Basics of Investment

1
Basics of Investment

• 2005

2
Contents

• When to Invest
• Establishing Personal Investment Policy
• Return and Risks
• Horizon and Liquidity
• Example - Policy
• Summary
• Appendix

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Setting up Priorities

1. Savings for Emergencies
2. Insurance Cover (accidents, medical, life)
3. Investment

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Traditional Investment

• 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

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Which Ones to Buy ?

• 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?

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Answer

• Depends on your
• Goals
• Age
• Asset Size and
• Risk Tolerance .

7
Contents

• When to Invest
• Establishing Personal Investment Policy
• Return and Risks
• Horizon and Liquidity
• Example - Policy
• Summary
• Appendix

8
Setting up Investment Policy

1. Return Objective (Goals)
2. Risk Tolerance

• Subject to
• 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 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
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Return in US Stock Market

• Eg. US Stock market investment of US100 in Dec
  1981
• SP 500

1981 100.00
1982 114.76
1983 134.58
1984 136.47
1985 172.40
1986 197.61
1987 201.62
1988 226.62
1989 288.37
1990 269.46
1991 340.34
1992 355.54
1993 380.62
1994 374.76
1995 502.59
1996 604.44
1997 791.86
1998 1,003.04
1999 1,198.90
2000 1,077.34
2001 936.83
2002 717.93
2003 907.32
2004 988.92
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Investment in US Stock Market

• US100 Investment in December 1981 turned to a
  handsome US988 in December 2004

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SP Monthly Returns

• Monthly Returns of US Stocks have been Volatile

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• Source Stocks, Bonds, Bills and Inflation 2002
  Yearbook

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Setting up Investment Policy

1. Return Objective (Goals)
2. Risk Tolerance

• Subject to
• Time Horizon
• Liquidity Requirement
• Laws Regulations
• Taxes where applicable
• Unique Needs

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2. Risk Tolerance

• Setting Return Objectives needs Risk Parameters
• No pain No gain No risk No Return
• What Risk to assume??

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Investing in Shares of Companies

• 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

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Return and Risk
US Equity
US Bonds

• Historical return of various asset classes
  against the risk (annualized)
• Sources Various

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Diversification Combining Assets

• Benefits of Correlation between asset classes

Stocks and Bonds rises and falls at different
times
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Setting up Investment Policy

1. Return Objective (Goals)
2. Risk Tolerance

• Subject to
• Time Horizon
• Liquidity Requirement
• Laws Regulations
• Taxes where applicable
• Unique Needs

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a. Time Horizon

• 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.

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Phases of Life
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Setting up Investment Policy

1. Return Objective (Goals)
2. Risk Tolerance

• Subject to
• Time Horizon
• Liquidity Requirement
• Laws Regulations
• Taxes where applicable
• Unique Needs

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b. Liquidity Requirement

• 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

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Setting up Investment Policy

1. Return Objective (Goals)
2. Risk Tolerance

• Subject to
• 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

• 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
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Currency Risks

• 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

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SP 500 index US vs SGD

• 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.

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Contents

• 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

• Return Objective (Goals)
• Wishes to have monthly income of US5,000 at the
  age of 56 - for 24 years
• Wishes to travel a lot when retired, US
  requirement not a priority
• Risk Tolerance
• Medium to High Risk (Age is 24 earning
  US2,000/mth 5 increment/year)
• Dont really mind currency risk Wish to have
  multi currency exposure

• Subject to
• Time Horizon - 31 years to go before 1st Payment
• Liquidity Requirement - No real need of
  liquidity from this investment fund
• Laws Regulations - US law regulation applies
• 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
Total 100 9.0 12.0
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Investment Requirement

• 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)

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Investment Requirement

• 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

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Policy Review Mr Ash burn

• 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

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Contents

• When to Invest
• Establishing Personal Investment Policy
• Return and Risks
• Horizon and Liquidity
• Example - Policy
• Summary 4 Key Points
• Appendix

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4 Key Points

• Set up Investment Policy - Return Risk goes
  hand in hand
• Avoid get-rich-quick-and-no-risk schemes
• Regular Review of Investment Policy
• At least once a year
• Adjust Risk Lower Towards Maturity
• Regular Investments
• Avoid the need to time market
• Entry points are averaged over the long run
• Painful lump sum investment can be avoided
• Diversified Portfolio
• Fund Type Investments generally simpler
• Avoid the pain of being hit by specific risks

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Appendix
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More Classes of Assets

• Trade-offs between Return and Risk
• High Return
• normally associated with
• High Volatility

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Risk versus Return

• Yet another chart depicting various assets
  return and risk characteristics
• (from the point of view of US investors)