Download Basics of Investment

Draft
Basics of Investment
2005
Contents
Draft
When to Invest
Establishing Personal Investment Policy
Return and Risks
Horizon and Liquidity
Example - Policy
Summary
Appendix
Setting up Priorities
1. Savings for Emergencies
2. Insurance Cover
(accidents, medical, life)
3. Investment
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Traditional Investment
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 Cash
– Liquid Assets, pay interest
– Eg. Short term deposits, Treasury Bills
 Bonds
– Fixed Income Instrument, pay coupons (or
interest)
– Eg. Government Bonds, Corporate Bonds
 Stocks
– Shares in companies, pay dividends
– Eg. Microsoft shares , IBB shares
Which Ones to Buy ?
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 Stocks have generally outperformed at some
point or another, hence have received quite a
lot of attention.
 Microsoft Shares? Tech Stocks? Value Shares?
Biotech? Growth Stories?
 Long term bonds? Munis? Asset Backed?
 Lots of Questions – Need Lots of Answers?
Answer :
 Depends on your
Goals
Age
Asset Size and
Risk Tolerance ….
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Contents
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When to Invest
Establishing Personal Investment Policy
Return and Risks
Horizon and Liquidity
Example - Policy
Summary
Appendix
Setting up Investment Policy
1.
Return Objective (Goals)
2.
Risk Tolerance
Subject to ;
a.
b.
c.
d.
e.
Time Horizon
Liquidity Requirement
Laws & Regulations
Taxes where applicable
Unique Needs
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1. Return Objective (Goals)
 Finding the right Return Objective
– Eg. To double your money in 10 years.
– Steady return over long periods of time
– To get $1,000,000 in 30 years
– To get $100,000 in 6 years
– etc
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Data From 1926-2001
Asset Type
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Average Return per year
Large (Blue Chip) Stocks
10.7%
Small Stocks
12.5%
Long Term Corporate Bonds
5.8%
Long Term Government Bonds
5.3%
US Treasury Bills (Cash)
3.8%
Return in US Stock Market
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Eg. US Stock market investment of US$100 in Dec 1981
S&P 500
1981
$100.00
1993
$380.62
1982
$114.76
1994
$374.76
1983
$134.58
1995
$502.59
1984
$136.47
1996
$604.44
1985
$172.40
1997
$791.86
1986
$197.61
1998
$1,003.04
1987
$201.62
1999
$1,198.90
1988
$226.62
2000
$1,077.34
1989
$288.37
2001
$936.83
1990
$269.46
2002
$717.93
1991
$340.34
2003
$907.32
1992
$355.54
2004
$988.92
Investment in US Stock Market
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1,400
1,200
1,000
800
600
400
200
US$100 Investment in December 1981 turned to a handsome
US$988 in December 2004
20
04
20
00
19
95
19
90
19
85
19
81
0
S&P Monthly Returns
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15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
85
19
90
19
95
19
00
20
Monthly Returns of US Stocks have been Volatile
04
20
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•
Source : Stocks, Bonds, Bills and Inflation 2002 Yearbook
Setting up Investment Policy
1.
Return Objective (Goals)
2.
Risk Tolerance
Subject to ;
a.
b.
c.
d.
e.
Time Horizon
Liquidity Requirement
Laws & Regulations
Taxes where applicable
Unique Needs
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2. Risk Tolerance
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• Setting Return Objectives needs Risk Parameters
– No pain No gain : No risk No Return
• What Risk to assume??
Investing in Shares of Companies
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
Risks in Investing in Shares of Companies
– Specific Risk (companies can be unprofitable and at worst can
go bankrupt)
– Sector Risk (share price can also fall following the same
companies within the same sector)
– Market Risk (share price of a company can also fall with the rest
of the stocks in the same market)

These risks need return compensation. Sometimes you are
well compensated, other times you are not.

Solution : DIVERSIFY, across many stocks, many sectors, many
markets.

Simpler solution : BUYING INDEX FUND
Return and Risk
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Return
10%
US Equity
5%
US Bonds
0%
0%
5%
10%
15%
20%
Historical return of various asset classes against the risk (annualized)
Sources : Various
25% Risk
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Diversification : Combining Assets
Benefits of
Correlation between
asset classes
Stocks and Bonds
rises and falls at
different times
Setting up Investment Policy
1.
Return Objective (Goals)
2.
Risk Tolerance
Subject to ;
a.
b.
c.
d.
e.
Time Horizon
Liquidity Requirement
Laws & Regulations
Taxes where applicable
Unique Needs
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a. Time Horizon
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• Risk and Return objective usually have different
parameters depending upon time horizon of the
investment
• Age plays an important role for individuals.
• Example Return Objective of Setting a Retirement
plan (at the age of 55)
–
A person who is 25 for instance, will have a different set of risk
tolerance compared to another who is already 48 years old.
Phases of Life
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Setting up Investment Policy
1.
Return Objective (Goals)
2.
Risk Tolerance
Subject to ;
a.
b.
c.
d.
e.
Time Horizon
Liquidity Requirement
Laws & Regulations
Taxes where applicable
Unique Needs
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b. Liquidity Requirement
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• Again, Risk and Return objective usually have
different parameters depending upon Liquidity
Requirement from the investment fund
–
Example, the need of a regular income as opposed to
one lump sum payment
–
or the need of a big payment (example a new house)
at age of 40. This liquidity requirement has to be
incorporated when we set up the portfolio
Setting up Investment Policy
1.
Return Objective (Goals)
2.
Risk Tolerance
Subject to ;
a.
b.
c.
d.
e.
Time Horizon
Liquidity Requirement
Laws & Regulations
Taxes where applicable
Unique Needs
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Other Considerations
• More Diversification
– Alternative Asset Classes
• Other Risks
– Currency, Country, Counterparties etc
• Regular Investments versus Lump Sum
Investment
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More Diversification
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 Spreading your risk
 by investing in a variety of assets to protect your
overall investment without sacrificing too much
of expected return.
 Need to find the optimal diversification mix
from a variety of instruments available subject
to again your age, asset size, tolerance for risk
and investment goals.
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Various Asset Classes and the Risk Profile
Currency Risks
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 Studies have shown the following
• Expected Returns of Equity Investments are generally
expected to be high. Much higher than the currency risks
• Bond Investment Return on the other hand tends to be
more moderate and as such, currency risk may be more
pronounced
 Currency Management may prove important in a
diversified portfolio. More importantly are the goals
of the fund
S&P 500 index US$ vs SGD$
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• During 1982-2004 SGD$ fell 20% against US$. Investing in US Stocks during
the period earned 11% p.a. in US$. In SGD$ term, return is 10% p.a.
Contents
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When to Invest
Establishing Personal Investment Policy
Return and Risks
Horizon and Liquidity
Example – Mr Ash Burn
Summary
Appendix
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Investment Policy Example : Mr Ash Burn
1.
Return Objective (Goals) :
Wishes to have monthly income of US$5,000 at the age of 56 - for 24 years
Wishes to travel a lot when retired, US$ requirement not a priority
2.
Risk Tolerance
Medium to High Risk (Age is 24 earning US$2,000/mth 5% increment/year)
Don’t really mind currency risk – Wish to have multi currency exposure
Subject to ;
a.
Time Horizon
- 31 years to go before 1st Payment
b.
Liquidity Requirement
- No real need of liquidity from this investment fund
c.
Laws & Regulations
- US law & regulation applies
d.
Taxes where applicable - No tax concessions
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Investment Strategy Example : Mr Ash Burn
Based on the policy set in the previous slide example
recommendation for Mr Ash Burn is as follows;
Allocation
Expected Return
Volatility
US Equity Index
20%
9.2%
21.7%
Developed Market Equity Indices (non-US)
30%
6.3%
18.9%
Emerging Market Equity Index Fund
20%
11.1%
27.9%
Private Equity Fund
15%
19.0%
20.0%
Long term Fixed Income Funds
15%
1.2%
6.5%
100%
9.0%
12.0%
Total
Investment Requirement
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Given 9% Annual Return Expectation, Mr Ash Burn will need to come
up with either
–
a lump sum investment amount of US$ 40,753,
or
–
an annual investment of US$ 3,615 ($301/mth)
15%
20%
US Equity Index
Developed Market Equity Indices (non-US)
15%
Emerging Market Equity Index Fund
Private Equity Fund
Long term Fixed Income Funds
30%
20%
Investment Requirement
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• If Return Expectation is more moderate 6.5%, need;
– a lump sum investment amount of US$ 103,896,
or
– an annual investment of US$ 7,390 ($616/mth),
Or an even better (less painful alternative)
• $4,885/year (but increasing this payment by 5% per year),
hence monthly installment will be $407 on the 1st year, $427 in the
2nd year, and so on and so forth. At 52 for instance, he will be
paying $956/mth.
Perhaps this will be an easier option as he is assumed to earn more
as he grows older
Policy Review – Mr Ash burn
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 1 year later, the investment policy is reviewed
 Return expectation may change, or his risk
appetite may change, or he suddenly decides he
wants to incorporate a mansion when he is 60 and
is willing to receive less monthly annuities
 All of which will require a different investment
strategy and hence different monthly installments
Contents
Draft
When to Invest
Establishing Personal Investment Policy
Return and Risks
Horizon and Liquidity
Example - Policy
Summary – 4 Key Points
Appendix
4 Key Points
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1. Set up Investment Policy - Return & Risk goes hand in hand
 Avoid “get-rich-quick-and-no-risk” schemes
2. Regular Review of Investment Policy
 At least once a year
 Adjust Risk Lower Towards Maturity
3. Regular Investments
 Avoid the need to time market
 Entry points are averaged over the long run
 Painful lump sum investment can be avoided
4. Diversified Portfolio
 Fund Type Investments generally simpler
 Avoid the pain of being hit by specific risks
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Appendix
More Classes of Assets
Trade-offs
between Return
and Risk
High Return
normally
associated with
High Volatility
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Risk versus Return
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Yet another chart depicting
various assets’ return and risk
characteristics
(from the point of view of US
investors)