The United Nations does it. Governments do it. Companies do it. Fund managers do it. Millions of ordinary working people – from business owners to factory workers – do it. Housewives do it. Even farmers and children do it.
‘It’ here is investing: the science and art of creating, protecting and enhancing your wealth in the financial markets. This article introduces some of the most important concerns in the world of investment.
Let’s start with your objectives. While clearly the goal is to make more money, there are 3 specific reasons institutions, professionals and retail investors (people like you and me) invest:
For Security, ie for protection against inflation or market crashes
For Income, ie to receive regular income from their investments
For Growth, ie for long-term growth in the value of their investments
Investments are generally structured to focus on one or other of these objectives, and investment professionals (such as fund managers) spend a lot of time balancing these competing objectives. With a little bit of education and time, you can do almost the same thing yourself.
One of the first questions to ask yourself is how much risk you’re comfortable with. To put it more plainly: how much money are you prepared to lose? Your risk tolerance level depends on your personality, experiences, number of dependents, age, level of financial knowledge and several other factors. Investment advisors measure your risk tolerance level so they can classify you by risk profile (eg, ‘Conservative’, ‘Moderate’, ‘Aggressive’) and recommend the appropriate investment portfolio (explained below).
However, understanding your personal risk tolerance level is necessary for you too, especially with something as important as your own money. Your investments should be a source of comfort, not pain. Nobody can guarantee you’ll make a profit; even the most sensible investment decisions can turn against you; there are always ‘good years’ and ‘bad years’. You may lose part or all of your investment so always invest only what you are prepared to lose.
At some point you’ll want to withdraw some or all of your investment funds. When is that point likely to be: in 1 year, 5 years, 10 years or 25 years? Clearly, you’ll want an investment that allows you to withdraw at least part of your funds at this point. Your investment timeframe – short-term, medium-term or long-term – will often determine what kinds of investments you can go for and what kinds of returns to expect.
All investments involve a degree of risk. One of the ‘golden rules’ of investing is that reward is related to risk: the higher the reward you want, the higher the risk you have to take. Different investments can come with very different levels of risk (and associated reward); it’s important that you appreciate the risks associated with any investment you’re planning to make. There’s no such thing as a risk-free investment, and your bank deposits are no exception. Firstly, while Singapore bank deposits are rightly considered very safe, banks in other countries have failed before and continue to fail. More importantly, in 2010 the highest interest rate on Singapore dollar deposits up to $10,000 was 0.375%, while the average inflation rate from Jan-Nov 2010 was 2.66%. You were losing money just by leaving your savings in the bank.
Today, there are many, many types of investments (‘asset classes’) available. Some – such as bank deposits, stocks (shares) and unit trusts – you’re already familiar with, but there are several others you should be aware of. Some of the most common ones:
Bank Deposits
Shares
Investment-Linked Product1
Unit Trusts2
ETFs3
Gold4
1 An Investment-Linked Product (ILP) is an insurance plan that combines protection and investment. ILPs main advantage is that they offer life insurance.
2 A Unit Trust is a pool of money professionally managed according to a specific, long-term management objective (eg, a unit trust may invest in well-known companies all over the world to try to provide a balance of high returns and diversification). The main advantage of unit trusts is that you don’t have to pay brokers’ commissions.
3 An ETF or Exchange-Traded Fund comes in many different forms: for example, there are equity ETFs that hold, or track the performance of, a basket of stocks (eg Singapore, emerging economies); commodity ETFs that hold, or track the price of, a single commodity or basket of commodities (eg Silver, metals); and currency ETFs that track a major currency or basket of currencies (eg Euro). ETFs offer two main advantages: they trade like shares (on stock exchanges such as the SGX) and typically come with very low management fees.
The main difference between ETFs and Unit Trusts is that ETFs are publicly-traded assets while Unit Trusts are privately-traded assets, meaning that you can buy and sell them yourself anytime during market hours.
4 ‘Gold’ here refers to gold bullion, certificates of ownership or gold savings accounts. However, note that you can invest in gold in many other ways, including gold ETFs, gold Unit Trusts; and shares in gold mining companies.
With the advent of the Internet and online brokers, there are so many investment alternatives available today that even a beginner investor with $5,000 to invest can find several investment options suited to her objectives, risk profile and timeframe.
Diversification basically means trying to reduce risk by making a variety of investments, ie investing your money in multiple companies, industries and countries (and as your financial knowledge and wealth grows, in different ‘asset classes’ – cash, stocks, ETFs, commodities such as gold and silver, etc). This collection of investments is termed your Investment Portfolio.
Some level of diversification is important because in times of crisis, similar investments tend to behave similarly. Two of the best examples in recent history are the Singapore stock market crashes of late-2008/early-2009, during the US ‘Subprime’ crisis, and 1997, during the ‘Asian Financial Crisis’, when the price of large numbers of stocks plunged. ‘Diversifying’ by investing in different stocks wouldn’t have helped you very much on these occasions.
The concept and power of compounding are best explained by example. Assume we have 3 investments: the first returns 0.25% a year; the second returns 5% a year; and the third returns 10% a year. For each investment, we compare 2 scenarios:
Without compounding, ie the annual interest is taken out of the account.
With compounding, ie the annual interest is left (re-invested) in the account.
Let’s look at the returns over 25 years for all 3 investments, assuming we start off with $10,000 in Year 0:
With 0.25% return a year, your investment will grow to $10,625 after 25 years without compounding; your investment becomes $10,644 after 25 years with compounding.
With 5% return a year, your investment will grow to $22,500 after 25 years without compounding; your investment becomes $33,864 after 25 years with compounding.
With 10% return a year, your investment will grow to $35,000 after 25 years without compounding; your investment becomes $108,347 after 25 years with compounding.
This shows the dramatic effects of both higher returns and compounding: 10% annual returns coupled with 25 years of compounding will return you more than 10 times your initial investment. And 10% returns are by no means unrealistic: educated investors who actively manage their portfolio themselves and practise diversification can achieve even higher returns, even with some losing years.
People of all ages and backgrounds need practical and customised guidance in developing their financial knowledge and skills in order to reach their financial goals. In this article we’ve tried to describe in simple terms some of the most important concepts and principles you need to understand on this journey.