 What is investment?
Investment in practical common sense means putting your money to work to earn more money. If you invest wisely, it will help you meeting your financial goals; e.g. securing an early comfortable retirement life, paying for your children's education fees, hedging against inflation or simply making more money. Investment is not confined to wealthy people. Even a small amount of money invested, can produce a considerable return over a period of time, should you make the right choice of investment.
Choosing the "Best" Investment Tools
Definition of "best" investment differs from one investor to another. What is good for one may not be true for others. No two investors are alike either in terms of personality or in their own financial situations. It is necessary to tailor your investment plan based on your own profile. This includes your investment time horizon, age, objectives, risk tolerance, taxation consideration and of course, your existing portfolio. To do that, you need to understand how the various aspects of your personal profile can affect investment decisions. We categorize the considerations into four aspects.
1. Expected Return
Expected return on investment of individual differs greatly from each other. It will, to a large extent, depend on your objective of investing and personal need. Take for example, if you need investment portfolio providing you annual income, then you will prefer returns that emphasize relatively high annual payouts, which tend to be persistent each year, and certainly together with principal protected. On the other hand, individuals who save for future targets such as child education, buying a house, or paying your retirement life, would prefer returns that tend to emphasize growth. Of course, many investors will require the mix of these two objectives. However, in reality, there is no investment that could at the same time promise you a high income, preserve your investment principal and still offer you high growth potential. That is why it is essential for us to first determine our return needs before making any investment decision. Understanding the trade-off between income and growth is a critical investment consideration. Usually, the more certain the annual payment, the less risky the investment, and therefore the lower the growth potential and vice versa.
Again, these securities are mentioned only as demonstration of return characteristics to help you identify your own needs. Besides, it is not necessary for an investor to put everything exclusively in assets with those same characteristics. Properly diversifying among different types of investment tools will definitely allow you to meet your return needs without taking extra risk.
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| TYPE OF INVESMENT TOOLS |
| Money market funds, certificates of deposit, short-term bonds, etc offer the most certain annual payouts and protection of principal. On the contrary, they selfdom offer potential for capital growth. |
| Treasury and municipal bonds, other high quality corporate bond, bond funds and balanced portfolio usually offer high coupon and little growth potential. |
| High-yield valued-stock, equity fund, alternative investment offer you higher growth potentials with low dividend payouts. |
| Single market equity funds, alternative investment, growth stock usually will not offer income, no protection over principal but relatively high capital growth potential. |
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2. Risk Tolerance
Investment involves taking risk but what is the risk involved? Theoretically, risk can be defined as the uncertainty of return, the possibility that the investment cannot perform as expected. When we decide on investment plan, the amount of risk you are willing to take is an extremely important factor to consider because of the severe consequences of taking on too much risk. A well-known general rule for risk is the higher the potential for reward, the higher the risk, and vice versa. To many people, the biggest risk is losing money, these investors will then look for investments they consider safe. As a rule of thumb, we will suggest that investors who could accept loss on an investment of no more than 5% to 10% in one year, can be defined as an investor with low tolerance of risk. They could invest in the appropriate category of investment tools such as money market funds, certificates of deposit, or treasury bond.
Generally, investors with a moderate tolerance risk acceptance level can sustain annual loss of around 6% to 15%. Types of investment tools available for them will include alternative investment funds, international stock funds, medium to long-term bond portfolios and high-quality, dividend-paying stock portfolios.
At last, investors with high tolerance for risk can generally withstand losses of over 15% annually. Security types which are suitable for them include growth stock funds, regional or single market equity funds, high-yield bond, single-strategy hedge fund, sector funds, or emerging market stock portfolios. Of course, the above guideline is merely a reference for investors. In order to control the level of risk in a portfolio, we are not solely limited to the category of choices mentioned above. We could simply achieve it through diversification of investment tools or markets of which individual tool has low or negative correlation with each other. Under most of the circumstances, diversification is a good way to manage risk. By including a different mix of assets over different markets, an optimal balance between your desired risk and return level can be achieved.
3. Time Horizon
The length of time you will or can invest is important because it can directly affect your ability to reduce risk. Undoubtedly, the longer the time frame you have for investing, the less conservative your investments should be. Time diversification is important especially for volatile investments such as individual stock, its price usually fluctuates greatly over the short term, but in return, its growth is quite steady over longer time period.
If your time horizon is short, say 1 month or below, you cannot effectively diversify your risk across different economic cycles and business environments. Therefore, longer time horizons permit you to take greater risk as some of the risk will be automatically reduced through time diversification.
Obviously, if you want to diversify your risk exposure over different stages of an economic cycle, you must make your money available for investment over the complete business cycle. It is generally accepted that nowadays, an economic cycle lasts around 5 years. Then, any investment plan which made over 5 to 10 years, can be considered as a long term investment horizon. We could put higher risk investment tools such as single security into the investment plan. On the contrary, for short term investment horizon, say if you need the money within a year, the effect of time diversification is lower and your investment choices may be only limited to shorter-term fixed income or portfolios of high quality securities. In summary, we could conclude that the sooner you need the investment, the greater the need for principal protection and liquidity.
4. Unique Considerations
Of course, on top of the above, each individual should have its own consideration which may ultimately determine the direction of your investment planning.
Taxation would be one of the primary considerations as for many investors, what is left after taxes should be their bottom line for investment. After-tax, investment return may differs depending on the income levels of each individual based on various tax brackets. Also, different investment tools, namely dividend-paying stock and mutual funds would certainly have in different implications for us. Given that tax laws in different countries are changing, all investors should take into account of this factor and discuss with the local tax consultants before making your overall planning.
Besides, some investors may put liquidity of investment as number one concern. Whether the money is easily accessible? How easy for us to convert the investment into cash? All these will determine which sectors of investment we could choose. Other unique concerns like ability to hedge against market risk, stage of economic cycle etc will be some common factors for individual investor to consider.
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