Most textbooks will define investing as a process of putting resources into something with the hope of getting a return. But is investing simply about returns? Well the answer is a definite NO.
Indeed, so much emphasis has been placed on returns from investments that the other aspect of it, which is risk, is forgotten. Not true? Suggest to someone that you have an investment opportunity and the first, second and third question to be asked will be: “what are the returns?” In fact, investing is more about risks than returns. Wanting a good ROI is a given. But can you take the risks, is there a need to take the risks and are you willing to take the risks? Different individuals all wanting high returns may have different acceptance on the risk that comes along with the investments. So really, it is about managing one’s expectation of risk, the returns as they say it, will take care of itself.
So what RISKS are we talking about?
There are generally 2 types of risks in investments. They are:
(1) Market Risk
As the name implies, this is the risk associated with the market. Examples of such type of risk are interest rates risk, political risk, economic risk, currency risk etc. These risks affect different investment instruments differently. For example, bonds are interest-sensitive and prices move up and down depending on factors that affect interest rates. The US currently is experiencing good economic growth. Unemployment rates though still hovering around 5 over percent, has seen great improvement. As consumer spending increases, inflation will begin to pick up. This signals the fact that the US central bank may raise the Fed rates soon and it means bond prices (especially those with low rates) may fall. However, all this while when the economy is doing well, the US equities market has been soaring. Closer to home in Taiwan, after the presidential elections, there was so much political uncertainty that the Taiwan equities market fell. Market risk not only affects different instruments differently; it also affects different continents or country differently.
(2) Company Specific Risk
Again, as the name implies, company specific risk has to do with risk associated with individual companies. Different companies perform differently in different market situations. For example, in good times, most companies do well. However, in bad times, whilst most suffers in terms of earnings, debt collection companies do very well.
How can we DEAL with RISKS?
There are a few ways we can deal with risks associated with investing. They are:
(1) Strategic Asset Allocation
In strategic asset allocation, you simply invest your monies in a portfolio consisting of different asset classes, different sectors, countries or continents. For this method to work, you must be a relatively long-term investor (at least 5 years) and not a market punter. Risk is reduced tremendously over a long period. The proportion of equities, bonds and cash in your portfolio depends on your overall risk profile. It is created using an iterative process based on the forecast on returns and risk of the individual asset classes. An example of strategic asset allocation for a balanced investor is found in diagram 1:
(2) Tactical Asset Allocation
In tactical asset allocation, the prime objective is to track down and exploit short-term profit opportunities arising from fluctuations in relative valuations/prices of individual investment alternatives. It is also to recognise turning points and analyse the most advantageous asset class ata given point of time. This is done from time to time on your portfolio that you have created earlier. For example, 6 months ago, we decided that there is value in the Singapore equities market; we can perform a tactical asset allocation for a balanced investor by shifting some funds into Singapore. The asset allocation is found in diagram 2:
(3) Diversification into Different Companies
The most logical way to deal with company-specific risk is to invest across different companies. In this way, the risk is reduced greatly. One of the most effective ways of investing into different companies is via the unit trust. It gives you great economies of scale and you do not have to make the daily trading decisions.
(4) Regular rebalancing
Last and definitely not the least, is for you to do regular rebalancing. Rebalancing is a process by which you re-allocate your monies in your portfolios to reflect your original portfolio’s asset allocation. This is because after some time, the different asset class in your portfolios will move in different directions and as such the original proportion would have changed. Rebalancing allows you also to sell away investments that have become expensive and buy investments that are of good value, thus following the principle of selling high and buying low.
A Practical Problem
Well, it all sounds well and good that we have dealt with the risks effectively. But there are real practical problems that you have to deal with, especially in Singapore. With most of the financial advisers in Singapore still charging front-end sales charges, it would not be cost effective to do tactical asset allocation as well as rebalancing regularly. Each time you get in and out from the funds, you lost a few percent! So, you really should look for financial advisers that do not charge front-end load but instead charge a retainer fee. Alternatively, simply invest in a balanced fund that does all the above on its own.
So what does all these mean to you?
This means that the next time you want to invest your money, don’t just focus on the returns. Ask yourself what kind of risk you need to take, want to take and can take, then do the necessary asset allocation to reflect the risk. The returns will come, if you monitor the performance and the market regularly. That way, you have peaceful sleep every night, regardless of where the markets are heading. If you do not have the necessary resources to do it, find a trustworthy and competent adviser to help you. But make sure that he practises the proper process of investing, and he has the interest to monitor it for you. Otherwise, you may find yourself buying investments for his gains rather than yours.
The writer, Christopher Tan, is Chief Executive Officer of Providend, a Fee-only Retirement Financial Adviser. Besides being financially trained, he is also an Associate Certified Coach with the International Coach Federation. The edited version has been published in Smart Investor.