16 Aug Drag – The Dreaded Four Letter Word
Aeroplanes have always fascinated me.
Hundreds of human bodies, tons of jet fuel, one long aluminum cylinder, propelled through the air by two (sometimes more) fan like engines at just a tad under the speed of sound.
On our own, we can barely jump and stay off the ground for more than a couple of seconds at a time. How then did the human race get these flying machines into the air at all? The thought is simply mind boggling.
Lift, weight, thrust and drag
The laws of physics breaks it down elegantly. In the air, a plane is subjected to four forces.
Weight is the pull of the earth’s gravitational pull. It acts on you and me and all objects within its gravitational field, planes included. To counter weight, a plane needs to produce lift.
Lift is created when air over the wing travels at a faster speed than air below the wing. The pressure difference creates a force that sucks the wings and the entire plane upwards.
Thrust in the modern jetliner is created by turbofan engines that suck in and compress massive amounts of air. Within the combustion chambers, the air is ignited and expelled out towards the rear. This creates a huge force that moves the plane forward.
Drag is the force that acts in the opposite direction of thrust. If you have ever stuck your hand out of a moving car and felt it being pushed back by the moving air, you would have experienced drag. There are two families of drag.
First up, Induced Drag. Air over and under the wings of a plane flows in different directions and spills over at the end of the wings. The lift generated by the wings is tilted backwards, contributing to a drag component. Aircraft designers attempt to reduce induced drag with various wing tip devices such as the raked wingtips on the A350.
Drag that is not associated with the production of lift is called Parasite Drag. They include form, interference and fiction drag. To reduce each component, aircraft are built to be streamlined with a rounded nose cone (form drag), junctures where the wing meets the fuelsage are built curved (interference) and the skin of the aircraft is painted and riverts are flush with the body (fiction).
Drag is the bane of the modern jetliner. It is the antithesis of efficiency. Drag is the reason why we cannot fly faster and further. Drag is the reason why planes burn so much fuel.
If aircraft manufacturers could reduce drag further, they would. They would then be able to build a plane that is quieter and faster, one that burns less fuel and cheaper to fly and maintain. It would be a massive breakthrough.
Drag is as much a pain in investment as it is in aviation.
Cost drag. The equation is straightforward here. Profits = Purchase Price – (Sale Price + Transaction Cost). To increase profits, we buy low, sell high and keep costs at a minimum.
When we purchase or sell a stock we pay an upfront, one off commission. Brokerage charges in Singapore are relatively standard. It should not cost more than 0.3% to buy or sell a share. Someone who invests for the long term would find this to be palatable enough. However, if one were to buy and sell shares often, the transaction cost will add up rather quickly.
Exchange traded funds can be bought and sold via your broker just like a stock. On top of commission charges, a passively managed index fund charges an annual management fee that is automatically deducted from dividend payouts. The SPDR STI ETF has a total expense ratio of 0.3% per annum.
Compared this with an actively managed mutual fund (or unit trust, as it is better known). The largest Singapore equity unit trust, the Aberdeen Singapore Equity Fund charges an expense ratio of 1.67% per annum. The second largest local equity fund, Schroders Singapore Trust, clocks in at 1.31%.
Assuming an 8 percent average annual returns over 30 years, a $100k investment will grow more than 10 fold to $1.01million. If we factor in 0.3% in annual fees, we will still end up with $919k. The returns are dragged down significantly when we factor in 1.67% charges per year. We end up with $607k, 40 percent lower than we would have without the fees.
To justify their additional fees, fund managers need to outperform the market year in year out. As research over the years have shown, this is often not the case. The additional fees contribute to Cost Drag.
Investing in properties
Cost drag is even more apparent in property investment. I take the simplest case of someone buying a one million dollar property directly from the developer. They pay up 20 percent in downpayment now and take possession of the unit four years later at completion.
The costs involved are buyers stamp duty of $24600, lawyers fees of approximately $2000. Assuming there is no seller stamp duty payable, there is still a commission payable to the agent at 1.5% upon sale of the property. The cost associated with each property transaction can easily add up to 4%. In this case, the property would have to be sold at $1.04m to break even.
In other words, if the property is sold exactly at purchase price, the owners would have lost $40k. This is excluding interest payments as the loan progressively kicks in. The drag is real.
Financial prudence dictates that we hold six months of our income as emergency fund. This cash sits untouched in a bank account or under a mattress somewhere, waiting for the rainy day. It is a comforting thought indeed.
Now take a minute to entertain yet another thought – that in keeping the cash stashed away, we are actually losing out on a few fronts. For a start, cash is a lousy investment. It is not expected to show a return at all. Remember that over 30 years and at 8%, any invested amount can actually grow 10 fold. That is the potential of the cash sitting in your account right now.
On top of that, inflation is also eroding at the value of our stash. While the absolute amount of cash remains the same, its purchasing power decreases. In time to come, the same dollar in the bank will only be able to buy lesser than what it buys today.
I am not undermining the need to hold emergency money. The need is real. For investors though, it is crucial to optimise our investible funds so as not to let cash weigh down on our potential returns.
In fact, cash drag is crucial enough for Robo Advisors in the USA to optimize their algorithm to ensure that all invested sums are put to good use and individual client portfolios hold minimum amounts of cash. According to Betterment, even residual amounts of cash in an account will result in inefficiency.
Like aircraft manufacturers who take reducing drag seriously, Robo Advisors are also doing everything they can to eek out that extra few basis points of returns.
I recently compared Investor Returns to Investment Returns.
Investment returns is the amount a particular asset or combination of assets return over time. The SPDR STI ETF has returned approximately 7% since inception in 2002.
Few investors however, would have bought and held on for the entire 14 year period. They may add on to their positions when they have more cash to invest (or when the market is good), or they may sell a portion when they are in need of cash (or when they are spooked by a tumbling market).
This actual return is termed Investor Returns. More often than not, Investor Returns lags Investment Returns. The Investor is much more fallible than the Investment. The difference is attributed to Behavioral Drag.
In his book, The Lottery Mindset: Investors, Gambling and the Stock Market, Dr Fong Wai Mun of the NUS Business School suggest four reasons why this is so.
Preferences. As with everything we do in life, we exhibit preferences. Unfortunately preferences investors exhibit tend to be more detrimental than beneficial. Most investors prefer to build concentrated portfolios, owning a few stocks rather than many. Most prefer to buy exciting lottery type stocks to have a shot at great riches rather than owning a variety of stable and strong businesses. We also prefer the familiar, and in the process, limit our investment options.
Beliefs. Chief culprit amongst the many erroneous beliefs investors hold is that of overconfidence. We tend to think that we are better than average, that our decisions more informed and more sound, that our stocks will do better than everyone else’s.
Heuristics. A heuristic is a mental shortcut we make. It is a quick and fast way to process information and come to a conclusion. During a market correction, gloomy news is more readily available. That makes it easy for us to believe that the situation is worse than it is. Such is the Availability Heuristic at work.
Emotions. Greed and fear causes us to think irrationally. Far too many investing decisions are anchored in emotions rather than rationality. If we are able to remove greed and fear from the investing process, we would have successfully removed a major source of drag on our returns!
Consciously or subconsciously, we as human beings are guilty of all the above investing behavior. Together, they slow us down and cost us more. Fortunately, unlike cost drag and cash drag, behavioural drag is much easier to address and arrest. A keen awareness is the crucial first step.
The Final Word on Drag
Drag is detrimental to a plane looking to fly high and fast. Drag is also undesirable in investing and for the investor who hopes to do well and outperform the market. Investors should keep a close eye on the factors causing Cost Drag, Cash Drag and Behavioral Drag.
image: airliners.net, medley aviation, cnbc, reddit