After determining your investment goals, you need to have some fundamental theoretical knowledge to ensure your investments have a good chance of being successful. This article introduces you to 5 investing concepts you must know.
Understanding this fundamental knowledge will allow you effectively plan your investment strategy and enable you to construct your investment portfolio that suits your needs or choose which existing portfolio model you can adopt.
Unfortunately, this section may seem theoretical, academic, dry, boring and tedious but these concepts are particularly important to the passive investor.
So, let us get this over and done with. I promise I will make it quick and relatively painless. Be prepared to put on your thinking cap.
Here are 5 key investing concepts you must know:
1) Risk & Return
2) Time Horizon
5) Dollar Cost Averaging (DCA)
Risk and Return
All investments involve some degree of risk. If you intend to invest in any financial asset, it’s important that you understand that you could lose some or a majority of your money.
No matter what you decide to do with your savings and investments, your money will always face some risk. You could stash your dollars under your mattress, but then you would face the risk of losing it all if your house burned. Investing in stocks, bonds, or ETFs carries risks of varying degrees.
In order to receive an increased return from your investment portfolio, you need to accept an increased amount of risk. Low risks are associated with low potential returns. High risks are associated with high potential returns.
The risk return trade-off is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return. Deciding what amount of risk you can take while remaining comfortable with your investments is very important. This is also called risk tolerance.
A common misconception is that higher risk equals greater return. The risk return trade-off tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.
Sometimes swings in the market can affect investors of all risk appetites. For example, in early 2001-2002 and again in 2007-2008, many investors were horrified that investments that had been performing so well dropped as much as 30-50% quickly.
Many of them erroneously thought that because they choose “moderately conservative” investments meant that that kind of loss could not happen to them but it did. If they were planning to retire during this down-market, they had two painful choices to make.
One, continue working and wait for the market to recover and rise up to pre-drop levels, if ever, depending on what they were invested in. This would realistically take at least 5 years.
Two, they could go ahead with retiring but only have 50% of their planned retirement fund. Many investors had no choice but to not retire and continue working longer to rebuild savings.
Understanding the risk and potential performance swing level of your investments is crucial to your financial well-being. An investor needs to arrive at his own individual risk return trade-off based on his financial & investment objectives, his life-stage and his risk appetite.
But note that when it comes to your long-term financial future, the biggest risk of all may simply be to do nothing. If you don’t invest for retirement or to help meet your personal financial goals, then you are most likely guaranteed a “rat race” future.
Your time horizon is the length of time over which you expect to invest your money. It’s a key consideration when choosing investments.
Investments like cash and short-term bonds carry little risk for an investor whose time horizon is short, for example, a person saving for a vacation in 2 years. However, they can be risky for an investor whose investment horizon is long, for example, a person saving for retirement. The low return on short-term investments may not keep pace with inflation, or be enough to meet the long-term goal.
In comparison, stocks are very risky for the short-term investor since their value may change frequently. People saving for a short-term goal could end up with less money than they originally invested. Stocks have a higher potential return than cash and bonds over the long term, and are better for investors saving for long-term goals.
Longer-term investors are in a position to allocate a larger portion of their portfolio to higher-risk investments like stocks than shorter-term investors because a longer time horizon is associated with lower volatility. This does mean that stocks are not risky over the long-term, but for long-term investors, stocks are more likely to provide higher returns.
Compounding is a key aspect of investing. Sometimes called “compound interest”, it is the process of generating earnings on an asset’s reinvested earnings. Albert Einstein called compound interest “the greatest mathematical discovery of all time”.
To work, it requires two things: the re-investment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment, which takes the pressure off of you.
Here is an example:
If you invest $10,000 today and assume you will get a 6% return, you will have $10,600 in one year ($10,000 x 1.06). Now let’s say that rather than withdraw the $600 dividends, you reinvest the dividends, along with your principal sum, for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year. If you reinvest the compounded earnings from the first two years, along with your principal sum, for a third year, your investment will grow once again.
This increase in the amount made each year is compounding in action: earnings growing on reinvested earnings, growing on reinvesting and so on. This will continue as long as you keep reinvesting and earning. The longer money compounds, the faster it grows. Money growing at 6 percent per year will double in about 12 years, but it will be worth four times as much in 24 years.
So, each additional percentage point in returns on your investment will improve your returns on investment significantly over time. That is why, even though you will earn compounded interest with your banks savings account, you will earn drastically more with the same amount even if you choose a very safe investment with just a 1% better return.
But remember, because time and reinvesting make compounding work, you must keep reinvesting the principal and earnings.
Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio.
Your mind must be spinning.
In simple English, that means you should not put all your eggs in one basket. Instead of investing all your money in a single financial asset, you should invest in a number of different assets who prices do not move together in the same direction at the same time.
For example, historically, when the price of stocks go up, the price of gold goes down and vice versa. When stocks go down, bonds tend to go up in price.
When asset prices move together in the same direction it is called correlation.
So, when you diversify, you are trying to build a portfolio of lowly-correlated assets that do not all move in the same direction at the same time or even if they do move in the same direction, it should at least be by different degrees.
Diversification means you may give up some gains but should also reduce some of the risk of losses in your portfolio. A diversified portfolio can help you better withstand the fluctuations of economic and market conditions and cycles over the long term.
When you diversify, there is no way you can lose all your money in the stock market. When you hear stories of people who have lost all their live savings in the stock market, it is because they put all their money in a single stock that tanked.
There are three main ways you can diversify your portfolio:
Vary your investments by asset allocation
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as bonds, stocks, real estate, gold and cash. Each asset class has different levels of return and risk, so each will behave differently over time. At the same time that one asset is increasing in value, another may be decreasing or not increasing as much. An asset-allocation strategy looks at your particular goals and circumstances and determines what asset mix gives you the optimal blend of risk and reward.
Vary the risk in your securities
If you are investing in equity funds, then consider large cap as well as small cap funds. And if you are investing in debt, you could consider both long term and short term debt. It would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas. You can also vary your risk by have diversity in investing in different countries or regions.
Vary your securities by industry
This will minimize the impact of specific risks of certain industries. For example, even if you invest in a number of different companies in different countries or regions, but all of the companies are in the same industry; in the event of a downturn in the industry, all your investments will be affected. By diversifying your investments in different industries, you ensure that even a downturn in one industry will not affect your entire portfolio.
Investing in different ETFs that tracks different market indexes is a way to have diversified investments. For example, to spread your risk, you could invest 50% in the STF ETF that tracks the Straits Times Index, 25% in an ETF that tracks the S & P 500 and 25% in an ETF that tracks the world markets, excluding the US.
Diversification is a very important component in helping you reach your long-range financial goals while minimizing your risk. At the same time, diversification is not an ironclad guarantee against loss. No matter how much diversification you employ, investing involves taking on some sort of risk.
Dollar-Cost Averaging (DCA)
Dollar-cost averaging is another form of diversification; only instead of spreading your money over different stocks or bonds, it diversifies your investments over time.
A classic problem with naïve investors is to try to “time the market”. They chase performance and buy whatever was up the most last year. Then, when it goes down, they sell it and buy the next best performer, and so on. The natural human tendency is to buy lots of stock when prices are rising and to stop buying them altogether when prices are on the downswing.
Dollar-cost averaging forces you to do the opposite. It involves investing a fixed sum of money at regular intervals, whether the market is up or down.
Different financial institutions (brokers, banks or fund companies) offer DCA plans for the securities or funds that they sell but may call it different names like PhilipCapital’s “Share Builder Program” (SBP), OCBC’s “Blue Chip Investment Plan (BCIP) or Fundsupermart’s “Regular Savings Plan” (RSP).
Here’s how it works: Suppose you decide to put $400 a month into an ETF that tracks an index.
If a share of the ETF costs $50 in October, your $400 will buy 8 shares. If the price rises to $80 in November, your $500 will buy 5 shares. If the price drops to $40 in December your $400 will buy 10 shares. The idea is that your money buys more shares when the price is cheap and fewer when the price is high. That lowers your total cost and, assuming the ETF’s overall performance is upward, you will capture more of the upside.
That’s not to say dollar-cost averaging protects you from a falling market. If the ETF’s value crashes, so does your overall investment. But the strategy does ensure that you invest new money when prices are low so that you can enjoy the run-up when the market recovers, as it always does with time.