Investing is one of the most important key aspects of financial planning. In today’s dynamic society, I can hardly think of any reasons why not to invest. With the national’s average inflation at around 2%, surely cash isn’t king in this context! Although depositing money into saving or fixed deposits is technically considered an investment, it is clear that returns for such investment instruments fail to clearly hedge against inflation. Moreover, with essential goals like retirement, housing and child’s education, one should all the more work your money while you are working hard yourself. In this article, I’ll just share some insights on the basic concepts of investing from the perspective of financial planning. My next article will be on what are the different types of investment instruments out there.
First of all, let me begin by delineating the difference between investing and speculating. Investing meets a purpose, is goal driven. You invest to reach certain financial goals. Speculating is more like gambling and is mainly market-driven with expectations to make quick buck. In financial planning, it is definitely more crucial to invest than speculate. After all, why overexpose yourself to speculative risk (much higher than investing) when one has not invested to meet essential needs like retirement? Is making a quick buck now more important than your future needs? Not that I’m suggesting speculating is bad, as I mentioned in my first introduction article – set clear priorities.
There are 3 main concepts to why one will invest. They are for income, growth and protecting your capital.
One who invests for income is concerned about receiving income to meet current needs. These investors usually have short-term horizon and usually more risk conservative. One who invests for growth is concerned about meeting a financial goal such as $1,000,000 when one retires. These investors usually have longer-term horizon and have higher risk appetite. One who invests to protect their capital is concerned about inflation and also tends to go for investments that guarantee their capital.
Next, let’s discuss the foundation of investing, i.e. relationship between risk and returns.
Investment risk for an instrument is defined as the variability of the underlying price. The higher the risk, the higher the potential returns. For example, a stock that has expected returns of 20% will also have an expected loss of 20%. So where does the investment risk come from? From a financial perspective, there are two kinds of risk namely systematic and unsystematic.
* Systematic risk is risk that one cannot control. In other words, it is a risk that affects the market as a whole. For example, the recent sub-prime financial meltdown is a systematic risk - something you are helpless with. Few other examples are the rise/fall of interest rates, the value of the currency and even political risks. An investor will always be subjected to such risks.
* Unsystematic risk is risk that is specific and unique to a certain investment instrument. For example, investing all your money in a single company such as Lehman Bros was exposing yourself to unsystematic risk. This risk can be greatly reduced by diversification. This is to pick out investment instruments in your portfolio that have little correlation to each other.
On this note, I’ll like to digress a little into diversification. Most people define diversification as “not putting your eggs in one basket”. But this definition is really half the truth. For example, owning only stocks in OCBC, DBS, HSBC and Maybank is not a form of diversification because these stocks are all banks. Banks tend to be a collective industry. One suffers, others will suffer as well. Buying a stock in OCBC, a gold bullion bar and a stock in an agricultural company is a form of diversification because these asset classes (investment instruments) have their own unique set of unsystematic risks. If the gold price were to suddenly fluctuate, your investment portfolio will not be greatly affected since the other stocks are generally not affected.
Now that we understand the trade-off between risk and returns, an investor should then find out his risk appetite. This can be assessed by a financial adviser usually in the form of questionnaire. However for the sake of this article, I’ll list down the three most important questions you can ask yourself. Firstly, what is your time-horizon, expected annual rate of returns and risk tolerance (i.e. what is the greatest amount of losses you can stomach in one year?)
The longer your time-horizon, the higher your risk appetite should be. MSCI world index (a benchmark of around 1500 stocks to illustrate the global stock market movement) illustrates an annual rate of returns of around 10% for the past 200 years. Therefore, the longer you stay invested, the lower the risk you are exposed to. Certainly, the higher your expected returns, the higher risk you must bear. In theory, there is a term call risk-free rate which means that rate of returns that are guaranteed without any hinge of risk at all. Well in reality, there isn’t really such a thing. Even putting your money in your POSB savings carries some risk (though almost negligible). But well if you are expecting 10% rate of returns, expect 10% of losses (I personally say 20 %.) Risk tolerance questionnaire is important because it truly analyses your risk appetite. One of my clients who once thought he was very averse to risk turned out to be adventurous after I assessed his risk tolerance. He actually said that as long as it is not more than 50% losses in a single year, he is willing to bear. That’s one adventurous investor!
Now that we have understood about risk, let me just finally touch on the forms of returns from an investment. There are few forms of returns. Firstly, it can be in a form of capital appreciation meaning that the rise in value of the asset you bought. A share price of $1 you bought is now worth $2 means that you gain 100%. Another form is dividend which is somewhat like income only declared by companies. However, dividend is non-guaranteed and is subjected to the discretionary of the company’s board of directors. Earning interest is also a form of returns. For example, you can earn interest by buying bonds from companies or even Government (I’ll explain what bonds are in my next article)
While pardon me if you find this article dry and technical, it is only because I find it a little tough explain investment terms in writing. This is it for now. My next article will be on the different types of investment instruments out there.
Category: Financial Planning | 22 Comments