Myth - High Return Equals High Risk

I met a gentleman this morning at an international university gathering. He told me how interested he was in growing his money through 'investing' - but not for the long term.

After further investigation, it was revealed that anything over a year was long term for him! His idea was trading leveraged instruments like Forex and options with a holding period of days, sometimes hours!

I had to share with him a few key points.

Defusing the Financial Time Bomb: Investing without Fear

Money makes the world go round, so goes the saying. Most of us spend a good part of our days thinking or doing something to make more of it.

So how much money do we really need? Surprisingly enough, that is the million dollar question and the answer of which so many of us have no clue about, or worse, have the wrong idea.

This article is not intended for those fortunate few who already have all that they will ever need nor is it for those who know exactly what to do to get what they want.

This piece is for the remaining 98% of the population - the average citizen who earns a salary, supports a family, and aspires to secure his retirement. And, with luck be healthy, wealthy and free enough to fulfill some of his dreams. (Who hasn’t thought of owning a beach-front bungalow or a snazzy sports car or even a yacht?) It is also for those who wish to grow their money, rather than work hard for every dollar.

So how does the average individual make it? The answer, discussed in this article, is deceptively simple.

So why do so many people not make it? Why is it that a majority of Singaporeans are living with a financial time bomb (often without even being aware of it)?

The answer points to three insufficiencies:

1. Lack of essential yet basic financial knowledge (and it is not rocket science)

2. Lack of implementation of that knowledge

3. Simple lack of time (yes, in this case, it can be too late)

Assuming you have enough time and you are adequately insured, this very article can be the start of your financial freedom.

So, where do you begin?

My first recommendation would be for you to consult with a competent and trustworthy financial advisor. I do not recommend leaving all decision-making to him or following his suggestions blindly (a good financial adviser would naturally involve the client as well as educate him at every step of the process). It is exactly like visiting a physician with regards to your health.

With the financial adviser, one must arrive at a comprehensive and consolidated report which clarifies what your current situation is (assets, liabilities, policies etc.) as well as a precise dollar amount that you need the day you retire and how much you need to save every month now in order to reach the above financial goal.

Example:

Consider Mr. Tan, aged 40, married to a homemaker and has two teenagers. He wants to retire at 62 and we assume that he has a life expectancy of 88 years. His income is $5,000 per month and he manages to save $500 each month. The total current savings (cash, investments & CPF) is $150,000. Inflation rate is 2% per year. He foresees he will need $3,000 per month (in today's dollars) during his retirement years. We are assuming he is adequately insured.

Scenario A

If he invests his money with a bank, he would get about 1% per year.

Scenario B

If he invests his money in good bond funds, he would get at least 4% per year.

Scenario C

If he invests his money wisely in a balanced, high quality portfolio (as explained below), we can safely assume he would potentially achieve 8% per year.

Table 1 – Comparison of Rate of Return

As is evident from Table 1, the key to achieving financial freedom is the investment rate of return.

So how is this rate of return achieved?

Well, the good news is an 8% - 10% return in the long term (5 years and above) is not out of reach for the average investor. A clear evidence of this assertion is that over 1926 through 2004, investing in the biggest US stocks, would have yielded an average return, with all dividends reinvested, of 10.46%! (Source: StandardAndPoors.com). This includes all the biggest crashes in the US markets.

More Good news: Over the last two decades, the rate of return has become even higher… close to 13%.

Figure 1 shows the Dow Jones Industrial Average from 1929 through to the present. We have considered the US stock market since it is the biggest, most mature and most influential market in the world.

Figure 1 - Dow Jones Industrial Average historic performance

Now, instead of simply throwing your money at some stocks, a simple strategy, when implemented over time, gives even greater returns while reducing the volatility dramatically. We call this the ‘magic portfolio’.

Simply park your investable cash into a portfolio comprising of a split of good bond funds and selected equity funds. The ratio of the split (usually 50:50), is based on your risk profile (your FA should help you with both: suggesting quality funds as well as your ratio).

The next step is vital and that is rebalancing.

What this means is simply to re-set the ratio of the equity and bond components of the portfolio periodically. Every 6 months is ideal. All the investor must do is that if the equity component is higher, he sells some equity and buys some bonds and vice versa. The effects are shown in Figure 2.

Figure 2 - Rebalancing

This strategy takes advantage of the fact that bonds give slow growth but lower volatility where as equities tend to grow fast but with sharper ups and downs.

Besides reducing portfolio volatility, this deceptively simple step automatically “buys low and sells high”.

Coupled with that, the investor can use another powerful strategy called dollar cost averaging (DCA). DCA simple means investing a fixed amount of dollars every month or so in bonds and equities in your ratio. This automatically facilitates buying less when the price is high and more when low, and is ideally suited to the salaried person.

Finally, the key aspects that the investor should always remember are:

1. Take a long-term perspective

2. Ensure liquidity of your investments, so that you can get your money when you want it without losses or penalties

3. Have enough diversification across asset classes and geography.

4. Evaluate the quality of your portfolio, i.e. growth prospects of each individual investment

We in Singapore are lucky to have an abundance of excellent unit trusts (also called mutual funds) which give us all the flexibility, liquidity, and convenience, plus some very competent fund managers who are able to consistently beat the markets they invest in. What’s more, unlike stocks, the government allows you to invest all your CPF holdings (after setting aside the first $20k in OA and SA) into unit trusts. So take action & start getting rich now!

TOP 5 Mistakes in Investing

Protect your money by avoiding these mistakes

1. Trying to strike it rich

Too often investors try to look for get-rich-quick investments. Speculation in the market is especially true when the market is rallying and success stories abound. The truth is those that make it overnight are far and few. Investment needs time to grow and definitely not without a well thought out strategy and framework for making investment decisions.

2. Following tips and impulses

Do you invest based on a stock tip, news or only after careful consideration?

Many people believe in making fortunes overnight. When they hear of a hot stock that will jump from $0.75 to $40 overnight, they immediately invest their lifesavings in order to have a chance at these overnight riches. When you ask them about the company they just bought and what it does, they have absolutely no clue. This is more like gambling than investing. Imagine how you would feel if the company dropped to $0.15 a share the following day. If you want to take a chance with stock tips, at least do your homework and find out the following:

• Is the company in a growth industry?
• Has the company had any problems in the past?
• Is the company profitable?
• Does the company have a low market capitalization, allowing room for growth?
• Does the company already have a high P/E ratio?
• What are the company's main operations/businesses?

The knowledgeable and prudent investor will do his own research and does not depend on heresay or ‘hot’ news.

Investors who plan on working with an adviser should check out the adviser's references beforehand in addition to this person's fee structure. Be aware that an adviser who works on commission has an incentive to buy and sell.

Even when you have a trusted advisor to manage your investments, it is recommended that you take an active involvement in learning about your investments and be in-the-know what your advisor is doing for you.

An advisor who is only familiar with managing investments linked to insurance plans possesses different qualities and skill set from one who is well trained and exposed to managing pure investment portfolios (stocks, mutual funds).

3. Timing the market

It is every investor’s desire to buy low and sell high. However, many investors who have tried to predict the market cycle have failed. No one can foretell the future of the market.

The best approach for the investor who invests for the long haul is to ignore timing entirely. This is difficult for most people but the following are reasons enough to support a long term approach:

Research has shown that a buy-and-hold strategy beats a trading or ‘speculative’ strategy.

No one has a crystal ball to tell exactly when the market will rally and when it will hit a trough. It is, therefore, fruitless to time the market to lock in profits.

4. Straying from your investment goal

The path to investment success is to stick to your investment goal. Suppose you are investing to secure your retirement funding trough a portfolio of balanced and fixed income mutual funds (unit trusts).

But when the markets show signs of a rally, you are tempted to reap some quick profits and you decide to adjust your asset allocation from a balanced to an aggressive portfolio.

What happens if the markets tank? Depending on the time line you have before retirement, this move could potentially wipe out your retirement nestegg and leave you with a battered portfolio.

Warren Buffett could not have put it more aptly: “Be fearful when others are greedy and greedy when others are fearful”.

5. Forgetting about Portfolio Diversification

Portfolio diversification is the mantra of investing. In choosing a property, we know it’s the location that matters. Similarly, with your investments, you have to diversify, diversify and diversify. It cannot be emphasized how important this is to one’s investments.

An investor who puts his money in a well diversified portfolio of say 8 to 10 stocks or mutual funds is in a far better position than another investor who prefers to bet all his money on 2 stocks.

Diversification is the spreading out of investments to reduce risks. Because the fluctuations of a single security have less impact on a diverse portfolio, diversification minimizes the risk from any one investment. Diversification involves allocating your money in different asset classes to achieve your target investment return.