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

Invest in Sydney/Brisbane property markets, or for media/public speaking requests, email pete@allenwargent.com

Monday, 14 January 2013

The law of incentives: there's no such thing as a free lunch

Incentives! One of the key laws of economics. We act in a certain way because we are incentivised to do so. 

Generally people don’t turn up to work purely for the enjoyment of so doing, although they might say that they do. Instead, the primary incentive is usually financial reward. Some older folk elect to keep working beyond the retirement age for the incentive of keeping active or sociable.

Coles and Woolies offer us shopper-dockets in order to incentivise us to come back to their store instead of another outlet.

Incentives don’t only apply to financial and economic decisions. In almost every decision humans make we consciously or unconsciously weigh up the incentives of each of our options. This is the origin of the phrase...

"There's no such thing as a free lunch"

Let’s take the example of…well, why not the example of an actual free lunch?

Let’s say I’m 21 again (sigh) and I wander down to a pub in Sydney tomorrow (sigh!) and meet a beautiful lady who I find funny and great company. I offer to buy her lunch next weekend. Obviously the lunch would not be free me. Nope, certainly no free lunch there!

But would it be a free lunch for her? No. Her assumption would be that I would be expecting something in return as an incentive (even if that incentive was simply her time and company) and would intuitively weigh up her own incentives. She’d balance up the mediocre quality of the suggested restaurant, the inane nature of my moribund 21-year-old conversational skills and - the clincher - my woeful requirement for a haircut, before politely declining.

Whether we think about it or not, we weigh up incentives in this way all the time. Blokes spend more time getting ready to go out on a hot date than they do for a day at the footie due to the incentive of a potential romance.

Even when we are apparently giving something for free such as a charitable donation, we often expect to feel good in return as our incentive. This is why we choose charities that have a meaning to us and is why I donate to cancer charities in in preference to other deserving causes.

Governments use tax cuts and parking or speeding fines to incentivise us to behave in certain ways, and so on, but can we…

Find a free lunch in investing?

Unfortunately, the law of "no free lunches" also applies to investment.

Investors who gave money to Allen Stanford thought they’d found a free lunch. Consistent, high returns with remarkably little volatility! But they forgot to ask what the cost was. In this instance, sadly, the cost was one of the greatest frauds ever committed, a gigantic Ponzi scheme which ultimately collapsed. No free lunch - and the cost many investors suffered of not having diversified was immense.

In The Intelligent Investor Ben Graham cautions readers not to invest in junk bonds. The incentive is a higher yield but you must always ask: what is the cost? The cost is a higher risk of the bond defaulting and loss of your capital, which to Graham is unacceptable.

Today, of course, you can invest in a diversified junk bond fund. Again, a potentially higher yield. Always ask: what is the cost? The cost is that by holding a diversified portfolio of junk bonds you can be almost certain that a percentage of them will default.

And the fund manager’s incentive? The cost is that they will siphon off a percentage of your investment to compensate for their management time and expertise. Personally I wouldn’t go near bond funds at this stage of the interest rate cycle; others might argue they represent a decent deflation hedge.

Something for nothing

One of the problems in the world today is that too many people want something for nothing. This is why many leap into trading leveraged CFD contracts or currencies, or buy speculative mining stocks. They might make some gains but more often end up losing them and back to where they started…or worse.

The incentive of building wealth for a prosperous future has a cost and that is sacrificing luxuries today for a better tomorrow while shunning unnecessary risk of investment loss of capital.

Incentives in property

In this recent article, Michael Yardney urges investors to be wary of property investment incentives such as discounts which can distort the market. Similarly, be wary of rental guarantees. What is the cost of a guarantee? Is it that the developer wants to sell you a property based upon a multiple of the high rent? What happens when the rental guarantee ends?

What if you buy a property via a property investment club? Are they helping you to buy just to be nice? Perhaps, but you need to fully understand their incentives. It may be 6% of the property purchase price. What of the developer’s incentive in this case? They may be selling via a club because it is a simple way for them to find buyers. At other times, they may be offloading properties they simply can’t get rid of.

Does that mean that all properties bought via clubs are sub-standard? Of course not, some might be excellent investments. You simply need to understand the incentives and the costs and to always do your own due diligence.

The incentive of yield

Property investors today are constantly being lured to invest in regional markets. The incentives are always listed as the same. Higher yield to lower your risk! Higher capital growth! More affordable and “room to grow”!

If anyone had designed a free lunch, this juicy trifecta must be the veritable entrée, main course and dessert. Might you get both positive cash flow and growth? Actually you well might if you choose your market well.

But always ask, what is the cost? Go back to basics. A yield is high because the market value is low. Prices are usually low because…demand is low. A property which is in low demand is a bad investment.

Be especially wary of investing in small cities or towns where there is vast acreage potentially available for new property development – if prices do go up it could become swamped with dwellings and prices may retrace. The best property investments are those you own forever.

Remember that by investing counter-cyclically in cities which are at the nadir of their cycle investors can get some pretty darned good yields anyway.

If you think you can outsmart the market in today’s climes by getting in and out a mining town with expert timing (materially beating stamp duty, legal fees, sales costs and capital gains taxes) you're probably wrong.

Property cycles

The best benchmark I have for a property market which is at a different stage of the property cycle to that of Australia is the British market.

A great many investors opted to buy properties before 2007 in outer areas and remote markets tempted by yields of 7% or even above. The cost was that when the credit cycle reversed properties in low demand have been absolutely clobbered, in many cases by more than a quarter. And it’s now 2013 with little in the way of a recovery having taken place.

Those who invested in some city markets in the south-east of England, including in and around London, had previously paid a cost of a somewhat lower yield. But today, the incentive they are paid back is that by buying properties in the part of the country with a shortage of property and massive demand, their property portfolios are stronger than ever before.

Property in Australia has delivered outstanding returns over the past decade and a half which incentivises investors into the market. 

The future is unknown, of course. Low interest rates in 2013 could well see some reasonable growth this year. But what is the cost? My fear is that when we reach the end of the interest rate easing cycle and rates move upwards, some markets where property is in low demand will get clobbered.

Remember the law of incentives. There’s no such thing as a free lunch and always ask yourself: “what is the cost?”