Make Your Money Work For You.pdf

(1)

KEON CHEE & BEN FOK

H

(2)

(3)

(4)

MAKE YOUR

M

RK

HOW TO GROW YOUR INVESTMENT DOLLARS

FOR YOU

W

NEY

KEON CHEE & BEN FOK

(5)

Cover images: kavitha/SXC.hu, hele-m/SXC.hu, 2007 Presidential $1 Coin image from the United States Mint

Design: Lock Hong Liang

No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Request for permission should be addressed to the Publisher, Marshall Cavendish International (Asia) Private Limited, 1 New Industrial Road, Singapore 536196. Tel: (65) 6213 9300, fax: (65) 6285 4871. E-mail: genref@sg.marshallcavendish.com. Website: www.marshallcavendish.com/genref Th e publisher makes no representation or warranties with respect to the contents of this book, and specifi cally disclaims any implied warranties or merchantability or fi tness for any particular purpose, and shall in no events be liable for any loss of profi t or any other commercial damage, including but not limited to special, incidental, consequential, or other damages.

Other Marshall Cavendish Oﬃ ces

Marshall Cavendish International. PO Box 65829, London EC1P 1NY, UK • Marshall Cavendish Corporation. 99 White Plains Road, Tarrytown NY 10591-9001, USA • Marshall Cavendish International (Th ailand) Co Ltd. 253 Asoke, 12th Flr, Sukhumvit 21 Road, Klongtoey Nua, Wattana, Bangkok 10110, Th ailand • Marshall Cavendish (Malaysia) Sdn Bhd, Times Subang, Lot 46, Subang Hi-Tech Industrial Park, Batu Tiga, 40000 Shah Alam, Selangor Darul Ehsan, Malaysia

Marshall Cavendish is a trademark of Times Publishing Limited National Library Board Singapore Cataloguing in Publication Data Chee, Keon.

Make your money work for you : how to grow your investment dollars / Keon Chee & Ben Fok. – 3rd ed. – Singapore : Marshall Cavendish Business, c2011.

p. cm.

ISBN : 978-981-4328-61-6

1. Finance, Personal. 2. Finance, Personal – Singapore. 3. Investments. 4. Investments – Singapore. I. Fok, Ben, 1961— II. Title.

HG179

(6)

To Sarah, For making bubbles ﬂ oat

and the sun shine.

Keon

To my wife, Sharon, For the encouragement, and to my children, Jeryn and Samuel,

for the love and laughter.

Ben

(7)

(8)

Introduction 8 Part 1 : Basic Investment Concepts

1 Why Learn About Investing 11

2 The Major Types of Investments 20

3 The Risks and Returns from Investing 28

4 Managing Crises and Diversification 40

Part 2 : Investing In Traditional Assets

5 Investing in Unit Trusts 56

6 Selecting and Managing Your Unit Trust Investments 67

7 Investing in Individual Stocks 84

8 Selecting and Managing Your Individual Stock Investments 95

9 Investing in Individual Bonds 110

10 Selecting and Managing Your Individual Bond Investments 122 Part 3 : Investing In Alternative Assets

11 Investing in Exchange Traded Funds (ETFs) and Index Funds 132

12 Investing in Real Estate 138

13 Socially Responsible Investing 150

14 Investing in Commodities 161

15 Investing in Gold 172

16 Investing in Hedge Funds 181

17 Investing in Art and Collectibles 191

18 Understanding Basic Derivatives 197

19 Understanding Structured Products and Other Derivatives 210

20 Understanding Currency 220

Part 4 : Special Topics

21 Investing for Kids 231

22 Investing During Retirement 237

23 Protecting Your Wealth with Insurance 243

24 When Things Go Wrong 249

25 Getting Financial Advice 254

26 Protecting Your Portfolio in Downturns and Upturns 265

(9)

We belong to the sandwich generation. Our children depend on us, as do our parents. For our children, we are seeing the price of a higher education rising faster than the rate of inﬂ ation. For our parents, we are possibly looking at hundreds of thousands of dollars in costs for treating major illnesses they run the risk of contracting. Th e sandwich generation is being chewed on at both ends.

We are struggling to support ageing parents and pay university tuition fees for our children. And this is probably the worst situation you can ﬁ nd yourself in — when you have to depend on others to support you in your retirement years.

In the future, you will either have enough money or you will not. If you don’t, chances are that your neighbour living next door to you will. People living in Singapore and in Asia overall are getting wealthier and wealthier.

In the year 2009, Singapore saw the highest growth in millionaire households, up 35 per cent, followed by 33 per cent for Malaysia, 32 per cent for Slovakia, and 31 per cent for China (2010 Global Wealth Report by Th e Boston Consulting Group). Singapore now has the highest concentration of millionaire households in the world. And Asia-Paciﬁ c, excluding Japan, is expected to generate millionaires at nearly twice the global rate.

It is horrible to retire when you don’t have enough money, and even worse if everyone around you has enough and you can’t even get by. Th at is why learning how to invest is so important. For many people, it could make the diﬀ erence between a blissful retirement and a painful one.

Th e investment environment has become very diverse in the last few years. We are seeing a rise in derivatives and currency trading by the public, commodity prices far outpacing stocks and bonds, hundreds of structured products being made available at any one time and challenging market conditions with inﬂ ation, lower real returns and a subprime crisis that is taking years to clean up. Th is is why for this third edition, we have added two

(10)

new chapters, revamped one chapter and expanded on previous chapters in the hope of better describing what is out there.

To succeed at investing, you need to keep two things in mind. First, you need to keep abreast of what is happening in the investment markets. Once you are armed with the basic knowledge of investing (which we hope you will gain from this book), knowing what is happening in the markets will become not only less strenuous but also an enjoyable pastime. Second, if you have never invested before, you need to take the plunge yourself. Th ere is nothing like direct experience. Only when you handle your own money will you be able to appreciate and understand fully the complexities surrounding the money markets. Finally, and most importantly, investing is your responsibility, not anyone else’s. It is neither the government’s responsibility, nor that of your remisier or ﬁ nancial adviser’s.

And when you do succeed, you will probably want to spare a thought for the less fortunate. Social enterprise and socially responsible investing are taking root in Singapore and around the world and not a moment too soon as income gaps around Asia have become particularly worrying. Singapore’s Ambassador, Tommy Koh, described “social inequity” as one of Asia’s three biggest challenges, along with corruption and the environment.

Despite headline hogging news about Asia’s booming economies, vast pockets of paralysing poverty remain. Dr. Ifzal Ali, Chief Economist of the Asian Development Bank, estimates that 42 per cent of Chinese live on the equivalent of less than $3 a day. In India, three-quarters of the population (more than 800 million people) survive each day on less than the cost of a Starbucks latte. All told, 60 per cent of all Asians still live in poverty.

In the future, you will either have enough money or you will not. Th ere are many exciting things you can do today to make sure that you will have enough — and better still — be able then to spare time and money to help others.

(11)

BASIC INVESTMENT

CONCEPTS

We start with the basic concepts you need to

know to understand and appreciate the art of

investment.

While there are many reasons for investing,

retirement is by far the most important one. In

this section, we will look at the main types of

investment assets and discuss whether they are

appropriate for you.

We will show how investment risks and returns

are calculated so you can assess the performance

of your investments.

Finally, we find out how crises affect investment

performance. The findings may surprise you.

1

(12)

Why Learn About Investing

Congratulations! You have accumulated $1 million in cash and assets, and you are planning to retire next year at age 55.

But here is a reality check. Your son, Brian, will be going to the U.S. in two years’ time to do a course in computer science. Th e cost of this four-year programme will amount to $200,000. Your mum is 78 and healthy. Your dad is 82 and has lung cancer. His expected cost of treatment is $100,000. Th at is $300,000 to be deducted from your retirement cheque. Th en, there is $400,000 tied up in your executive condo. Your million-dollar retirement now looks a lot less attractive.

Th is story may not reﬂ ect your situation completely, but the underlying facts are real. We are marrying later, and consequently, by the time we near our retirement, our children may still be ﬁ nancially dependent on us, as may our parents.

But let us not allow such grim facts to get us down. Th ere are ways to get around our various commitments, and prudent investing is one of them.

WEALTH ACCUMULATION — THE NUMBER ONE

REASON WE INVEST

To plan successfully for retirement, we must have a clear picture of when we want to retire (the earlier the better) and how much retirement funds we want to have (the more the better). Being strapped for cash when we are past our peak earning years is not going to be fun.

Suppose you are now 40 years old and plan to retire at age 60 and want a monthly income of $5,000 for 25 years. How much money would you need to accumulate in your retirement fund? Assuming these funds are invested at a modest rate of return of 2.5 per cent, you would need to accumulate $1,114,537 between now (at age 40) and retirement (at age 60). Th at is a huge sum of money!

(13)

12 MAKE Y OUR MONEY W ORK F OR Y OU

If you keep your savings under the pillow, you would need to set aside even more — $1.5 million. If you invest and achieve six per cent returns, you halve your burden to $776,034. At higher and higher rates of return, your burden starts to look lighter and lighter. Th at is the whole idea behind investing — to reach your ﬁ nancial objectives with the least amount of eﬀ ort and time possible.

TABLE 1.1.TOTAL FUNDS NEEDED TO PROVIDE $5,000 MONTHLY INCOME FOR 25 YEARS

Rate of Return Funds Needed

0.0% $1,500,000

2.5% $1,114,537

6.0% $776,034

12.0% $474,733

Source: Authors’ own computations

TWO MYTHS ABOUT RETIREMENT

Myth 1: I Will Live Till 80 and Th at’s It

We have one of the highest life expectancies in the world at over 80 years. However, the number 80 is somewhat misleading. It’s not a ﬁ gure cast in stone. For example, a woman who has reached 65 years of age can reasonably expect to live on till 85 years.1

Th is means that the longer we live, the more money we will need during retirement. While we should plan for our ﬁ nancial needs based on 80

1_{Koh Eng Chuan, “Measuring Old Age Health Expectancy in Singapore”, in}

(14)

13 Wh y L ear n A b out In ve sting

years as a base mark, it is best we plan for a few extra years — till age 90 or more. So give yourself more leeway when making your investment plans.

Myth 2: I Will Be Spending Less During Retirement After subjecting your mind and body to 40 years of hard labour, you probably want the best vacations, the best doctors and the best foods. No doubt you could spend less by downgrading your lifestyle, but this is surely not something you want.

Don’t fall into this self-fulﬁ lling trap. If you plan to spend less during retirement, you will end up with less. Expect to spend more, plan for it and you will end up with more.

CHOOSE YOUR INVESTMENTS WISELY

When we invest, there is a multitude of instruments we can put our money into. Historically, some have given higher returns than others. Choosing the right instruments that provide the best returns can make all the diﬀ erence to your retirement.

You can invest in two main investment categories: ﬁ nancial assets and real assets. Real assets — such as real estate, jewellery or art — are tangible; you can touch and take physical possession of them. One drawback of owning real assets is that they are generally harder to buy and sell. For example, selling a house takes time because it is a big-ticket item and potential buyers need time to evaluate. Or if you wanted to buy an antique fountain pen or a rare painting, you may have to go to a specialised auction house such as Sotheby’s.

Financial assets — such as stocks, bonds and unit trusts — are ﬁ nancial claims on assets. Rather than taking physical possession of the asset, your ownership is documented by a legal document. So when you invest in a stock, you receive a certiﬁ cate that acknowledges your claim as a shareholder of the company. Unlike

(15)

real assets, ﬁ nancial assets are easy to buy and sell through organised exchanges such as the Singapore Exchange. As you can probably sense, the scope of investment opportunities is too huge to cover in this book. For this reason, our primary focus is on ﬁ nancial assets.

RETIRING A MILLIONAIRE

Consider this: If you contribute $500 per month to your CPF Ordinary Account (CPF OA)2_{, after 40 years, you will have}

contributed $240,000. Since the Ordinary Account earns 2.5 per cent annual returns, after 40 years, you will have accumulated $411,709. Th at’s nearly $172,000 in interest. Not bad.

If, instead, you invested the $500 per month over the same period while earning 6 per cent interest, you would have accumulated $995,745. Th at is almost $1 million. You can retire a millionaire!

But if you had annual returns of 12 per cent over the same period, you would have close to $5.9 million ($5,882,386 to be exact). You would retire a multimillionaire!

TABLE 1.2. RETURNS SCENARIOS

Instrument Rate of Return Accumulated

Keep under pillow 0.0% $240,000

CPF OA 2.5% $411,709

STI 6.0% $1 million

S&P 500 12.0% $5.9 million

Source: Authors’ own computation

2_Th_{e Central Provident Fund or CPF is Singapore’s mandatory social security}

savings plan towards which working Singaporeans have to contribute. Such plans are commonly found in other countries. In Malaysia, it is the EPF or Employees Provident Fund. In Hong Kong, it is the MPF or Mandatory Provident Fund.

Given the wide disparity of possible results, we ought to ﬁ nd out which of these investment returns are realistic and which are not. Based on the history of ﬁ nancial markets, all three return possibilities can actually be achieved.

(16)

Th e interest rate for CPF OA is 2.5 per cent. Between 1990 and 2005, the Singapore Straits Times Index (STI) of common stocks yielded an annual return of about 6 per cent. In the U.S., over the 75 years between 1930 and 2005, the Standard & Poor’s (S&P) index of large-company common stocks yielded about 12 per cent.

WHAT ABOUT RISK?

If we were given these three investment choices, the obvious choice would be the S&P 500, which provides the best returns. Our decision making would then be a simple process of choosing the investments with the highest returns.

But we have yet to talk about risk. Risk is the possibility of losing money on our investments. Th e CPF OA rate of 2.5 per cent is an almost unchanging rate. It may move up a little, or go down a little, but it will never hit negative, which means that we can’t possibly lose money. Putting our money into the Ordinary Account can be considered risk-free.

FIGURE 1.1. S&P 500, JANUARY 1996 TO DECEMBER 2007

(Source: Standard and Poor’s)

1800 1600 1400 1200 1000 800 600 400 200 0 A B C A A A A A B B B B B B B B B B B B B C C Jan-96 Sep-97 Ma y-99

Jan-01 Feb-03Jul-03Dec Jan-06 -03 Ma y-04 Oct -04 Jun-96 Feb-98 Oct -99 Jun-01 _Jun-06Nov-06 Nov -96 Jul-98 _Mar-00 Mar -05 Nov -01 Apr -97 Dec -98 Aug-00 Apr Aug-05 -02 Apr -07 Sep-02 Sep-07

(17)

TABLE 1.3. RELATIVE RISK LEVELS

Investment Choice Risk Level

CPF OA Low

STI Medium to High

S&P 500 Index High

Source: Authors’ own illustration

Look at Figure 1.1 (page 15), which plots daily prices of the S&P 500 for the period January 1996–December 2007. Investors who bought around the third quarter of 2000 (indicated by B) and sold in 2003 (indicated by C) would have lost a lot of money compared with those investors who bought at the beginning of 1996 (indicated by A). Investing in the S&P 500 produces winners and losers, and along with that, a sense of unpredictability.

We can see that looking at returns without considering risk is clearly a major mistake for any investor. But we are sure you will agree that if you want to seek out the best returns, you will have to tolerate some risk. What history tells us is that there is a positive relationship between risk and return, and we can assign relative risk levels to the three investment choices as follows:

BIG MISTAKES CAN SET YOU BACK — PERMANENTLY

An investor needs to do very few things right as long as he or she avoids big mistakes.

~Warren Buﬀ et in Berkshire Hathaway, Annual Report, 1992

Even smart people can make silly mistakes when it comes to investing. Do not take investment lightly — one mistake can set you back for a long time.

Just to illustrate, let us tell you about someone we know. Michael was a very successful investor who made $2 million in the markets

(18)

over the last four years. In January 2001, he went to the bank to deposit a cheque. Th e manager serving him suggested he invest some money in a technology unit trust. Michael said no and left.

Back home, Michael brought out his charts and found that the fund was trading at 50 cents to its initial off er price of $1. In other words, the fund had already lost 50 per cent of its initial value, which appeared cheap to Michael. IT sector news was robust and a recovery was expected. Being an IT buff and bullish about the sector, he invested $2 million the next day. Th e technology fund was the fi rst ever unit trust he owned. In six months, the price of the fund dropped to 25 cents. His paper loss was over $1 million.

Th ere are a few lessons to learn from Michael’s experience. Th ere are two we would like to highlight. One, avoid the big obvious mistakes by doing your homework. Even a successful investor like Michael should have kept this in mind as he went in impulsively. In the end, he took four years to earn $2 million in investment returns, but lost half of it in only six months. Second lesson: learn to take responsibility. Michael blamed the bank, the IT sector analysis he read, his bad luck, etc. He admitted only much later that it was his own mistake and he was responsible for it.

Three Mistakes to Avoid When Investing

Th ese mistakes are common yet some of them are not so obvious.

1. Keeping Too Much Cash

According to statistics from the Monetary Authority of Singapore (April 2010 MAS Monthly Statistical Bulletin), over $320 billion now sit in savings accounts and ﬁ xed deposits. Th is works out to $60,000 per person, young and old.

Financial advisers recommend putting away six months’ salary in the bank in case of rainy days. Th e reason is that if an emergency arises, such as the loss of your job or a major illness, these savings can tide you over while you look for another job or settle medical bills.

(19)

You may not need so much ready cash, especially if you are still a good way ahead of your retirement age. We recommend you save three months’ salary. First, some of this money can be invested in ﬁ nancial assets such as bonds and unit trusts, since they can be liquidated almost any time, with little or no penalty. Second, if you have a working spouse, there should be suﬃ cient “back-up” income in the event of an emergency.

Keeping too much cash means you are earning less, and anticipating emergencies that occur only infrequently in reality.

2. Skimping on Life Insurance

If you or your spouse dies or suﬀ ers a major illness, you have to make sure your dependents will be provided for. Who cares then if your investments are making 10 or 15 per cent returns if you do not have enough funds for your immediate needs?

While you may have some life insurance coverage through your employer, such coverage is not portable. If you get laid oﬀ , you lose the coverage. Imagine getting laid oﬀ when you have medical problems. Getting a new policy would be extremely expensive, sometimes even impossible if you are in poor health.

How much insurance do you need? One rule of thumb is to get at least ﬁ ve times your earnings, plus the total amount of your mortgage, with a little to spare to cover your children’s basic education.

Having enough life insurance is so essential that you shouldn’t even think about investing unless you are already suﬃ ciently covered.

3. Taking Care of Others Before Yourself

Many people often go the distance for family members and forget to take care of themselves. For example, once you are faced with the monumental task of saving for your child’s university education, it is easy to forget about saving for your own retirement. Th is is a big mistake.

(20)

Saving for retirement should always come ﬁ rst. You and your child can ﬁ gure out ways of getting through school when the time comes, whether through loans, co-payments or otherwise. What you want to avoid is channelling all your surplus funds into your children’s education, only to discover later that you have little left over for yourself. By all means, provide for your children, but do spare a thought for yourself.

(21)

MAKE Y OUR MONEY W ORK F OR Y OU 20

The Major Types of Investments

Consider this: Two months ago, both you and your aunt decided to make an investment in FoodMall, a food wholesaler. You invested $10,000 in its common stocks, while your aunt bought $10,000 worth of FoodMall warrants. You now sell your shares for $12,000, realising a 20 per cent return. But your aunt managed to sell her warrants for $20,000 — a 100 per cent return. Clearly, there is a diﬀ erence between common stocks and warrants. Th e type of security we put our money into matters.

In this chapter, we will introduce the diﬀ erent types of investments that are commonly bought and sold by investors — stocks, bonds, derivatives and unit trusts. We will be brief in our introduction because we will be discussing each of these investments in greater detail in later chapters.

THE THREE MAIN TYPES OF BASIC INVESTMENTS

One of the most important factors in deciding where to put your money is how soon you think you’ll need it back. Also, what is your overriding motive in investing? Do you need your money safe and secure at all times? Do you need it to grow? Or do you need it to produce a regular income?

Your answers to these questions point to the type of basic investment that is most suited to you. Th ere are three main types:

1. Stocks or equities

2. Bonds or ﬁ xed income securities

3. Money market investments

Each of these is attuned to the three things you need from your investments: growth, income or safety.

(22)

Th e Ma jor T yp es of In ve stmen ts 21

Stocks or Equities

If you own common stock of company A, you have an ownership interest in the company. If only a few individuals hold a company’s shares, the ﬁ rm is said to be privately held. Many companies choose to go public by selling common stock to the general public on a stock exchange. Companies go public because they can raise additional capital that way, since there will be a far bigger buying audience.

If you buy 100 shares of A’s common stock, you would own 100 per cent of the company, where “n” is the total number of common stock shares. As a stockholder, you have a residual claim on the company’s earnings and assets. When a company generates earnings, you are entitled to the earnings that remain after all expenses have been paid. Such expenses include staff salaries and payments for those who hold fi xed income securities (including preferred stockholders). In other words, as a holder of common stock, you will be the last in line when the company pays out its earnings. As a stockholder, you also have a residual claim to assets in case the company goes bankrupt and liquidates its assets. In that case, you will be entitled to the remaining assets only after all other claims (including those made by holders of preferred stock) have been satisfi ed. Th is is much like eating the leftovers at a wedding dinner when everyone else has eaten.

As owners, the holders of common stock are entitled to elect the directors of the company and to vote on major issues. Stockholders also have limited liability, meaning that they cannot lose more than their investment in the company. Hence, should the company run into ﬁ nancial diﬃ culties, creditors can only claim against the assets of the company, and not the assets of individual stockholders.

Stock Returns

Th e returns from owning stock come from two sources. Cash dividends are earnings that are distributed to shareholders. Unlike

(23)

bonds, stocks do not guarantee the timing or the amount of dividends. At any time, they can be increased, decreased or taken away altogether.

Th e other source of returns is capital gains. Th is is the main reason people buy stocks. Th e value of your stock may rise when the earning prospects of the company are favourable. And, of course, your shares may also lose value if the company performs poorly.

Stock Risk

As a group, stocks generally move up and down in value more than any other type of investments in the short term. People are usually afraid of purchasing stocks because they hear about bear markets, corporate scandals and stock market crashes. But this should be a concern only to investors who need their money back within a few years. In fact, over the longer term, you stand a greater risk of losing money if you don’t invest in stocks.

Bonds or Fixed Income Securities

Bonds are loans issued by companies and governments to borrow money, and they have two main characteristics:

1. Th ey have life spans greater than 12 months at the time of issue.

2. Th ey typically promise to make ﬁ xed interest payments according to a given schedule.

Bonds are hence also called ﬁ xed income securities.

Bonds have their own unique terms. Let us work with an example. Suppose you buy bonds with a face value of $10,000. Th ese bonds mature in two years and pay 4 per cent interest annually. Th e 4 per cent interest equates to $400 a year. Th e face value of the bond, or the principal amount of $10,000, will be returned to you when the bond matures in two years.

(24)

Th e Ma jor T yp es of In ve stmen ts 23 Bond Returns

Th e returns from owning a fi xed income security come in two forms. Th ere are the fi xed interest payments and the fi nal payment of principal at maturity. Secondly, there is the potential for capital gains when you sell a bond before its maturity at a price higher than when you purchased it. Imagine a see-saw. Th e price of a bond rises when interest rates fall, and there is thus the possibility of a capital gain from a favourable movement in rates. Of course, inversely, a rise in interest rates will produce a loss.

Bond Risk

Besides interest rate risk, bonds have default risk. Default risk refers to the possibility that the borrower will not make the promised payments. Th is risk is almost non-existent for Singapore government bonds, but for many other issuers, such as private companies, the risk of default is very real.

Money Market Securities

Money market securities are similar to bonds, except that they are short-term investments. Th ey have two main characteristics:

1. Th ey are loans issued by companies and governments to borrow money.

2. Th ey mature in less than a year from the time they are sold, which means the loan must be repaid within a year.

Some of the most common money market securities include Treasury Bills (issued by the government and considered the safest investments around), ﬁ xed deposits, bank savings accounts and certiﬁ cates of deposit.

Money Market Returns

(25)

can be easily converted into cash. Of the three types of investments, money market instruments pay the lowest rate of return.

So why bother with them? For the same reason you leave large chunks of your uninvested money in a ﬁ xed deposit — safety. When you buy a money market investment, you are pretty sure you will get your money back with some interest. Th e chances of losing money — whether from the government or the bank defaulting on its payments or a loss in principal value of the investment — are very low. In other words, when you invest in a money market investment, you are taking very little risk and your expected return should reﬂ ect the amount of risk that you have taken.

When is a money market investment appropriate? When you need to use the money in a year or so, and you want to know that the money will be there with few surprises.

Money Market Risk

Beware of infl ation. Th e longer you leave your money in a fi xed deposit, the higher the risk of infl ation eating away the purchasing power of your money. Money market investments are safest when the money is needed in the short term. Th e very same safe investments become high-risk the longer they stay invested.

Stocks are on the opposite track. Th ey are high-risk investments in the short-term, but are lower-risk investments in the long-term:

TABLE 2.1. RISK COMPARISON OF STOCKS AND FIXED DEPOSIT OVER TIME

Investment 1 Year 10 Years

Fixed Deposit Lower Risk Higher Risk Stocks Higher Risk Lower Risk

For example, according to a study by U.S. investment management ﬁ rm, T. Rowe Price, that looked at the S&P 500 index (a basket of stocks that represents the largest 500 companies in the U.S.) from

(26)

1926 to 2002, in any one-year period, there is about a 27 per cent chance of losing money. If the holding period is three years, the odds of losing money fall to 14 per cent. And if the holding period is a whole decade, the chances of losing money goes down to just 4 per cent.

DERIVATIVES

Stocks and bonds are ﬁ nancial assets. When you invest in a ﬁ nancial asset such as a stock in Company X that is currently priced at $10, you receive a contract stating that you have a legal claim on the assets of Company X. If the company does well and its share price rises to $15, you have a direct claim on the company’s assets that is now worth $15, the share price.

A derivative is also a financial asset, but it differs from stocks in one fundamental way: the value of the derivative is based on the performance of an underlying financial asset that you do not own.

Options

Options are one of the most common types of derivatives. Th ere are two main types of options — calls and puts. A call option gives the buyer the right to purchase a specifi ed number of shares, say 100, of a particular stock at a specifi ed price (called the exercise price) within a specifi ed time frame. A put option does the reverse — it gives the buyer the right to sell 100 shares at a specifi ed price within a specifi ed time frame. A defi nite advantage for the buyer of an option — whether a call or a put — is that there is no obligation to exercise the option.

Let us illustrate with a simple example of a call option. Suppose that you want to own 1,000 Microsoft shares at $30 each. If you are fortunate enough to have this large amount of money ($30,000) on hand, you can pay up right away and own the shares.

But suppose you do not have this sum of money to invest directly, and your roommate is willing to sell you the right to buy the 1,000

(27)

shares at $30 each. For this right, he will charge you a fee of $1,500 and this right lasts three months. In eﬀ ect, your roommate has sold you a call option.

If you buy the call option, the value of your investment now depends on the underlying asset — the share price of Microsoft. If the price of Microsoft goes up, so does the value your call option. Th e reverse is true as well. If the price of Microsoft goes down, your derivative falls in value.

When you buy a call option, you pay the seller $1,500 for the right, but not the obligation, to buy the shares at $30 each. If you change your mind because you found a better deal elsewhere, you can just walk away. You will lose only $1,500, which is called the option premium.

UNIT TRUSTS

Direct investment in stocks, bonds and derivatives is not for everyone. It requires time to research good buys and a fair amount of skill to sieve the duds from the winners. Th is is not a simple task, given the inﬁ nite number of investment choices available.

Indirect investment through unit trusts provides a very attractive alternative. When we invest in a unit trust, we pool our money with that of thousands of other investors. For as little as $1,000 and a relatively small fee, a professional investment manager invests our money in money market securities, bonds and stocks, to reap the greatest possible returns consistent with our objectives. Th e range of companies and securities invested in will be far more diverse than we could achieve on our own.

As with stocks and bonds, unit trusts provide us with a wide range of investment choices. Th ere are more than 500 unit trusts to choose from in Singapore. Add to these the funds available from places such as the U.S., the U.K. and Malaysia, and we have an awesome number of choices.

Some unit trusts, such as global equity funds that invest in the top companies in the world, have very broad objectives.

(28)

Some others have a very speciﬁ c focus. For example, some funds focus on high-yield bonds, a particular market segment such as biotechnology, or a speciﬁ c country such as Th ailand.

With unit trusts, we can choose funds that match our risk proﬁ le. Stock funds are for the more risk-tolerant investors who want their money to grow over a long period of time. Bond funds are for those who want current income and do not want investments that ﬂ uctuate as widely in value as stocks do. And if we need the money in the short-term and we do not want our invested principal to drop in value, money market funds can be chosen.

(29)

The Risks and Returns

from Investing

Th e rewards from investing do not come free. Th ey are accompanied by the four-letter word, risk. Th ankfully, history oﬀ ers us two important lessons we should know about. First, there is a reward for accepting risk, and when good investment choices are made, that reward can be substantial. Th at is the good news. Th e bad news is that greater rewards usually go hand in hand with greater risks. Th e fact that risk and return are intricately linked to each other is probably the single most important lesson in investing.

Returns are easily understood because it comes down to a number — how much did the investment make? Whether the number is 80 per cent, or -20 per cent, its message is clear. What is not so clear is the concept of risk. We all want high rewards and we all want to bear low risk for it, but we intuitively know that high rewards and low risk seldom go together.

In this chapter, we lay the groundwork to understanding the nature of risk and returns, and learn how to measure them. We will mainly consider buying shares in this chapter although the calculations are the same for any investment.

RETURNS

When you make an investment, your gain or loss is called the return on your investment. Th is return has two parts: income and capital gain (or loss).

Th e dividends from shares and interest from bonds you receive constitute the income portion of your returns. Th e capital gain part of your return comes from the proﬁ t you earn when you sell your investment at a price higher than what you paid for your purchase.

(30)

Th e R isk s and Re tur ns f rom In ve sting 29

Measuring Total Returns Over One Period

Suppose you buy stock of Xanadu for $10,000 on 1 January. During the year, you receive cash dividends of $500. On 31 December, you sell your stock at $12,000. Your Total Return is 25 per cent:

Total Return (1 year) = (Income + Capital gain) / Purchase Price = (500 + 2,000) / 10,000

= 25%

If you sell the stock at $9,000, your loss is 5 per cent: Total Return (1 year) = (500 – 1,000) / 10,000

= -5%

Measuring Total Returns Over Several Periods

Suppose you become completely enamoured of Xanadu. You stay invested for 10 years and re-invest the dividends you receive. Table 3.1 is a record of the last 10 years:

TABLE 3.1. XANADU RETURNS OVER 10 YEARS

Year Total Return 1 + Total Return

Year 1 25% 1.25 Year 2 -15% 0.85 Year 3 -20% 0.80 Year 4 -10% 0.90 Year 5 -5% 0.95 Year 6 5% 1.05 Year 7 10% 1.10 Year 8 15% 1.15 Year 9 25% 1.25 Year 10 20% 1.20

(31)

To calculate Total Return for the entire period, we ﬁ rst add the ﬁ gure “1” to each yearly Total Return number, then multiply all of these together. (After that, simply subtract “1” from the product) Th e result is this:

Total Return (10 years) = (1.25 x 0.85 x 0.80 x 0.90 x 0.95 x 1.05 x 1.10 x 1.15 x 1.25 x 1.20) – 1 = 1.45 – 1

= 45%

Hence, every $1 invested at the beginning would have returned you $1.45 at the end of the 10-year period, or you would have a Total Return of 45 per cent over 10 years.

Measuring Annualised Returns

How much did your Xanadu stock earn you on an annual basis? Th e calculation looks complicated, but it is not that bad. What is important is that you understand what the end result means.

Th e Annualised Return for Xanadu over a 10 year period is:

Annualised Return = (1.25 x 0.85 x 0.80 x 0.90 x 0.95 x (10 years) 1.05 x 1.10 x 1.15 x 1.25 x 1.20)1/10_{– 1}

= 1.451/10 _{– 1}

= 3.8%

If the calculation seems complicated initially, do not worry. Unit trust fact sheets and annual reports already calculate this number for you.

Here is what the end result means and this is important for you to understand. Th e Annualised Return is a compounded rate of return over 10 years. It means that after staying invested for 10 years and after having reinvested all your dividends, your return on an annual basis is 3.8 per cent.

(32)

RISK

A risky investment is one where there is a strong likelihood that actual returns will diﬀ er from what was expected. Th e more those returns ﬂ uctuate, the greater the risk.

Th ere is a positive relationship between risk and return — the higher the risk, the more returns we should expect. Th e opposite is true as well. At the same time, you cannot reasonably expect high returns if you are only willing to assume a small amount of risk. Supposing then that you want to avoid risk at all cost, you could deposit money into a fi xed deposit account to earn a safe and known amount. However, this return is fi xed, and you cannot earn more than this fi xed rate. In this case, risk has eff ectively been eliminated, but so have your chances of earning a higher return.

Where Does Risk Come From?

Risk consists of two components:

1. Diversiﬁ able (or Non-systematic) Risk

2. Non-Diversiﬁ able (or Systematic) Risk

Th at is, Total Risk = Diversiﬁ able Risk + Non-Diversiﬁ able Risk

Diversifiable Risk

We wish we could spare you the egg-and-basket routine, but in this instance, it is very useful in explaining diversiﬁ able risk. If eggs were your money and baskets were investment choices, then putting all your eggs (money) in one basket (a single investment choice) is a risky proposition. Anything unpleasant that happens to your one and only invested asset would negatively aﬀ ect your entire investment portfolio. But if you were to diversify by placing your money into several investment baskets, then chances are good that your entire investment portfolio will be stable enough to withstand

(33)

an unexpected shock from any one sector. In short, diversiﬁ able risk has these three characteristics:

1. It can be diversiﬁ ed away.

2. It can be controlled or reduced.

3. It is unique to a stock or industry.

A diversiﬁ able risk is easy to identify. Let’s look at a few examples.

1. Business Risk

Th is is the risk of doing business in a particular company, industry or environment. For example, a semiconductor manufacturing company faces risks inherent in the electronics industry. An investor can control business risk by investing in other industries.

2. Liquidity Risk

A security with poor liquidity means that the security is diﬃ cult to buy and sell in the secondary market without incurring price concessions. A Treasury Bill has little or no liquidity risk, whereas a highly priced collectible such as a 1899 Coca-Cola bottle has high liquidity risk because it can be a challenge to ﬁ nd buyers and sellers. An investor can control liquidity risk by investing in assets with high liquidity.

3. Country Risk

Country risk refers to all the negative things that can happen to a country’s economy as a whole, including political crises, wars and recessions. If you are like many Singaporean investors who invest most of their money domestically, take note. Despite receiving consistently favourable risk ratings by Political and Economic Risk Consultancy, Ltd. (PERC), Singapore is still

(34)

subject to country risk. An investor can control country risk by diversifying his portfolio internationally by placing funds in several countries.

Non-diversifiable (or Systematic) Risk

An investor can construct a diversifi ed portfolio and eliminate part of total risk (i.e. the diversifi able or non-systematic portion). What is left is the non-diversifi able portion called market risk or systematic risk. Th is is any risk that, left in the portfolio, will be directly related to the overall movements of the general market or economy. Like non-systematic risk, systematic risk also has three characteristics:

1. It aﬀ ects all securities.

2. It cannot be diversiﬁ ed away.

3. It cannot be controlled or reduced.

Virtually, all securities have some systematic risk, whether bonds or stocks. Th ere are three systematic risk factors:

1. Interest Rate Risk

Security prices tend to move inversely with movements in interest rates. When interest rates go up, security prices come down, and other things being equal, all securities will be aﬀ ected. Even if you hold a well-diversiﬁ ed portfolio of Singapore stocks, a sudden surge in interest rates will bring down the value of each of the securities in your portfolio.

2. Market Risk

Th is is the risk that comes from ﬂ uctuations in the overall market as reﬂ ected by an aggregate stock index such as the STI. Poor market sentiment as a result of wars, recessions or plain old pessimism are often mirrored by declines in the overall

(35)

market. All securities will be aﬀ ected no matter how fundamentally sound the companies are.

3. Inﬂ ation Risk

When infl ation rises, all securities are aff ected. Infl ation erodes the purchasing power of your invested dollars, such that what you expect to receive in the future would be worth less today in real terms. Infl ation also positively aff ects interest rates. When infl ation rises, interest rates generally rise as well because lenders

will demand more for their loss of purchasing power.

It is important to understand that an investor cannot escape non-diversifi able risk because the risks of the overall market cannot be avoided. If the stock market falls sharply, most stocks will be adversely aff ected. Or, if the interest rate or infl ation soars, most stocks will fall in value. Th ese market movements do occur.

Measuring Risk

Risk is the chance of losing money when you sell your investment. Th is is the defi nition that most of us are familiar with although we will refi ne the defi nition later in this chapter. But for now, let us keep to this familiar defi nition.

If you put your money in the Post Oﬃ ce Savings Bank (POSB) and you suddenly need to cash out after six months, what are the chances that you would lose money? Zero, unless POSB defaults. Your entire principal sum will be returned to you, plus interest.

Risk is calculated by a method called standard deviation (SD). Let us work out a numerical example. Suppose you keep your money in POSB for three years, and each year, the return is constant at one per cent. Th e average return per year is:

Average Return = (1 + 1 + 1) /3 = 1%

Notice that each year’s return does not deviate from the three-year average. Hence, Standard Deviation = 0

(36)

A zero standard deviation means that there is no risk, and no volatility. At any time, you will be able to cash out, knowing exactly what you will get. No surprises, ever. (To be sure, standard deviation is an academic deﬁ nition that refers to the uncertainty of returns — whether negative or positive. In reality, there is no such thing as zero risk. Risk can arise from POSB folding, inﬂ ation rising out of control, and many other situations.)

Let us take another example. Suppose investment ABC had total returns of 5 per cent, 20 per cent and 35 per cent over the last three years. Th e Arithmetic Mean is 20 per cent (5 + 20 + 35) / 3. Notice that the ﬁ rst return deviates from the mean by -15 per cent (5% – 20%), the second by zero (20% – 20%), and the third by 15 per cent (35% – 20%).

To compute the standard deviation of investment ABC, we square each of the deviations, add them up, divide the result by the number of returns minus 1, and take the square root of the result:

Note that by itself, standard deviation is not as meaningful as when it is compared with those of other investments. If the standard deviation of POSB returns is zero and investment ABC’s standard deviation is 15 per cent, we can conclude that investment ABC is a riskier investment because its returns are far more uncertain than POSB savings’.

Standard deviation can be calculated very easily on a spreadsheet or ﬁ nancial calculator so this ought to be the ﬁ rst and last time you

(5 – 20)2 _{= 225} (20 – 20)2_{= 0} (35 – 20)2_{= 225} Total = 450 Standard Deviation = √[450 / (3 – 1)] = 15%

(37)

will need to go through a worked-out example. Th e main point is that the returns from an investment such as Xanadu, for example, are inherently more uncertain than the returns from putting your money in POSB. And the more uncertain the returns are, the higher the standard deviation.

The Risk-Return Trade-Off

Now if we were to line up some of the most traditional investment choices such as stocks, bonds and derivatives, we could create a ranking of their standard deviations. Th e following are listed in the order of increasing standard deviation and risk, with Treasury Bills having the lowest of each:

• Treasury Bills

• Government Bonds

• Corporate Bonds

• Common Stocks

• Derivatives

Figure 3.1 puts together our ﬁ ndings on risk and return. What it shows is that there is a risk-return trade-oﬀ . At one extreme, we have Treasury Bills, which are virtually risk-free. At the other end of the continuum, if you are willing to bear a high level of risk, you may then expect to earn what is called a risk premium. Risk premium is the additional return beyond the risk-free rate that one expects to receive for taking on risk.

Th e return we expect from an investment in a risky asset can thus be expressed as:

(38)

37

FIGURE 3.1. RISK-RETURN TRADE-OFF

Derivatives Common Stocks Corporate Bonds Government Bonds Treasury Bills Risk Premium Risk-free Rate Retur n s Line A Risk R ond Stocok

In Figure 3.1., Line A is drawn from the risk-free rate to show the risk premium. If, for example, the expected return of common stocks is 8 per cent and the yield oﬀ ered by Treasury Bills is 2 per cent, the risk premium will be 6 per cent:

Expected Return = [ Risk-free Rate + Risk Premium ] 8% = 2% + 6%

Risk-Adjusted Returns

Look at the returns and risk of these two investments in the utility industry (Table 3.2 on page 38).

Which do you prefer? If you decide by returns alone, then company A is the clear choice. Company A generated 10 per cent returns compared with company B’s 6 per cent. If you decide by risk alone, then company B is the clear winner. Company B generated a tiny 2 per cent standard deviation compared with company A’s 5 per cent. How do you break the tie?

(39)

A risk-adjusted measurement takes an investment’s return and divides it by its standard deviation:

Risk-adjusted Return = Return / Standard Deviation

Investments with higher risk-adjusted returns are generally considered superior to investments with lower risk-adjusted returns because they oﬀ er more returns for each unit of risk taken. Company B is considered superior because it oﬀ ers three units of return for every unit of risk taken.

You may have come across measurements such as the Sharpe, Treynor, Jensen’s or Information Ratios. Th ese ratios all provide risk-adjusted returns.

TABLE 3.2. RISK-ADJUSTED RETURNS OF UTILITY COMPANIES A AND B

Investment Return Standard _Deviation Return/Standard _Deviation

Utility Company A 10% 5% 10/5 = 2.0 Utility Company B 6% 2% 6/2 = 3.0

MORE ON RISK

Earlier, we defi ned risk as the chance of losing money when you sell your investment. At this point, we need to make two refi nements to this working defi nition.

In investments, risk is deﬁ ned more broadly as the chance of receiving a return that is diﬀ erent from the return we expected to make. Risk, in fact, includes not only bad outcomes, such as lower than expected returns, but also good outcomes such as higher than expected returns. Th us, if the expected return of an investment is 5 per cent, the risk that you will earn a 10 per cent or zero per cent return is exactly the same. In other words, using

(40)

standard deviation, you do not distinguish between downside risk and upside risk.

For this reason, some investors may not be completely comfortable with standard deviation as a measure of risk. Th ey may use a measurement called the semi-variance, where only returns that fall below the expected return are considered. Or they may go for simpler yet commonsensical proxies for risk. For example, it makes sense that stocks of technology companies are riskier than those of food companies. Others prefer to create ranking categories. (For example, those ranking money market instruments as lower risk, and technology stocks as higher risk).

Th e risk we have deﬁ ned so far relates to actual returns being diﬀ erent from expected returns.

Th e second reﬁ nement to our understanding is that there are investments whose expected return is known ahead of time. For example, when you buy a bond that pays a ﬁ xed interest payment every six months and the return of principal at maturity, you can tell ahead of time what your actual return will be.

Hence, in general, it is important for investors to understand that the risk of an investment is indeed broader and more varied than what is typically understood — that risk equals the potential that actual returns will diﬀ er from expected returns.

MANAGING INVESTMENT RISK

Th e best way to manage risk is to allow yourself ample time. Start investing now rather than later. When you have time on your side, more of your money can be invested in stocks rather than bonds and money market instruments because you will have a larger capacity to ride the ups and downs of the stock market.

Finally, the way you divide your investments depends on your speciﬁ c situation and goals. Spend some time thinking about the best way to divide your money, based on your needs and the type of risk you can take. Th is exercise will make a big diﬀ erence to your investment success.

(41)

Managing Crises and

Diversification

We have a crisis today. Oil prices are at historical highs. Terrorists can strike anywhere and at any time. Th ere is uncertainty regarding a sustainable global economic recovery. High inﬂ ation is causing problems all over the world.

How do you react to these crisis points? Would you sell or stay put? If your answer is “stay put”, you might be doing the right thing.

In this chapter, we learn that historical events do indeed have a signiﬁ cant impact on ﬁ nancial markets. Uncertainty often clouds judgement, sending even the best of us into panic and gloom. But history shows that negative events do not necessarily spell doom for investors.

While past performance cannot guarantee similar future results, historical evidence suggests that most investors can beneﬁ t by staying put.

Of course, some investors are skilled at anticipating market movements. Th ey would buy on ups and sell on downs. But how many people can do that consistently? Th e big question for many of us is whether it makes sense to stay invested regardless of market ﬂ uctuations. According to a study by asset allocation expert Ibbotson Associates, the answer is “yes”.

TABLE 4.1. $1 INVESTED IN S&P 500: STAYING PUT OR MINUS BEST 35 MONTHS Value in 1996 (Stay Put Th roughout) Value in 1996 (Minus 35 Best Months) $1 invested in 1925 $1,371.00 $12.50

Source: Ibbotson Associates

04

(42)

Manag ing Cr is es and Diversiﬁ c ation 41

Th ey found that a dollar invested in the S&P 500 in 1925 grew to $1,371 in 1996. Th at’s a compounded annual return of 10.6 per cent. But when the best 35 months (less than 4 per cent of total time invested) were removed from the analysis, the same dollar grew to only $12.50, a compounded annual return of only 3.6 per cent.

So, unless you are conﬁ dent of predicting accurately the best and worst months for your investment dollar, stay put.

STAYING PUT IN THE FACE OF CRISES

Th is century has seen many crises and disasters, including two world wars, the 9/11 attacks and the 1997 Asian economic crisis. Crises will continue to take place today and in the future. What would you do when the next crisis hits? If you are still not convinced about staying put in the market, here is more information to consider.

Ned Davis Research tracks the reaction of the Dow Jones Industrial Average (an index on major U.S. industrial stocks) to political, economic and military crises since World War I in 1914.

Th ey found that staying put makes sense because each time a crisis hits, the index will fall, then rebound to near pre-crisis levels within three months. (Th e average drop in the market during crises was -6.1 per cent, and from there, the Dow rallied on average 5.2 per cent after one quarter). Instead of being fearful during market downturns, you should be getting “greedy”, because crises provide tremendous opportunities for investing.

TABLE 4.2. DOW JONES INDEX DURING AND AFTER MAJOR CRISES

Event Month/ Year % Change 1 Month Later 3 Months Later 6 Months Later 12 Months Later Exchange closed WWI 7/14 -10.2% 10.0% 6.6% 21.2% 80.2% Bombing at JP Morgan oﬃ ce 9/20 -5.5% 2.4% -14.9% -9.5% -17.3%

(43)

MAKE Y OUR MONEY W ORK F OR Y OU 42 Event Month/ Year % Change 1 Month Later 3 Months Later 6 Months Later 12 Months Later Pearl Harbour bombing 12/41 -6.5% 3.8% -2.9% -9.6% 5.4% Korean War 6/50 -12.0% 9.1% 15.3% 19.2% 26.3% Suez Canal crisis 10/56 -1.4% 0.3% -0.6% 3.4% -9.5% Cuban missle crisis 10/62 1.1% 12.1% 17.1% 24.2% 30.4% Martin Luther King assassination 4/68 -0.4% 5.3% 6.4% 9.3% 10.8% Kent State shootings 5/70 -6.7% 0.4% 3.8% 13.5% 36.7% Nixon’s resignation 8/74 -17.6% -7.9% -5.7% 12.5% 27.2% USSR in Afghanistan 12/79 -2.2% 6.7% -4.0% 6.8% 21.0% Falkland Islands war 4/82 4.3% -8.5% -9.8% 20.8% 41.8% U.S. invades Grenada 10/83 -2.7% 3.9% -2.8% -3.2% 2.4% U.S. bombs Libya 10/83 2.8% -4.3% -4.1% -1.0% 25.9% Financial panic ’87 10/87 -34.2% 11.5% 11.4% 15.0% 24.2% Invasion of Panama 12/89 -1.9% -2.7% 0.3% 8.0% -2.2% Iraq invades Kuwait 8/90 -13.3% -0.1% 2.3% 16.3% 22.4% Gulf War 1/91 4.6% 11.8% 14.3% 15.0% 24.5% Gorbachev coup 8/91 -2.4% 4.4% 1.6% 11.3% 14.9% U.S. currency crisis 9/92 -4.6% 0.6% 3.2% 9.2% 14.7%

(44)

DIVERSIFICATION: THE RANDOM WAY

Th e easiest way to reduce risk is to diversify, by applying the Law of Large Numbers. By randomly adding a large number of securities to a portfolio, the exposure to any particular source of risk becomes smaller and smaller.

Random diversiﬁ cation is like investing in stocks selected by darts thrown at an SGX stock report. When you randomly diversify, you care only about selecting as many stocks as possible without caring about criteria such as expected return or risk. Can such a naive strategy work? Th e answer is “yes”.

Event Month/ Year % Change 1 Month Later 3 Months Later 6 Months Later 12 Months Later World Trade Center bombing 2/93 -0.3% 2.4% 5.1% 8.5% 14.2% Oklahoma City bombing 4/95 1.2% 3.9% 9.7% 12.9% 30.8% Asian stock market crisis 10/97 -12.4% 8.8% 10.5% 25.0% 16.9% Bombing of U.S. embassies in Africa 9/98 0.0% -11.2% 4.7% 6.5% 25.8% WTC and Pentagon terrorist attacks 9/01 -14.3% 13.4% 21.2% 24.8% -6.7% Enron testiﬁ es before Congress 1/02 -3.0% 10.5% 4.3% -9.5% -17.7% Iraq War 3/03 2.3% 5.5% 9.2% 15.6% NA Mean -6.1% 3.9% 5.2% 9.2% 15.1%

(45)

TABLE 4.3. STANDARD DEVIATIONS OF RANDOM PORTFOLIOS OF NYSE STOCKS

No. of Stocks in

Portfolio SD of Portfolio Returns

Ratio of Portfolio SD to Single Stock SD 1 49.24 1.00 2 37.36 0.76 4 29.69 0.60 6 26.64 0.54 8 24.98 0.51 10 23.93 0.49 20 21.68 0.44 30 20.87 0.42 40 20.46 0.42 50 20.20 0.41 100 19.69 0.40 200 19.42 0.39 300 19.34 0.39 400 19.29 0.39 500 19.27 0.39 1000 19.21 0.39 Inﬁ nity 19.16 0.39

Source: Meir Statman, “How Many Stocks Make a Diversiﬁ ed Portfolio?”. Journal of Financial and Quantitative Analysis, September 1987, p.355

Table 4.3. shows the standard deviations for equally weighted portfolios, each containing diﬀ erent numbers of randomly selected New York Stock Exchange (NYSE) stocks.

(46)

Column 1 lists the number of stocks in each equally weighted portfolio. In a 10-stock portfolio, each stock has a 10 per cent weight; in a 20-stock portfolio, each stock has a 5 per cent weight, and so on. In column 2, we see that the standard deviation for a portfolio of one stock is about 50 per cent. What this means is that if you select a single NYSE stock randomly and put all your money into it, your standard deviation of return would be about 50 per cent per year. If you were to select randomly two NYSE stocks and put half your money in each, your average annual standard deviation would be about 37 per cent.

Column 3 measures how risky a portfolio is relative to a one-stock portfolio, which is obviously the riskiest portfolio. If you sink your money into a 20-stock portfolio, your annual risk would be about 22 per cent, and it would only be 44 per cent as risky as a one-stock portfolio. Stated another way, a 20-stock portfolio is 56 per cent less risky than a one-stock portfolio.

Th ere are two important observations to note:

1. Standard deviation declines as the number of stocks increases. By the time we have 20 randomly chosen stocks, the portfolio’s volatility has declined from 50 per cent per year to about 22 per cent per year.

2. Standard deviation declines at a decreasing rate as the number of stocks is increased. With a portfolio of 20 stocks, diversiﬁ cation’s maximum eﬀ ect has been realised, and there

remains very little incremental beneﬁ t to be gained by adding more stocks. Adding 20 more stocks (a 40-stock portfolio) will further reduce standard deviation by only an insigniﬁ cant 1.22 per cent (from 21.68 per cent to 20.46 per cent).

Figure 4.1 (page 46) illustrates these two points. Plotted is the standard deviation of the return versus the number of stocks in the

(47)

portfolio. Notice that risk reduction from adding securities slows down as we add more and more securities.

Hence, spreading an investment across many assets will eliminate some or most of the risk, but not all. Th e risk that can be diversifi ed is appropriately called diversifi able risk (non-systematic risk). And the risk that stubbornly remains and cannot be diversifi ed is called non-diversifi able risk (systematic risk).

Number of Stocks St and ard D e v ia tion

Non-diversiﬁ able Risk

Diversiﬁ able Risk

1 2 4 6 8 10 20 30 40 50 100 200 300 400 500 1000 60.0 50.0 40.0 30.0 20.0 10.0 00

Diversiﬁ able Risk

FIGURE 4.1. PORTFOLIO DIVERSIFICATION

DIVERSIFICATION: THE BETTER WAY

Harry Markowitz was the ﬁ rst person to formally show how portfolio diversiﬁ cation works to reduce portfolio risk. He showed how the inter-relationships between security returns — called correlation — could be used to diversify a portfolio so that risk is minimised while returns are maximised.

What is Correlation?

Correlation measures the extent to which the returns on two assets move together. If the returns on two assets tend to move up and

(48)

FIGURE 4.2. PERFECT POSITIVE CORRELATION (CORR = +1.0)(( ))

Time Retur n s Asset X Asset Y

down together, we say they are positively correlated. If they tend to move in opposite directions, we say they are negatively correlated. If there is no particular relationship between the two assets, we say they are uncorrelated.

Th e correlation coeﬃ cient is used to measure correlation, and it ranges between -1.0 and +1.0:

Corr = +1.0 perfect positive correlation Corr = 0.0 zero correlation

Corr = -1.0 perfect negative correlation

Perfect Positive Correlation

Figure 4.2 shows the returns of two assets with perfect positive correlation. If asset X has positive returns, so does asset Y. And if asset X has negative returns, so does asset Y. Do note that perfect correlation does not mean that the two assets move by the same amount; correlation is a measure of direction, not magnitude.

(49)

FIGURE 4.4. ZERO CORRELATION (CORR = 0.0)( )

Retur n s Time Asset X Asset Y

Perfect Negative Correlation

In Figure 4.3, the returns of the two assets X and Y move in opposite directions. If asset X has positive returns, asset Y will have negative returns.

FIGURE 4.3. PERFECT NEGATIVE CORRELATION (CORR = -1.0)

Time Retur n s Asset X Asset Y Asset X Asset Y A t Y Zero Correlation

If we know that the returns of X are positive, but have no idea what the returns of Y are likely to be, there is zero correlation.

(50)

Understanding correlation helps us improve the diversiﬁ cation process of reducing portfolio risk:

1. Combining securities with perfect positive correlation with each other provides no reduction in portfolio risk. We should avoid securities that are positively correlated as the total risk is then higher.

2. Combining securities with zero correlation with each other does provide signiﬁ cant risk reduction, although portfolio risk cannot be eliminated completely.

3. Combining securities with perfect negative correlation can eliminate risk altogether.

4. To see how correlation works, suppose you invest 100 per cent of your money in banking stocks. As a group, banking stock returns are highly positively correlated. Good prospects in the industry will see the group rise as a whole. And when prospects are poor, your entire portfolio will suﬀ er as well.

In reality, securities typically have some positive correlation with each other. Although risk can be reduced, risk usually cannot be eliminated. As an investor, you should hence ﬁ nd securities with the lowest amount of positive correlation as possible.

DIVERSIFICATION USING STOCKS AND BONDS

One of the most eﬀ ective ways to diversify is to invest in the two main asset classes of stocks and bonds because of their low correlation with one another. How much money should you allocate to each asset group?

Th e ideal asset allocation diﬀ ers from person to person and is based on the individual investor’s risk tolerance. A young executive typically has a higher risk tolerance than a retiree. Th e young

(51)

executive, therefore, may have an asset allocation of 80 per cent stocks and 20 per cent bonds (since stocks are riskier than bonds), while the retiree may have a less risky allocation of 20 per cent stocks and 80 per cent bonds.

Th e idea is to mix and match stocks and bonds in the proportion that generates the highest return possible based on the amount of risk we are able to tolerate. In general, the higher our risk appetite, the higher will be the proportion of stock in our portfolio, vis-à-vis bonds.

Two questions you could be asking thus far:

1. What returns can I expect from a diversiﬁ ed portfolio of stocks and bonds?

2. How can I create a diversiﬁ ed portfolio of stocks and bonds if I do not have much money?

We will answer these two important questions in the next section where we talk about investing in the major investment types. We end this chapter and this section by ﬁ nding out how much risk you can take as an investor — that is, your risk tolerance.

FINDING OUT YOUR RISK TOLERANCE

Are you a conservative investor or an aggressive investor? Th e answer to this question determines the amount of risk you can tolerate and hence the type of asset allocation appropriate for you. To keep things simple for now, let us work with just stocks and bonds.

The Risk Profile Questionnaire Approach

Risk profi le questionnaires ask pointed questions to fi nd out your risk tolerance. Th ere is no one single version but many. Th e CPF Board has one. Your bank offi cer has one. Your insurance adviser has one. Chances are that you are likely to see a diff erent version from every company you deal with.