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Investment (Part 7 of 8)

>> Thursday, June 10, 2010

The main objective of investing is to grow wealth.

There are many forms of investments: It ranges from the plain vanilla deposits (savings accounts, fixed deposits, insurance, endowments, CPF, SRS) to stocks, bonds, T-bills, unit trusts, ETFs, real estate; for some more adventurous hedge funds, derivatives (options, warrants, futures), forex, and even to the more unique like art, watches, wine and physical commodities.

This list is definitely not exhaustive, but it illustrates the importance of portfolio management towards investing.

Therefore, the important first, and often neglected, step towards investing is developing an investment policy.

Investment Policy Statement (IPS)

It should contain the following:

  1. Purpose: What is the money intended for?
  2. Time horizon: When will the money be needed?
  3. Risk - Return expectation: What is your risk appetite?
  4. Benchmark: What is the performance going to be reviewed against?
  5. Any other unique considerations? Like tax considerations, legal constrains, religious restrictions, unique preferences, etc.
Having an IPS commits to memory the financial goal of the investment, provides a road map, moderates the expectations, instills discipline for a long term approach and provides a scale to monitor performance.

The next step is to determine the asset allocation that will best suit the IPS requirements.

Asset Allocation

A common theoretical method used to plan is the modeling concept of using historical returns to determine the assets risk based on its statistical deviation and correlation to other assets.

The justification is that different asset classes performance varies relative to each other, correlation is a measure of that difference. It is difficult to time which asset is going to perform the best, therefore, diversification taking correlation into consideration, reduces overall risk given a level of expected return. Sometimes adding a risky asset like commodities into a portfolio of stocks/bonds might increase returns and in fact reduce the risk because the correlation of commodities to stocks/bonds is low.

Diversification not only takes on the form of asset classes but geographical (International, Regional) as well.

According to research, asset allocation determines 90% of the returns achieved for a portfolio as compared to individual security selection and timing.

Next is to consider the investment strategy.

Strategies

The 2 main types are passive and active strategies.
  1. Passive strategies involve an approach aimed at minimizing transaction costs.
  2. Active strategies involve attempting on market timing to maximize returns.
For most small retail investors, the passive strategy would be recommended because the opportunity cost in terms of time spent to beat the market in addition to hefty transaction costs will result in lower returns.

The common passive approach uses a buy and hold strategy as well as dollar cost averaging.

Next is the actual selection.

Security Selection

Individual asset classes has various methods and models of analysis.
  • Top-down approach of economic, industry and company analysis
  • Dividend Discount Model, Capital Asset Pricing Model, Risk Premium
  • Financial statement analysis using key financial ratios
  • Technical analysis, contrarian, smart money trends
  • Cost recovery, similar transaction comparison, return of income approach
  • Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index
Finally, to close the loop for the process, is the continuous monitoring and re-balancing.

Performance Measurement

The benchmark in the IPS will used to gauge the performance of the portfolio and determine if any adjustments are needed.

The IPS will also need to be reviewed in regards to changes in the market conditions and personal circumstances.

Investing helps to meet future financial objectives, learning about investing improves the chances.

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    1 comments:

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