Assets are always subjected to risks. What are these risks? If we know what the risks are, we can find ways to manage these risks. Not doing anything defaults to one kind of risk management technique which is called Risk Absorption (will come to this later). Thus, everyone defaults to one way of managing risk when nothing else is done. Thus, everybody must know how to manage risks in your assets:

By assets I meant: Fixed assets and Current Assets. Fixed Assets will be like properties and machineries. Current Assets will be like cash, fixed deposits, unit trusts, shares, bonds, money market funds, notes, etc. I want to talk more about Current Assets. The risks of current assets are:

• Market risk. The value of Current Assets fluctuates with market movement. For example, share prices are quoted on the stock exchange depending on the bid/offer price by buyers and sellers in the market. Foreign currency fixed deposits moves with the prevailing foreign currency exchange rate. Singapore dollar denominated cash and fixed deposits do not move in “price” because there is no currency risk. Instead it increases in value whenever interest is credited to it.
• Fund manager risk. Certain Current Assets like unit trusts are active managed. This is where an appointed fund manager has the discretionary power to buy and sell securities hoping to do better than his benchmark. The benchmark is usually the performance of the assets assuming 100% market risk. If the fund manager does a bad job, the asset will underperform the benchmark. If the fund manager underperforms the benchmark, it means it does not pay to take on the addition fund manager risk since the 100% market risk has better performance.
• Custodian risk (Trustee risk). As almost every Current Asset are scriptless, we heavily rely on custodian service to keep these assets. People do not have share certificates anymore. Statements from unit trusts distributors do not possess the same legal proof of ownership like a title deed. The statements are merely a snapshot of the market value of the asset. In other words, it is a historical statement, not necessarily proof of ownership. What happens if the Custodian does a “bad” job? It depends on the how the Custodian service is structured. If the Custodian is a Trust, than on bankruptcy of the fund manager (for unit trusts or shares or the unit trusts distributors), the assets held in Trust is safe from the bankrupting party. This is because the separate entity call the Trustee holds the legal ownership of the assets. What happens if the Trustee is the culprit and becomes insolvent for whatever reason? Or put it another way, what happens if the Trustee squander the assets away and falsely reported assets which it never had? In this case, beneficiaries of the Trust and the Settlor (the entity that setup the Trust) will need to take legal sue against the Trustee. If the Trustee is already insolvent (i.e. assets < liabilities) than the beneficiaries (investors) will take back less than their entitlement. After factoring legal costs, beneficiaries of the Trust will make losses. Putting the Trustee and its employees into jail does not help to take back assets that are already lost through negligent or fraud.
• Custodian risk (others).  If the custodian service is not a Trust but is part of the institution’s balance sheet, than the assets could be subjected to be attack by creditors. Investors money could be potentially be lost to more senior creditors. For example, cash deposits and fixed deposits in the bank are held not in Trust but part of the banks’ balance sheets. Creditors can attack these assets. Depositors would have to queue with other creditors to get back their money. To help ease depositors worry, governments have installed government-backed insurance scheme to protect portion of the depositors’ money in the event of a banks’ bankruptcy. In the United States, the amount protected is the first US$100,000. In Singapore, it is only the first S$20,000 backed by Singapore Deposit Insurance Corporation (SDIC).

How to manage these risks? There are 4 ways to manage such risks namely:

1. Risks Avoidance (e.g by not investing in unit trusts and shares we avoid market risk totally).
2. Risk  absorption (e.g. if there is any losses in the unit trusts, we just assumed the losses and not blame any one else)
3. Risk Reduction (e.g. active managed unit trusts have two risks: market risk & fund manager risk. By investing in passive funds, we eliminate the fund manager risk but retain the market risk. Thus 2 risks become 1.)
4. Risk Transfer (e.g. insuring the first S$20,000 of cash deposit transfers the risk of losing this amount to a 3rd party and in Singapore context it will be the SDIC). 

I would like to do a case study on how to apply these concepts to a Current Assets call “Cash.”

Case Study on “Cash”

“Cash” is normally deposited in the bank account. Some people would also put it in money market funds to get slightly better interest rates (but technically money market funds are unit trusts and hence does not qualify as “cash” assets). Unless it is a foreign currency, there is no market risk. The risk of cash asset is mainly custodian risk. Since cash in the bank is not held in trust, it is part of the banks’ balance sheet.

In Singapore, the first S$20,000 risk is already transferred to a 3rd party which we know as SDIC. This is the Risk Transfer approach. For the uninsured amount, Risk Absorption is the default approach if nothing else is done.

The uninsured amount can be managed via

1. Risk avoidance. This is by converting “cash” to something else safer. Here, Singapore Government Bonds is even safer than cash because Singapore Government cannot default. The issue now is market risk. Bond price fluctuate on a daily basis. However, if it is held to maturity than the redemption price is the par value. The maturity value is well defined and known. Thus, if one is prepared to hold to maturity than there is no market risk. Unfortunately a custodian is required to hold the bond and thus we introduced another custodian risk.  
2. Risk Reduction. This can be done by placing cash and fixed deposits across many banks in Singapore since the likelihood of all banks collapsing is much less probable than one bank collapsing, it implies that the Risk is reduced.
3. Risk Transfer by increasing the sum assured. This can be done by placing the monies into insurance companies which enjoy certain level of protection by legislation. Foreign countries such as United Kingdom and Isle of Man have legislation to protect policyholders up to certain limit. In Isle of Man it will be 90% of the insurers’ liabilities to policyholders. In Singapore context there appear to have similar protection however the mechanics on how this is done is unclear and non-transparent. Other countries are more transparent. For example, under Isle of Man regulation the exact procedures on how this 90% protection is to administered is enshrine in legislation itself (see download here for procedure HERE for the document).
4. Risk Absorption. Without doing anything this is the default risk management technique in which any losses are borne by the person himself.

In practice, the risk management will consists of a combination of all the above. Example: let’s say a person has $1 million in cash. The following is an example portfolio:

a)     Place $500,000 across 20 banks. The uninsured amount is (500,000-20000*20) = $100,000 which its risk has to be absorbed.

b)     Place the other $500,000 with an insurer (registered in Singapore but also is registered in UK or Isle of Man) so as employ Risk Transfer of 90% of the cash amount to 3rd party as provided for by the relevant legislation. The remaining 10% has to have its risk absorbed. The insurer acts as like a “custodian” in this case. The custodian risk is managed by Risk Transfer via its 90% protection scheme.

c)     Further, invests the amount with the insurer in Singapore Government Bonds (SGS) to enjoy higher interest rate. Since SGS bonds cannot default, there is no default risk.

Notes for future generation of readers.

The above content was written in days when financial institutions have been stricken with problems namely in credit problems. Due to over-leveraging and the development of innovative toxic waste (known as CDOs), many institutions which had bought them on the premise of being “safe” found these CDOs to have defaulted. It is quite unbelievable that sub-prime mortgages (i.e. mortgage which has no inability to repay) were packaged and sold to capital market as bonds. Amazingly, the financial industry created tranches and labeled them from AAA investment grade to junk bonds. Those AAA bonds turned out to be toxic waste. Currently there is no buyer for these toxic waste. Many institutions are in trouble due to cash flow. Without the ability to raise cash from selling assets, these institutions enters into cash flow problems. Some companies have defaulted and investors have lost money. Insurer such as AIG which insure the default risk of bonds through credit-swaps have found itself in cash flow problems due to increased claims on bonds default. With its rating now at A- (there was one time it was AAA), its cost of raising capital has become so costly.  Currently banks do not trust each other and hence inter-bank leading has dropped. To increase liquidity, central banks all over the world have to print more money by pumping money into the system to increase the circulation of money. Institutions that are too big to fall like AIG, Freddie and Fannie have to be bail-out by US government while 11 smaller US banks have collapsed causing uninsured hard earn money to be wiped out. If you are reading this 3 years from now, you’ll think this post to be ridiculous and you may even accused me of being mad. Perhaps 3 years from now when I read this post, I will really think I am mad for writing this down.

This blog shall serve as an online diary for myself and future generation on how to manage wealth even when the environment is peppered with madness.