9814328618

KEON CHEE & BEN FOK

3RD EDITION

HHHOW TO GROW YOUR INNVESTMENT DOLLARRS

MYMWFY (3rd Edition) 4 Jan.indd 1 1/25/11 8:14:02 AM

MAKE YOUR

MRK

HOW TO GROW YOUR INVESTMENT DOLLARS

FOR YOUW

NEY

KEON CHEE & BEN FOK

3RD EDITION


© 2006 Marshall Cavendish International (Asia) Private Limited.

© 2008 Marshall Cavendish International (Asia) Private Limited. 2nd Edition.

Reprinted 2010

© 2011 Marshall Cavendish International (Asia) Private Limited. 3rd Edition.

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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

332.024 — dc22 OCN690062488

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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


Introduction 8

Part 1 : Basic Investment Concepts1 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 Assets11 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

Contents


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

Introduction


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.


BASIC INVESTMENT CONCEPTSWe 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.

1PART


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!

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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

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

Singapore Department of Statistics newsletter, 3rd quarter, 2000.


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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 WISELYWhen 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


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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 MILLIONAIREConsider 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.


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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

CAAAAA

BBBBBBBBBBBBB

CC

Jan-9

6

Sep-

97

May

-99

Jan-0

1

Jan-0

6

Feb-

03Ju

l-03

Dec

-03

May

-04

Oct

-04

Jun-9

6

Feb-

98

Oct

-99

Jun-0

1

Jun-0

6N

ov-0

6

Nov

-96

Jul-

98

Mar

-00

Mar

-05

Nov

-01

Apr

-97

Dec

-98

Aug

-00

Aug

-05

Apr

-02

Apr

-07

Sep-

02

Sep-

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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


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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 InvestingTh 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.


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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.


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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.


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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 INVESTMENTSOne 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.

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21Stocks or EquitiesIf 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


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22bonds, 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 SecuritiesBonds 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

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23Bond 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 SecuritiesMoney 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

Money market investments maintain a stable value, pay interest and


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24can 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


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251926 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.

DERIVATIVESStocks 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.

OptionsOptions 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


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26shares 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 TRUSTSDirect 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.


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27Some 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.


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.

RETURNSWhen 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.

03


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29Measuring Total Returns Over One PeriodSuppose 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 PeriodsSuppose 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

Source: Authors’ own computation


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30To 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 ReturnsHow 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.


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31RISKA 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


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32an 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


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33 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


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34 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 RiskRisk 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


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35A 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%


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36will 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-OffNow 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:

Expected Return = Risk-free Rate + Risk Premium


37FIGURE 3.1. RISK-RETURN TRADE-OFF

DerivativesCommon StocksCorporate

BondsGovernment BondsTreasury

Bills

RiskPremium

Risk-freeRate

Ret

urn

s

Line A

Risk

R

ond

Stoco k


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 ReturnsLook 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?


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38A 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 RISKEarlier, 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


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39standard 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 RISKTh 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.


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40

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


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41Th 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 CRISESTh 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

EventMonth/

Year

%

Change

1

Month

Later

3

Months

Later

6

Months

Later

12

Months

Later

Exchange

closed WWI7/14 -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%


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EventMonth/

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

crisis10/56 -1.4% 0.3% -0.6% 3.4% -9.5%

Cuban missle

crisis10/62 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

shootings5/70 -6.7% 0.4% 3.8% 13.5% 36.7%

Nixon’s

resignation8/74 -17.6% -7.9% -5.7% 12.5% 27.2%

USSR in

Afghanistan12/79 -2.2% 6.7% -4.0% 6.8% 21.0%

Falkland

Islands war4/82 4.3% -8.5% -9.8% 20.8% 41.8%

U.S. invades

Grenada10/83 -2.7% 3.9% -2.8% -3.2% 2.4%

U.S. bombs

Libya10/83 2.8% -4.3% -4.1% -1.0% 25.9%

Financial

panic ’8710/87 -34.2% 11.5% 11.4% 15.0% 24.2%

Invasion of

Panama12/89 -1.9% -2.7% 0.3% 8.0% -2.2%

Iraq invades

Kuwait8/90 -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

coup8/91 -2.4% 4.4% 1.6% 11.3% 14.9%

U.S. currency

crisis9/92 -4.6% 0.6% 3.2% 9.2% 14.7%


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43

DIVERSIFICATION: THE RANDOM WAYTh 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”.

EventMonth/

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 bombing4/95 1.2% 3.9% 9.7% 12.9% 30.8%

Asian stock

market crisis10/97 -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%

Source: Ned Davis Research Inc.


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44

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.


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45Column 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


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46portfolio. 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

Sta

nd

ard

De

via

tio

n

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


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


Time

Ret

urn

s

Asset XAsset 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.


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48

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


Ret

urn

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

Ret

urn

s

Asset X

Asset Y

Asset X

Asset YA 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.


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49Understanding 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 BONDSOne 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


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50executive, 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 TOLERANCEAre 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 ApproachRisk 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.


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51Despite the many versions, risk profi les all have the same objective

— they ask you questions to fi nd out the appropriate balance of stocks

and bonds for your investment allocation. Questions in general ask:

1. Your Ability to Take Risk

How old are you? When do you need the money? How long will

your assets be invested? Th e younger you are or the longer your

investment time horizon, the higher the amount of risk you can

aff ord to take.

2. Your Appetite for Risk

Th is is the amount of risk you are comfortable with taking. Do

you sleep soundly at night when your investments fall in value?

Are you patient enough to see your investments grow over the

long-term?

3. Your Overall Financial Situation

How much money do you already have? Th e richer you are, the

more willing you are to take on risk.

Sample Risk Profile

Below is a sample risk profi le. Answer the six questions by circling

the choice that best represents your investment situation.

Questions 1 and 2 ask your age and investment time horizon,

two objective factors that test your ability to take risk. Th ey have

each been given twice the number of points as the other questions

because age and time horizon tend to weigh more heavily in

considering one’s tolerance for risk.

Th e other four questions are more subjective; they test your

appetite for risk. Add up the points from the six questions to

determine your risk tolerance score.

Th e possible range of scores is 8 to 24. In general, the higher your

score, the more comfortable you are with taking risk, and the higher

the proportion of stocks your portfolio should contain.


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52 RISK TOLERANCE QUESTIONAIRE

1

How old are you?

a. (6 points) Below 40 years oldb. (4 points) 40 to 54 years oldc. (2 points) 55 years or older

2

When do you plan to use the money you have invested?

a. (2 points) Within 3 yearsb. (4 points) 4 to 9 yearsc. (6 points) 10 or more years

3

Given two hypothetical unit trusts, how would you invest?Unit Trust A — Gives an average annual return of 5% with minimal downside in any one year.Unit Trust B — Gives an average return of over 10% but portfolio can fall 20% in any one year.

a. (1 point) 100% in Unit Trust Ab. (2 points) 50% in Unit Trust A and 50% in Unit Trust Bc. (3 points) 100% in Unit Trust B

4

How do you feel about losing money?

a. (1 point) I hate losing money and I am willing to accept lower returns.b. (2 points) I do not mind moderate risk. It is OK to see some fl uctuation in my returns, but not too much.c. (3 points) I am willing to take high risk because I believe returns will be higher over the longer term.

5

You accept that your portfolio will fl uctuate in value over time. What is the maximum loss you could accept in any one-year period?

a. (1 point) 5%b. (2 points) 15%c. (3 points) 30%


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6

Suppose the market lost over 25% in value in just one day today. How will that aff ect you?

a. (1 point) I would be so upset that I would not be able to sleep.b. (2 points) I will fi nd out what happened from the news or from my contacts. I might be tempted to sell.c. (3 points) I would not be overly bothered as it is probably a short-term fl uctuation.

Calculate your total score and record it here:

TOTAL SCORE: _______

Th en check Table 4.4 below for your risk profi le and the matching

allocation for stocks and bonds. Th is sample risk profi le has fi ve

allocations.

TABLE 4.4. RISK PROFILE AND INVESTMENT ALLOCATION

Total Score Risk Profi le % Stocks % Bonds

8–10 Conservative 20% 80%

11–13Moderately conservative

40% 60%

14–16 Balanced 60% 40%

17–19Moderately aggressive

80% 20%

20–24 Aggressive 100% 0%



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54Your Target Investment Allocation

Before moving on, use the following checklist to record your target

investment allocation.

Check one:

_________ Aggressive

_________ Moderately Aggressive

_________ Balanced

_________ Moderately Conservative

_________ Conservative

_________ % Stocks

_________ % Bonds

You realise that risk profi le questionnaires and the recommended

allocations for equity and bonds are not an exact science. As we

mentioned, you will not fi nd two risk profi le questionnaires that are

exactly alike.

Risk profi les, nevertheless, give you a fi rst level guide to what

your risk tolerance is, from which the appropriate asset allocation

of stocks and bonds can be determined.

Remember that a particular asset allocation is appropriate only at

a certain point in time. When you get older and your circumstances

change, your risk tolerance will change and your asset allocation

must evolve along the way.


2PART

INVESTING IN TRADITIONAL ASSETSThe best way to benefit from this section is to invest in something — if you have not already done so. Suppose you had $2,000 or $20,000 to invest. How exactly do you begin?

We recommend unit trusts as a start because they offer instant diversification and professional expertise at a low initial price. Then, when your skills and confidence are better developed and you are ready to do more, investing in individual stocks and bonds will be an appropriate next step.


Investing in Unit Trusts

Many investors start out with unit trusts. Even experienced investors

with large portfolios make generous use of unit trusts. Investors

today have a lot of choices. Th ere are over 3,200 funds available to

investors in the Singapore marketplace (www.fundsingapore.com)

— six times more than the number of stocks listed on the SGX.

Unit trusts fall into two main categories:

1. Equity Funds (or stock funds)1 — unit trusts consisting of stocks,

2. Fixed Income Funds (or bond funds) — unit trusts consisting

of bonds.

Equity funds invest in the equity of companies and are for the

more risk-tolerant investors who want their money to grow over a

long period of time.

Fixed income funds are for those with a smaller risk appetite.

Th ey invest in the debt of governments and corporations. Fixed

income funds off er current income and do not fl uctuate as widely

in value as equity funds do.

If you need a brief refresher on some of the more popular types

of unit trusts found in the Singapore market, refer to the unit trust

glossary at the end of this chapter.

You should have, by now, fi gured out what sort of investor you

are. If you have not, answer the risk profi le questionnaire found in

Chapter 4. Th e next step is to fi nd out the type of equity and fi xed

income funds to invest in.

1 An equity fund (as compared with a stock fund) is actually the more common

name for a fund containing mainly stocks. A fi xed income fund (as compared with

a bond fund) is the more common name for a fund containing mainly bonds. We

will use both these terms interchangeably.

05


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TABLE 5.1. RECOMMENDED ALLOCATION OF EQUITY FUND INVESTMENTS

Type of Equity Fund Recommended Allocation

U.S. Equity Fund 30%

European Equity Fund 30%

Asia ex-Japan Equity Fund 30%

Japan Equity Fund 10%

TOTAL 100%

Source: Authors’ own recommendations

FIGURING OUT THE TYPES OF EQUITY FUNDS IN WHICH TO INVEST If you invest all your money in Singapore and the Singapore economy

tumbles, your entire portfolio will fall. Th at is because the stock

market is sensitive to what happens to the economy as a whole.

Now, if you split your money 50-50 and say, invest in both

Singapore and the U.S., then it is likely that when Singapore falls,

the U.S. might rise or when Singapore rises, the U.S. might fall.

Economies do not rise and fall at the same time. (It is the reason we

place our money in diff erent asset classes, namely stocks and bonds.)

Th at is why it makes sense to diversify our investments across

countries. Th is process is called global diversifi cation.2 We can

easily achieve this by investing in four types of funds, each

representing one of the four major economic regions of the world,

in the following proportions:

2 Th e act of diversifying your money into equity funds and fi xed income funds is

called asset class diversifi cation. Global diversifi cation then takes each asset class

and diversifi es it across the globe — into global equities and global fi xed income.

According to the IMF World Economic Outlook, these four

regions represent 75 per cent of world gross domestic product

(GDP), which is a measure of economic output. Th e economic

output of each is weighted roughly in the percentages given above.


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58Th ese GDP fi gures are not static of course. Th ey go up and down,

but in general, unless there is some long-term structural change

in the economic outputs of the four regions, we can simplify the

recommended allocation to 30-30-30-10.

Japan is set apart from the rest of Asia, the reason being that

Japan is itself a very large and developed economy — the third

largest in the world. Even though it is not geographically a region,

its economic status qualifi es it as such. Funds invested in Asia fall

mainly into two fund categories: Asia ex-Japan and Japan.

FIGURING OUT THE TYPES OF FIXED INCOME FUNDS IN WHICH TO INVEST Now that you have fi gured out the types of equity funds in which

to invest, fi guring out the types of fi xed income funds to invest in is

a walk in the park. Th e same principle of diversifi cation holds true,

with a few exceptions:

• Asian Fixed Income Fund

In the equity fund allocation, we had Asia broken down into Asia

ex-Japan, and Japan. In this fi xed income fund allocation, both

regions are clumped together because Japan’s fi xed income funds

are not sold in Singapore, whereas all-Asia fi xed income funds are.

• Singapore Fixed Income Fund

Singapore bonds are typically of the highest quality and have

very low risk compared with other types of fi xed income funds.

Th ey also have little exchange rate risk and provide good

stability for your fi xed income fund portfolio.

Always bear in mind that the allocation to each type of equity

and fi xed income fund is not an exact science. Treat what has been

discussed as a general guideline. Generally, in order to create a

globally diversifi ed equity or fi xed income portfolio, you should be

investing in all the major economic regions in the world.


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Type of Fixed Income Fund Recommended Allocation

US Fixed Income Fund 30%

European Fixed Income Fund 30%

Asia Fixed Income Fund 30%

Singapore Fixed Income Fund 10%

TOTAL 100%


TABLE 5.2. RECOMMENDED ALLOCATION OF FIXED INCOME FUND INVESTMENTS

HOW DO GLOBALLY DIVERSIFIED UNIT TRUST PORTFOLIOS PERFORM?Here is a study that summarises the important points we are making.

Look at Figure 5.1 on page 60, which is based on 32 years of data. Th e

uppermost 100 per cent equity line is based on the highest amount

of risk taken by the Aggressive Investor. You can see that returns

fl uctuate up and down quite a bit, and are very volatile.

Starting with a 100 per cent Equity portfolio, we can lower

risk by adding fi xed income funds to our portfolio as seen by an

increasingly fl atter return line on the graph. Notice that adding

fi xed income funds to the equity portfolio also reduces the returns

we can expect.

As we add fi xed income in 20 per cent increments, returns

fall gradually to 5.4 per cent (for a 100 per cent Fixed Income

portfolio).

You must treat the return numbers shown in Table 5.3. (page 60)

as mere guideposts to what can be expected of asset allocation in

general. It is impossible to use any historical fi gures to project the

future with 100 per cent accuracy. Taking a diff erent period for

study would yield diff erent results, but the pattern of higher returns

from portfolios with higher concentrations of equities can almost

always be expected to occur.


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60

TABLE 5.3. ANNUALISED RETURNS OF VARIOUS EQUITY-FIXED

INCOME COMBINATIONS

Equity-Fixed Income Fund Allocation Annualised Return

100–0 9.0%

80–20 8.4%

60–40 7.7%

40–60 6.7%

20–80 5.6%

0–100 5.4%

Source: iFAST Financial Pte Ltd, “Rebalancing With Bond Funds”, (24 Febuary 2003)

FIGURE 5.1. PORTFOLIO VALUE STARTING WITH $10,000

Source: iFAST Financial Pte Ltd, “Rebalancing With Bond Funds”, (24 February 2003)

$

Yr1970 1974 1978 1982 1986 1990 1994 1998 2002

300,000

250,000

200,000

150,000

100,000

50,000

0

100% equity40% bonds, 60% equity 80% bonds, 20% equity

20% bonds, 80% equity 60% bonds, 40% equity100% bonds


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TABLE 5.4. RECOMMENDED ALLOCATION FOR A CONSERVATIVE INVESTOR

WITH $50,000 TO INVEST

Equity Funds Recommended Allocation

Investment Amount

US Equity Fund 30% $3,000

European Equity Fund 30% $3,000

Asia ex-Japan Equity Fund 30% $3,000

Japan Equity Fund 10% $1,000

TOTAL Equity Funds (20%) $10,000

TOTAL Fixed Income Funds (80%) $40,000

TOTAL Invested $50,0003

Source: Authors’ own recommendation

3Th e minimum amount needed can be calculated as the minimum investment

amount per fund ($1,000) divided by 20% (equity fund allocation) x 10% (smallest

equity fund allocation) = $1,000 / (0.2 x 0.1) = $50,000.

HOW TO BEGIN INVESTING WHEN YOU DO NOT HAVE MUCH MONEYIn order to create your portfolio so that it includes all the above

recommended fund types, you will probably need between $10,000

and $50,000. Th is is because most funds require a minimum

investment of $1,000.

For example, if you are a conservative investor (20-80 equity-

fi xed income fund allocation), you could organise your portfolio the

following way:

If you have less than $5,000 to invest — buy a global balanced

fund (also called an Asset Allocation fund). Th ese funds invest in

both equities and bonds in almost equal proportions.

Global Balanced Fund 100%


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62

TABLE 5.5. RECOMMENDED SEQUENCE OF BUYING FOR ONE-AT-A-TIME

PURCHASES

Equity Fund Fixed Income Fund

1 Global Equity Fund Global Fixed Income Fund

2 Asia ex-Japan Equity Fund Asian Fixed Income Fund

3 U.S. Equity Fund Singapore Fixed Income Fund

4 European Equity Fund U.S. Fixed Income Fund

5 Japan Equity Fund Europe Fixed Income Fund


If you have less than $10,000 to invest – buy two funds, a global

equity fund and a global fi xed income fund. For example, if you are

a moderately aggressive investor (80-20 equity-bond allocation),

your portfolio can look like this:

Global Equity Fund 80%

Global Fixed Income Fund 20%

If you have more than $10,000 to invest — you can begin by

buying individual fund types in sequence. As you have more and

more money available for investment, you may buy another fund in

another category.

Th e following is a suggested buying sequence. While you may

not be following your recommended investment allocation to a tee,

you should still end up with a reasonably well-balanced portfolio.

Do this until you have enough money to take full advantage of the

allocation that applies to you.

So, if you have more than $10,000 to invest, buy them in the

following order:

We suggest you start off with a global fund in order to obtain

instant global diversifi cation. You may be thinking that this is tricky

to pull off , but it is not. You see, you do not have to be precise as


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63to how to allocate your money as long as you conform to these

guidelines at the start.

Succeeding in your investment allocation has less to do with

being precise in the way you allocate your money than in making

sure you are invested in diff erent fund types, so that you will always

have some money in categories that are doing well.

Following this approach also frees you from the stress of worrying if

you are too heavily invested in weak areas. Your challenge is deciding

how to invest money so that it becomes available in the future.

From our experience, the above guidelines will help you reach your

desired investment allocation in a sensible and stress-free way.

UNIT TRUST GLOSSARYTh ere are more than 3,200 funds available to investors in the

Singapore marketplace, of which two out of three are equity funds.

Equity Funds (Also Called Stock Funds)An equity fund is a unit trust that invests in stocks (or equities). A stock

represents a share of ownership or equity in a company. While the

stock market is known for its ups and downs, equities have historically

provided higher returns than bonds over a long-term period.

International Equity Funds

An international portfolio of securities promises less risk and

greater diversifi cation than one that is purely domestic. A 100 per

cent domestic portfolio consisting only of investments in Singapore

makes your entire portfolio vulnerable to any Singapore market

downturn. International equity funds are of several types:

• Global Equity Funds invest in promising companies anywhere

in the world.

• Regional Equity Funds invest in the stocks of a single geographic

region, such as Asia, Europe or Latin America. Th e share prices


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64 of these funds typically fl uctuate more than the share prices of

broadly diversifi ed global equity funds.

• Single-Country Equity Funds invest in the stocks of a single

foreign country such as China, Singapore or the U.S. Th ese

funds are considered riskier than regional funds because of their

narrower focus.

• Emerging Market Equity Funds invest in countries that are

moving towards an industrialised economy or to a free-market

economy. Th ese markets off er the potential for faster economic

growth than established markets, but they also present

substantial risks. Examples of such countries are Brazil, Mexico,

Indonesia and South Africa.

Keep in mind that emerging markets and single-country funds

can fl uctuate widely because of their narrower focus, and they are

not for everyone. If you wish to diversify internationally and seek

safety, it is best to consider global and regional funds before single-

country and emerging market funds.

Sector Funds

Sector funds invest in a specifi c industry such as technology or

healthcare. Investing in a narrow segment is higher risk, because if

fortunes in that sector fall, the whole portfolio becomes vulnerable.

Sector funds are attractive if you already hold a diversifi ed portfolio

and you want to take on more risk because these funds can

sometimes achieve spectacular returns.

Index Funds

Index funds are unit trusts that closely track and replicate market

indices such as the Straits Times Index. Th e fund manager does

not actively seek the best investments to outperform the market.

As a result, they are cheaper to own as they have lower operating


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65expenses. One drawback of index funds is that they do not off er any

chance of above-market returns.

Indexing is a passive form of fund management that has been

successful in outperforming most of the actively managed mutual

funds in the U.S.

A close relative of the index fund is the exchange-traded fund

(ETF), which trades like a stock on an exchange, thus experiencing

price changes throughout the day as it is bought and sold. We have

devoted a chapter to index funds and ETFs.

Fixed Income Funds

Fixed income funds invest in bonds issued by companies and

governments.

Like equity funds, there are fi xed income funds that invest globally,

regionally, in emerging markets and in individual countries. We

do not need to explain these fund types. Many other types of fi xed

income funds exist. Here are two:

1. High-Yield Fixed Income Funds

Such funds seek higher returns by investing in high-yielding,

lower-quality corporate bonds.

2. Mortgage-Backed Funds

Th ese funds seek to maximise income by investing in mortgage-

backed securities. Such securities are bonds backed with

a claim on specifi c property, and are thus of lower risk than

unsecured bonds that are not backed by any asset.

Other Types of FundsMoney Market Funds

Closely related to bonds are very short-term loans (between three

and 12 months) known as money market instruments. Singapore

government Treasury Bills, commercial paper and corporate bonds

maturing within a year are some examples.


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66Money market funds are good for your portfolio because they

tend to be used like savings accounts, where the goal is not to

generate maximum income, but to preserve capital.

Balanced Funds (Also Called Asset Allocation Funds)

Such funds combine about equal proportions of stocks and bonds

in a single fund. In this sense, balanced funds provide the best of

both worlds, off ering the growth potential of equities and income

from bonds.

Offshore Funds

Th ese are funds that are registered outside Singapore in places such as

Luxembourg and Dublin. Th e benefi ts provided by these jurisdictions

are well-developed regulations to register and operate funds and a

low-to-no-tax requirement on both capital gains and income.

Feeder Funds

A feeder fund is a fund that is registered locally and invests in an

off shore fund. Rules have now been relaxed and fund houses today

can bring off shore funds directly into Singapore for sale, thereby

eliminating the expenses incurred by registering a feeder fund.


Selecting and Managing Your

Unit Trust Investments

You have by now an equity-fi xed income fund allocation that matches

your risk profi le. You know the type of equity funds and bond funds

that will diversify your investment portfolio across the world. It is

time to select good unit trusts in each fund category and to manage

your portfolio over the longer term.

As there are several hundreds of funds available, the process of

fi nding good funds must be undertaken with care. Th at is because

fund distributors can typically fi nd some performance measure that

they can beat, such that all funds appear to be “good” funds. For

example, a fund may be shown as having beaten all its peers during

the last one year. Impressive in itself — until one fi nds out that the

fund lost out in every other measurement over the last 10 years.

Not all funds are good, but there are many that are, and the

challenge is fi nding the ones that are right for you. If you have a

fi nancial adviser helping you, make sure you ask why he is positive

about any particular fund. Better still, do your homework fi rst. We

will show you how you can get a list of good funds later.

SOURCES OF INFORMATION ON FUNDS If you want to select your own funds, there are four main sources of

information available:

1. Th ird party fund analysis from Lipper,

2. Banks,

3. Online distributors of unit trusts such as Fundsupermart,

DollarDex and Finatiq, and

4. Financial advisers.

06


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68Each of these sources uses similar criteria to evaluate funds. If the

fund you are interested in buying is rated highly by at least two of

these sources, chances are that you have found a good fund.

THIRD PARTY FUND RATINGSAs a start, we prefer to consult the ratings provided by Lipper. Th is

organisation does not sell unit trusts. Th at is why we can expect them

to off er objective, independent ratings. Use the following criteria as

a fi rst cut. Keep in mind that the steps outlined below are based on

actual screenshots at a certain date. So be sure to expect diff erent

results when you do your own search.

Review Top-Performing FundsHere is how you can generate a list of top-performing equity funds

with at least a 5-year record.

Go to www.fundsingapore.com

• Click on the Basic Search tab

• Make the appropriate selections:

Universe – select Unit Trust

Asset Type – select Equity

Th is produced 1,963 Fund Type Matches that are “Unit Trusts”

of type “Equity” (Figure 6.1., as at mid-2010). To narrow our search

to the top-performing equity unit trusts over a 5-year period, make

the following selections:

• Time Frame – select 5 Year

• Total Return – select 5

• Consistent Return – select 5

• Preservation – select 5

• Expense – select 5

Th is produced 15 Lipper Leader Matches (Figure 6.2.). Click the “15

Matches” icon and the fi rst 10 Lipper Leaders (Figure 6.3.) appears:


69FIGURE 6.1. SETTING CRITERIA TO FIND ALL EQUITY UNIT TRUSTS

Fund Type Matches: 1963

CPF Account type

Ctrl=click selects multiple options

HIGHER RISK

MEDIUM TO HIGH RISK

LOW TO MEDIUM RISK

LOWER RISK

CPF Account type

Aberdeen Asset Management Asia Limited

AIMS AMP Capital Industrial REIT Management Ltd

Alliancebernstein (Luxembourg) SA.

Allianz Global Investors KAG mbH

Universe

Unit Trusts

CPF Included

All

CPF Account type

All

Select An Asset Type

Equity

FIGURE 6.2. SETTING CRITERIA TO FIND TOP PERFORMERS OVER 5 YEARS

Source: www.fundsingapore.com

SGP Lipper Leader Matches 15

Historical Performance

Choose the Lipper Leader Rating from the categories below that match your

investment goals. You can make multiple selections.

Select a Time Frame Overall 3Years 5Years 10Years

SELECTALL

S

SELECTALL

S

SELECTALL

S

SELECTALL

S

4

4

4

4

3

3

3

3

2

2

2

2

1

1

1

1

5

5

5

5

Total Return

ConsistentReturn

Preservation

Expenses

4 3 2 15Highest Lowest


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70 FIGURE 6.3. DISPLAYING THE LIST OF TOP PERFORMERS

Lipper Leader Ratings — What They Mean

Funds are ranked against their Lipper peer group classifi cations each

month for 3-, 5-, 10-year, and overall periods. For each measure:

Rating Position in Peer Group

‘5’ Top 20% of funds

‘4’ Next 20% of funds

‘3’ Middle 20% of funds

‘2’ Next 20% of funds

‘1’ Lowest 20% of funds

Th is is what each of the measures1 mean:

• A high rating for Total Return denotes a fund that has provided

superior total returns (income from dividends and interest as well

as capital appreciation) when compared to a group of similar funds.

Th is measure is for investors who want the best historical return,

without looking at risk and may not be suitable for investors who

want to avoid downside risk.

1 adapted from www.lipperleaders.com


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71• A high rating for Consistent Return identifi es a fund that has

provided relatively superior consistency and risk-adjusted returns

when compared to a group of similar funds.

• A high rating for Preservation is a fund that has demonstrated

a superior ability to preserve capital in a variety of markets and

minimize downside risk relative to other fund choices in the same

asset class.

• A high rating for Expense identifi es a fund that has successfully

managed to keep its expenses low relative to its peers.

About Your List of Good FundsAs you can see, fi nding good funds is really easy. You should go

through this exercise every six months to see how your fund is

performing or what other good funds have come within range of

your radar. We will teach you how to read some of the performance

statistics later in this chapter.

On the other hand, if you prefer to let your fi nancial adviser do

the selection for you, do not forget to ask how he generates his

list and why he thinks the funds are good. Be careful not to follow

recommended funds blindly. Treat your list of funds as a source of

names for further investigation.

ADDITIONAL TIPS ON IDENTIFYING GOOD FUNDSHere are other suggestions to help you avoid mistakes when making

buying decisions.

Should Big Funds be Avoided? It is common to hear investors say that big funds — those with over

$500 million or $1 billion in size — should be avoided altogether. Th ey

argue that when a fund gets that big, it is very diffi cult to be nimble.


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72Let us take Singapore funds for example. Prudential’s PruLink

Singapore Managed Fund, which invests 70 per cent in Singapore

equities and 30 per cent in Singapore bonds, had a fund size of

$3.1 billion in July 2010. It is the largest fund invested in Singapore

securities. Th at must seem too big for a Singapore fund.

But did you know that there are nearly 100 companies on the

Singapore Stock Exchange valued at $1 billion or more? Th at Singtel

alone has a value of over $55 billion? Now the Prudential fund does

not seem so big after all.

In fact, fund managers look long-term and close their funds to

further subscription if they feel their fund is too large. After all,

they will not want a fund so large that they cannot manage it well

enough to bring in good results.

Should Small Funds be Avoided? Suppose for the last three years, a fund averaged $10 million in size

and its expense ratio is 2 per cent. Th at means $200,000 is available

to pay for the fund manager’s salary, the salary of research staff ,

electricity, PCs and other operating expenses. Do you think that is

enough?

Experience points to funds getting closed when their size is too small.

Funds have to be a certain size to be feasible for the fund manager.

For the investor, it makes sense too for the fund to be big enough

because small funds are expensive to run. Mercer conducted a

study on CPFIS funds in 2001. What the study found is that smaller

funds are a lot more expensive to run than bigger funds:

TABLE 6.1. BIG FUNDS HAVE SMALLER EXPENSE RATIOS

Fund Size <$5m $5–10m $10–50m >$50

Expense Ratio 3.1% 2.4 2.2 1.8

Source: Expense Ratios: Analysis of Trends, Oct 2001, Mercer Article No. 5 – Oct 2001


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73

TABLE 6.2. CPF’S EXPENSE RATIO THRESHOLD

Equity Risk Type of Unit Trust Max. Expense Ratio

Higher risk Equity funds 1.95%

Medium to high risk Balanced funds 1.75%

Low to medium risk Bond funds 1.15%

Lower risk Money market funds 0.65%

Source: www.cpf.gov.sg

Should Funds with Large Expense Ratios be Avoided?It depends. Just as a Lamborghini takes more fuel to run than a 150cc

Vespa scooter, some funds are inherently cheaper to run, such as

index funds whose expense ratios are as low as 0.3 per cent annually.

Th en there are specialised funds that focus on particular sectors

such as technology and healthcare; these funds tend to be more

expensive to run because they require heavy resources for research

and analysis. It follows then that given two funds of the same type,

it makes sense to avoid, or to think thrice, about funds with larger

expense ratios.

Th e CPF Board is so concerned about expense ratios eroding

investment returns that at the end of 2006, it announced that unit

trusts and Investment-Linked Policies (ILPs) cannot accept CPF

monies if their expense ratios exceed certain benchmarks. From 1

January 2008, expense ratios cannot be higher than those shown

in Table 6.2.:

If you have already invested in funds that exceed these benchmarks,

the CPF Board will not require you to sell or switch your investments

although it will likely off er you opportunities to switch from these

funds for free within a certain time frame.

In the end, remember that expenses is just one of the factors

(although a big factor!) that aff ect your returns. It is usually

worthwhile to pay more for a fund that gives you superior

performance even if they are expensive to own. So if you come


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74across a fund that has a high expense ratio, don’t write it off just

yet. Ask yourself or the salesperson why it has higher charges, and

accept nothing less than a good and convincing reason. It may be

a specialised fund or it has a superior performance record. Other

than a really good reason, drop funds that have high expense

ratios.

Should You Invest in New Funds? Th e easy answer to this perennial question is, “I won’t invest in a fund

that has not been around for at least three years.” Some investors

would like to see how funds have performed relative to their peers

as well as in good and bad markets.

Still, there are those adventurous souls amongst us who would

consider taking the plunge each time a new fund or stock is available.

If you are one of these risk-loving investors, ask yourself the following

questions and be comfortable with your answers:

• Is your portfolio already diversifi ed? Do you now want to add

risk? If yes, go ahead and take some risk. If not, then you are

taking a big risk with your money. Remember, your fi rst duty

is to have a portfolio protected by diversifi cation. Th en you

can set aside some money or a portion of your portfolio to

include riskier, even speculative, investments.

• Does the fund manager already have a track record elsewhere?

If he is a newly minted MBA or just old enough to shave, do not

touch the fund.

• Are you going to set aside the time and eff ort to monitor these

new fund investments? Our advice to you is that while it might

be worthwhile buying a new fund that is run by an established

fund manager, you are advised to monitor its performance more

regularly than you might an aged fund.


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75MONITORING FUND PERFORMANCEOne of the great things about owning a unit trust is that you are paying

someone (about $200 per year for a $10,000 investment) who is very

qualifi ed and smart to worry about how your money is invested. But

you still need to check periodically on how the funds you own are

doing. You do not want to fi nd out 10 years from now when you need

the money that the fund you bought has turned into a pumpkin.

How Often Should You Check?Every six months is usually a good bet. If you really want to get into

your investments, you might do it monthly, but those who review

their investments too often might overreact to short-term market

movements.

Th e fact is that every fund, even the best ones, will underperform

its peers periodically. For example, if you are checking a fund every

month and you see that it is underperforming for the last four

months, you might pull the trigger and sell the fund. But as so often

happens with good funds, the underperformer comes back alive

and produces quarter after quarter of dazzling results.

So, review your funds every six months, and do not leave your

funds alone for more than one year. Reviewing fund performance

only takes a few minutes when you use a website like www.

fundsingapore.com.

Th e second thing to do when you monitor your portfolio is to

rebalance it, if necessary. Suppose you started off with a 90-10

equity-bond portfolio. During the next six months, the portfolio

shifts to 70-30 equity-bonds because equity prices have fallen and

bond prices have risen. To rebalance it back to 90-10, you would

simply sell off part of the bond portion and use the proceeds for the

equity portion to return the portfolio back to a 90-10 allocation.

WHY REBALANCING MAKES SENSERebalancing forces us to put into practice the “Buy Low, Sell High”

principle. For example:


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76• Th e equity portion had fallen sharply and we rebalanced by

buying low.

• Th e bond portion had risen sharply and we rebalanced by

selling high.

Rebalancing also forces us to add bonds when interest rates rise

(bond prices fall) and sell equities when the stock market goes up.

Th ese are very wise things to do.

Does Rebalancing Work Over the Long-Term? In the iFAST study we examined in Chapter 5, the 100 per cent equity

portfolio produced a 9 per cent annualised return over 32 years.

Well, this portfolio was actually rebalanced every year. Whenever

equities fell relative to fi xed income, equities were bought and fi xed

income was sold. If the strategy had been buy and hold, the return

produced would only have come to 7.3 per cent.

How Often Should You Rebalance? You may want to set some rules. For example:

• Rebalance right away when any of the major regional stock

indices such as the S&P 500 or Nikkei 225 has moved up or

down by more than 20 per cent.

• Rebalance right away when interest rates have moved up or

down quickly by more than 2 per cent.

Rebalancing: Points to ConsiderWhile the mechanics of rebalancing are straightforward, sometimes

the cost or inconvenience of rebalancing may outweigh the

benefi ts.


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77Transaction Costs

Th is is the most obvious drawback. How much does it cost to switch

funds? Th e transaction costs can be high enough to stop you.

Fortunately, switches between funds of the same family are

usually cost-free. Better yet, you may want to try something called

a wrap account. When you have a wrap account off ered by some

fi nancial advisers, you can rebalance for free among funds from

several fund managers.

Time and Effort

If you have a large number of funds and the amount to rebalance is a

mere few hundred dollars, it may not be worth the trouble. Perhaps

you should wait another six months. In any case, you cannot reach

that conclusion without going through exactly where your portfolio

stands today. Even if you do not want to rebalance, you should review

your portfolio every six months.

Change in Risk Profile

As your time horizon nears, your risk profile will change. When

you are 10 years away from your objective, your risk profile is

likely to be more aggressive. This may call for an 80-20 equity-

fixed portfolio.

As you get closer and closer to your objective, your profi le will

become more conservative and your portfolio will take on more

and more fi xed income and fewer and fewer equities. Bear in mind

that the risk profi le you started off with is not going to be the same

profi le you end up with eventually. Ask yourself each time when you

rebalance — has my risk profi le changed? After every few years, the

answer should be “yes”.

One criticism of rebalancing is that when a fund does well, you

will be removing those positions that can go up even higher.


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78

Can You Count on Past Performance?If you had picked any one of the top-performing Lipper Leaders fi ve

years back, you will have come out a winner. But we are investing for

future results, not past. Th e question we need to answer is, “Is past

performance indicative of future results?”

If your answer is “yes”, then you believe that any of these three

dream performers should be winners again in the future. You

believe that relying on fund rankings (when you want to buy a

fund or to check if you should sell a fund because it is not ranked

favourably anymore) is a good strategy.

If your answer is “no”, then you are saying that these top

performers will probably not be able to hold their position in the

future. Many experts believe this to be true. Th ey say that past

performance is pretty much worthless when it comes to fi guring

out the future.

Unlike reports that measure the reliability of cars, investment

performance is very diffi cult to predict. Economies go up and

FIGURE 6.4. DON’T FORGET TO REDO YOUR RISK PROFILE


> Aggressive80% Equity20% Fixed Income

10 years 5 years 3 years

Balanced60% Equity40% Fixed Income

>Conservative20% Equity80% Fixed Income


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79down, funds change, managers and sectors such as technology can

blow hot, then cold.

In fact, underperforming after being a hot fund is common.

Nobel Prize Laureate in Economics, William Sharpe, in an article

on past performance, for example, discussed Barkdale and Green’s

fi ndings: funds that fi nished in the top 20 per cent over the past fi ve

years were the least likely to fi nish in the top 50 per cent over the

next fi ve years:

TABLE 6.3. TOP PERFORMERS MAY NOT STAY ON TOP FOR VERY LONG

Performance Over 5 Years Top 50% Finishers Over Next 5 Years

Top 20% Performers 44.8%

Second 20% 47.7%

Th ird 20% 51.5%

Fourth 20% 52.3%

Fifth 20% 0.99%

Source: www.efmoody.com/investments/pastperformance.html

We believe that while the past is not indicative of the future,

it still does a decent job, but we have to be careful. To make our

choices more bullet-proof, we rely on the following rules of thumb:

• Buy funds with good track records with as long a history as

possible. If fund A is the top performer over the last three years

and fund B is a steady performer over the last 10 years, we

would choose B.

• Buy funds with lower expense ratios, all else being equal. If fund

A’s expense ratio is 2.5 per cent and fund B’s is 1 per cent,

fund A will cost 1.5 per cent more to run per year. If you hold

the fund for 10 years, you lose out on 15 per cent of returns.


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80• When it comes to investing, it is important to examine current

trends, rather than past ones. For example, technology is part

of a long-term trend even though it fl uctuates during shorter-

term cycles. China is a long-term growth opportunity even if it

might overheat and have high infl ation.

• Most of all, diversify your assets across the diff erent asset

classes, across the globe, and across diff erent fund managers,

and stick to a strategy that keeps your retirement goal in

perspective.

IS THERE A RIGHT TIME TO SELL?Newspapers and fund distributors have little trouble telling you what

funds to buy and when, but fi nding advice on when to sell a fund can

be much harder to come by.

More often than not, investors tend to sell their funds for the

wrong reasons. So, is there really a right time to sell? It is generally

accepted that the best time to sell is when you have reached your

profi t goal. But as we will see, there are also situations where the

fund ought to be sold, even when it is not profi table.

You Need the MoneySometimes there will be emergencies in your life when you need

money and you have little choice but to sell your investments. Despite

the urgency, you should still weigh your choices. Can you get a loan

that charges you a rate of interest lower than the rate of return you

are getting on your investments? If you can, it might be best to hold

off selling your investments.

Your Objective is Met If you set out a clear target of accumulating $100,000 in 10 years

for your daughter’s education, then when your $100,000 target is

attained, sell your investments.

Sure, your investments could skyrocket after you sell, but can you


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81stomach the alternative? Suppose you hung on and the market falls

sharply and you end up with insuffi cient money for your objective.

Th e best thing to do when you reach your objective is to sell.

Your Fund is UnderperformingIf your fund is not doing well, fi nd out why. One of the worst reasons

for selling a fund is when its category is going through a tough time.

If equity funds have gained 8 per cent this year and fi xed income

funds have lost 6 per cent, you might think fi xed income funds do

not belong in your portfolio. Th is is the best way to shoot yourself

in the foot.

But as you know from Chapters 1 and 2, allocating your money

appropriately in equity funds and fi xed income funds is far

more important to investment success than chasing after the

hottest funds.

Here is a good rule to follow when a fund is underperforming

its peers: “Never sell a fund unless it has underperformed its

peer group for two years in a row.” A good fund underperforming

its peer group in any one year is a common thing. But when a

good fund underperforms for two years in a row, something is

probably wrong.

Drastic Change in Fund SizeFund size can change dramatically during bull and bear markets.

Sometimes funds that get big very quickly can be a problem. Here

is an example. Suppose fund manager Tommy is great at picking a

portfolio of 20 company stocks. His success brings a lot of attention,

resulting in a large infl ux of investor money.

Th e problem is that with so much more money, he may end

up owning a majority of several stocks, which leads to liquidity

problems, because as a major shareholder of the stock, his moves

are going to be closely watched by the market. To get around this

problem, he has to hold more stocks. His job is much tougher now

because he is forced to fi nd 40 or 50 good stocks.


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82On the other hand, it is also diffi cult for a small fund to survive.

Th is is because the fund managers will have a tough time meeting

expenses and investors will be paying high expense ratios.

The Fund Manager LeavesA good unit trust is often backed by a solid fund manager. If the

fund you hold is run by a star manager and the manager leaves,

think about selling the fund if the replacement is not known to be

a performer.

Selling a fund right away because of the fund manager’s departure

is generally a mistake. Th e fund management company surely

wouldn’t replace its star performer with a slouch or loser.

Th is does not mean you should blindly ignore a change in manager.

Watch your fund more closely after the change. If its performance

lags far behind for a few quarters, you may want to sell all or part

of the fund more quickly than you would in normal conditions. (We

should mention that in Asia, fund management companies tend to

adopt a team approach to investing rather than rely on individuals.

Th is makes monitoring manager turnover less meaningful.)

Conversely, a manager’s departure can be a good thing as well. If the

fund has been underperforming its peers, a change in fund manager

may encourage an investor to hold onto the fund more tightly.

YOU NEED TO REBALANCE YOUR PORTFOLIO If you have an asset allocation you want to stick to, you may need to

rebalance your holdings by selling and buying securities in order to

return your portfolio back to its desired allocation.

Th ere is another time when you may want to rebalance, and that

is when your risk profi le changes. If your retirement is fi ve years

away and your risk profi le has turned conservative, your current

portfolio may no longer be appropriate.

If you are thinking about selling a fund and the primary reason

for selling it is not on the list above, you may want to reconsider.

Selling a unit trust is not something you do without a great deal


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83of consideration. Remember that you originally invested in the

fund because you were confi dent of it — make sure you are clear on

your reasons for letting it go. But if you have carefully considered

the pros and cons and you still decide to sell it, do it and do not

look back.


Investing in Individual Stocks

When you buy a unit trust, you are entrusting someone else to make

decisions for you and you lose control over what to buy and sell,

and when. Investing in individual stocks requires time and money to

manage them eff ectively.

Th e good news is that by combining both methods of investing

— unit trusts and individual stocks —you can take advantage of the

opportunities that both ownership methods off er.

And fortunately, buying and selling stock is a relatively simple

task, as seen by the millions of stocks that are traded among

investors every day. You begin the process by opening a trading

account with one of the 20 or so brokerage companies in Singapore,

and you can begin submitting orders to buy or sell.

But before you do, let us fi rst beef up on more details.

INVESTING IN INDIVIDUAL STOCKS AND BONDSAssuming you already have a diversifi ed unit trust portfolio that

you plan to hold for retirement or some other objective, then you

could allocate up to 20 per cent of your total invested money in

individual stocks.

For example, if you have $50,000 in total to invest, you can

allocate up to $10,000 or 20 per cent in individual stocks.1 We

feel 20 per cent is a safe guideline. If these investments suff er a

major setback, such as a 30 per cent drop, the eff ect on the overall

portfolio is just minus six per cent (-30% x 20%).

Th is guideline is, of course, not etched in stone. For example,

you could build a globally diversifi ed portfolio consisting of

individual stocks, bonds and other supplementary investments for

your retirement.

1We recommend that up to 20 per cent of your total invested money be invested in

individual stocks, bonds, more speculative and other supplementary investments

that need not form part of your long-term retirement portfolio.

07


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TABLE 7.1. MAJOR DIFFERENCES BETWEEN COMMON AND PREFERRED STOCK

Common Stock Preferred Stock

Voting Rights Always Seldom

DividendsNot fi xed or promised

Fixed. Can be suspended if company has net loss.

Maturity PerpetualNormally perpetual. Sometimes the company can terminate the issue or investors can convert to common stock.

Price Movement

More volatile

Less volatile

Source: Authors’ own compilation

COMMON VERSUS PREFERENCE STOCKMost stocks sold in Singapore are common stock. If you buy a

common stock, there is no guarantee that you will make money. You

bear the risk that the stock price might go down or that it would not

pay any dividends. It is possible that you could lose a big chunk of

your initial investment.

For the risk that you take, you stand to make money if the company

does well. In fact, over time, stocks have always outperformed bonds,

often by a comfortable margin.

Owners of preference stock are also shareholders. Unlike common

shareholders, preference shareholders benefi t from a fi xed dividend

that does not increase even if the company has a boom year.

Of the 500 companies on SGX Mainboard and Catalist, there are

just about fi ve preferred stock issues traded. For this reason, our

focus will be on common stock.

Types of Common StockCommon stock returns come in the form of dividends and capital

appreciation — an increase in the share price. But not all stocks are

the same. Some pay dividends, some do not. Some have stable prices

while others have volatile prices.


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86One way to diff erentiate stocks is to observe how closely a

company’s prospects is tied to the economy:

FIGURE 7.1. A TYPICAL BUSINESS CYCLE

As the business cycle (see Figure 7.1.) moves from bottom to peak

during an expansion, diff erent industries benefi t diff erently from the

economic changes that accompany the cycle.

Cyclical Stocks

Cyclical stocks are the most sensitive to business cycles. Th ey do best

during expansions, but do badly during recessions. Airline stocks

are typically cyclical. People postpone travel when the economy is

slow, but when the economy grows, travellers can suddenly appear

in droves at the travel agent’s offi ce.

Defensive Stocks

Defensive stocks are the least sensitive to business cycles. Food and

utility stocks are defensive because people will still eat and turn on

the electricity during market downturns. On the fl ip side, defensive

stocks underperform during expansions — people would not

suddenly eat a lot more or keep the lights on all night.

Peak

RecessionExpansion

Bottom



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87Growth Stocks

Growth stocks perform better than the industry average, and growth

may occur regardless of the business cycle. A growth stock usually

pays little or no dividends, but puts profi ts back into the company to

fi nance new growth. Investors buy growth stocks for their potential

price appreciation and not for dividends. While the prices of growth

stocks usually rise in value more than those of other types of stocks,

they also decline in price more signifi cantly.

Value Stocks

Value stocks are stocks that are underpriced by the market for

reasons that have nothing to do with the business itself. Value stocks

are good investment opportunities that may have been oversold or

may be temporarily out of favour.

Blue-Chip Stocks

Blue-chip stocks are solid performers that generate some dividend

income, decent growth and, most of all, safety and reliability. Consider

blue-chips if you want to invest in a stock for the long-term and you

do not have much tolerance for risk.

Speculative Stocks

Speculative stocks are typically unproven young companies. Prepare

for a rollercoaster ride if you invest in a speculative stock. Th ey may

be erratic, but can be winners in the making when there are, for

example, promises of technological breakthroughs.

Interest Rate Sensitive Stocks

Interest rate sensitive stocks are greatly aff ected when interest

rates change. Utility companies have huge fi xed costs in plant and

equipment, and they typically pay a lot of bond interest. When

interest rates rise, the cost of servicing its loans rises and this has a

downward eff ect on its stock price.


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88Income Stocks

Income stocks pay a higher-than-average dividend. Companies whose

stocks fall into this category are typically in stable and mature industries

such as utilities and tobacco. While income stocks may not have the

growth potential of growth stocks when prices are rising, their prices

tend to hold up more when growth stock prices are tumbling.

International Stocks

International stocks are stocks of foreign companies. Many of the

world’s largest companies have their headquarters overseas. While

buying shares of foreign companies can pose a challenge for some

investors (we will discuss some of these challenges in the next

chapter), many large companies are listed on the Singapore Stock

Exchange. In any case, the easiest way to own international stocks is

to buy international unit trusts.

SELLING NEW STOCK THROUGH AN IPOIt is the dream of every entrepreneur to take the company he started

from private to public ownership. Th e road to an Initial Public

Off ering (IPO) often begins with an entrepreneur who comes up

with an idea for a product or a service and raises money from his

own family and friends to start up a business.

If the business grows, the entrepreneur often seeks a second

level of funding called venture capital that is provided by wealthy

investors and investment companies. Venture capitalists expand the

private ownership of the business by sharing the risks of the new

business in exchange for the privilege of helping to run the business

and sharing in its profi ts.

The Primary Market — Buying an IPOGoing public means that the business sells new stock that previously

did not exist. Th is is done in the primary market, which is the fi rst

part of a fi nancial market and is part of the process of getting listed

on a stock exchange.


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89Th e management of the IPO goes to an investment banker who

agrees to underwrite the stock issue, that is, to buy all the public

shares at a set price and to resell them to the public at a higher

price for a profi t. Th ese underwriters advise the company on the

valuation of the company, the number of shares that should be

issued and the price per share.

IPO shares are sold during a subscription period, which typically

lasts up to a few weeks. Some IPOs are so hot that they can be

completely sold out in just a few days, and become oversubscribed.

The Secondary Market — SGXAt the end of the IPO subscription period, the shares trade in the

secondary market such as the Singapore Exchange (SGX), the only

formal exchange for stocks in Singapore. Once shares start to trade

in the secondary market, the share price can rise and fall, depending

on investor expectations. At this time, the original issuers receive no

additional cash from these secondary market transactions.

READING THE STOCK PAGETh is is an adaptation of a quotation from a mainboard-listed company,

which we shall call Stock X.

52-wk

high

52-wk

lowCompany

Last

sale

Vol

‘000

Day

High

Day

Low

Net

P/E

M Cap

$Mil

222 188 * Stock X 210 789 213 210 18.6 6071


Th e highest and lowest prices for the past 52 rolling weeks

are reported daily. Th e range between the high and low is an

indication of the stock’s volatility or price movement. Th e more

volatile the stock, the more you can profi t or lose in a relatively

short time. For example, the price ranged between $1.88 and

$2.22, or about 18.1 per cent.


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90

Th e stock was issued with a par value of 10 cents. Th e * on

the left of the company name indicates that it is one of the

index stocks that make up the STI. Th e last sale or closing

price was $2.10. Volume of 789,000 refers to the number of

shares traded the previous day.

“High” and “low” reports the highest and lowest prices

for the previous day. Th e daily diff erence is usually small

compared with the 52-week spread.

Th e price-earnings ratio (PER) shows the relationship

between the stock’s price and the company’s earnings for the

previous year. It is obtained by dividing the current price per

share by the earnings per share. Stock X’s P/E of 18.6 means

that its current price of $2.10 (last sale) is 18.6 times the

previous year’s earnings per share. Th is implies that earnings

per share is 11.29 cents (barring any rounding error):

P/E = 18.6

2.10 / E = 18.6

E = 2.10 / 18.6

= 11.29 cents

If you were to buy up all the outstanding shares of the

company, you would have to fork out $6.071 billion — its

market capitalisation. It is calculated as the number of

outstanding shares multiplied by the current share price.

BUYING AND SELLING SHARES IN THE SECONDARY MARKETOpening an AccountTh ere are a few ways to trade shares in the secondary market. If

you know exactly what you want and are more a “do-it-yourself ”

investor, you can trade shares through an online brokerage such

as Phillip Securities (www.poems.com.sg). Commissions for online


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91

trades are usually lower than for offl ine trades done through dealers

and remisiers who are representative of the brokerage. Trades

commonly cost a minimum of $25 for online and $40 for offl ine,

and the cost increases based on various contract value sizes.

In order to trade shares, you fi rst have to open an account at the

Central Depository Pte. Ltd. (CDP), which handles the clearing

of trades. Once you have your CDP account, you can approach

a member stockbroking company to open a sub-account and

begin trading.

Opening a Cash or Margin AccountYour broker will need to know if you want a cash account, margin

account or both. Cash accounts require you to pay in full after a

purchase is made. A margin account allows you to borrow money

from the brokerage company to buy more securities. Th is is called

leverage and is not for everyone because you can double or triple

your profi ts as well as losses.

HOW THE CDP WORKS

Imagine that you paid $20,000 through your broker for 1,000

shares of BigCo. One week later, the price of BigCo has doubled

and your shares are now worth $40,000. Elated by your windfall,

you call your broker and ask him to sell your shares. But your

broker tells you that the individual who sold you the BigCo

shares failed to deliver the shares to your broker.

Now if your BigCo shares were traded through a regulated

exchange like SGX, the integrity of your share purchase is

guaranteed by CDP. CDP provides the clearing and depository

function for the Singapore share market — it guarantees and

clears all securities traded on SGX. Brokerage fi rms act as

intermediaries between you, the investor, and the CDP.


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92Brokerages in Singapore typically off er a margin equal to 3.5 times

your cash amount deposited. Hence, a deposit of $10,000 cash

translates into a margin account of $35,000 to buy up to $35,000

worth of securities.

Establishing a Long or Short PositionWhen you buy a share, you are said to have a long position. Your

decision to buy means that you hope to profi t from an increase in

price in the future.

If you had no existing long position and you expect the market

to decline, you may wish to take a short position to profi t from

the expected decline. When you “short” a security, you are in fact

hoping and praying that the price of the security will go down so

that you can buy it back and replace the security at a lower price.

To you, bad news is good news.

How can you sell something you do not own? You can today with

the SGX Securities Borrowing and Lending (SBL) Programme

launched in January 2002.

To see how this works, suppose you short 1,000 ABC shares at

$10 a share.

If the short sale was for $10 a share and you buy the stock a

month later at $7 a share, you make a profi t of $3,000 ([$10-$7] x

1,000 shares). If, instead, ABC is bought back at a higher price of

$12 ($2 higher than the short-sale price), you will have a loss of

$2,000 ([$10-$12] x 1,000 shares).

Short selling is a very aggressive strategy since your upside

potential is fi xed (the price of the stock cannot go below zero), and

your downside potential is unlimited (the stock can go up and up).

Issuing Buy and Sell OrdersWhen you decide to buy a share, how exactly do you tell your broker

to establish a position? If you are not careful, you may end up paying

more than you expected. It is really important to understand how

orders are given and executed.


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93Th ere are three common types of orders:

1. Market orders

2. Limit orders

3. Stop orders

Market Orders

When you phone your broker and say, “Buy 1,000 shares of XYZ,” you

are placing a market order. A market order does not specify a price.

Some investors feel that market orders are risky because if the

market runs up suddenly, they may end up paying much more.

But market orders make sense for other investors. If they think a

stock is really hot and they do not want to miss getting the stock, a

market order at whatever the current price does the job.

Limit Orders

A limit order, on the other hand, specifi es the exact price at which

you want an order executed. For example, “Buy 1,000 shares of XYZ

at $10.00.” Th ere may be other buy orders in front of yours at more

than $10.00. Th ese investors will be serviced ahead of yours because

they are all willing to pay more than you are.

You can see that a limit order may never be executed so long as

there are orders ahead of yours in terms of price.

Stop Orders

If you want your order to go through no matter what, you can place a

stop order. A stop order guarantees that your order is fi lled by stating

the price at which a market order takes eff ect. A buy stop order is

placed above the current market price, while a sell stop order is

placed below the current market price.

For example, say you absolutely must own XYZ and it is currently

trading at $1.00. You can place a stop order to buy XYZ at $1.20. Th e


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94order becomes a market order to buy as soon as the market price

reaches $1.20. Th e order may not be fi lled exactly at $1.20 because

the closest price at which the stock trades may be $1.25. Th e exact

price specifi ed in the stop order is therefore not guaranteed.

A sell stop can be used to protect a profi t. Now suppose XYZ

has risen to $2.00. You want protection against a price decline, and

at the same time, you want to hang on to the share for extra gains.

To lock in most of the profi t, a sell stop order could be placed at

$1.80. When market price falls to $1.80 or below, a market order

to sell is triggered.



Individual Stock Investments

Th ere really is no secret to picking good stocks. Th e winning

techniques have been tested over and over. Th ey may not work all

the time, but they work often enough.

Because good stocks tend to stay good, take your time to fi nd the

right information. Do your homework, learn about the industries

your favourite stocks are in and do not rush into any purchase even

when the stock price is running away from you.

FUNDAMENTAL ANALYSISSo how do the pros sort out the good stocks from the bad? By looking

at a business at its most fundamental and fi nancial level. Th is type of

analysis examines key fi nancial ratios of a company, giving us an idea

of the company’s fi nancial health and the value of its stock.

Even if you do not plan to do thorough fundamental analyses

yourself, it will help you follow stocks more closely if you

understand these key terms and ratios.

IT IS ALL ABOUT EARNINGSTh e bottom line is what investors want to know. How much money is

the company making and how much is it going to make in the future?

Earnings are profi ts and that is what buying a company is about.

Increasing earnings generally lead to a higher stock price and,

in some cases, a regular dividend. And when earnings drop, the

market may knock the stock price down.

Suppose company A and company B are in the same industry.

Both companies made sales of $1,000 but company B earned more

as it incurred lower expenses. Which company would you buy?

08


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96 TABLE 8.1. EARNINGS OF COMPANIES A AND B

Company A Company B

Sales 1,000 1,000

- Expenses -700 -600

Earnings 300 400


Company B for sure. Yet while earnings are important, by

themselves they do not tell you anything about the value of the

company’s stock.

Earnings Per Share (EPS)One of the challenges of evaluating stocks is making sure we make

apple-to-apple comparisons. Comparing the earnings of one company

with another really does not make any sense, if you think about it.

Suppose Adam’s family earned $300 and Adam is the only child, while

Betty’s family earned $400 and she’s got nine other siblings. Which

family has more earnings to go around?

Using raw numbers ignores the fact that two companies have a

diff erent number of outstanding shares. Let us look at earnings per

share (EPS). We calculate EPS by dividing earnings by the number

of outstanding shares:

EPS = Earnings / Outstanding shares

TABLE 8.2. EPS OF COMPANIES A AND B

Company A Company B

Earnings 300 400

Number of Shares 10 100

EPS $30 $4



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97Now suppose company A has 10 shares outstanding, while

company B has 100 shares outstanding. Which company’s stock do

you want to own?

Should you buy Company A because its EPS of $30 is higher? We

are not quite there yet to answer that question, but we are close. We

still do not know how much we would pay for the stock of company

A and B. Before we move on, you should note that there are two

main types of EPS numbers:

1. Trailing EPS — last year’s actual numbers.

2. Forecast EPS — based on future numbers, which are projections.

Price-Earning Ratio (PER)If there is one number that people look at than more any other, it is

the Price-Earning Ratio (PER). It looks at the relationship between

the stock price and the company’s earnings. Th e PER is the most

popular tool for analysing a stock, although it should not be the only

one to consider.

You calculate PER by taking share price and dividing it by the

company’s EPS.

PER = Stock price / EPS

For example, if company A has a stock price of $300 and company

B’s price is $80, their PER are 10 times and 20 times respectively:

TABLE 8.3. PER OF COMPANIES A AND B

Company A Company B

EPS $30 $4

Stock Price $300 $80

PER 10 times 20 times



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98What does PER tell us? Th e PER gives us an idea of what

the market is willing to pay for the company’s earnings. Th e

higher the PER, the more the market is willing to pay for the

company’s earnings.

A high PER can be read as an overpriced stock. While this may

be true, a high PER stock can also indicate that the market has high

hopes for the future prospects of this stock and has bid up the price.

Such a stock is called a growth stock. Th eir PERs can be quite high

and they can still be considered “cheap” by the market.

On the other hand, a low PER stock may indicate the market’s

lack of confi dence in the stock. Its future prospects are dim and the

market is depressing its stock price relative to its earnings. Or it

could be a value stock — an underpriced stock that the market has

overlooked. Investors can make fortunes by spotting these sleepers

before the rest of the market discovers their true worth.

Still, a company’s PER does not provide much of any buy and sell

clues until it is compared with:

• PER values of the same company over the past few years

If the PER of company A is currently 10 and its PER average over

the last 10 years is 15, we can say that the stock is cheap

compared with its past.

• PER values of other companies in the same business

If company A has a PER of 10 and is in the chemicals industry

that as a whole has a PER of 5, we can say that the stock is

expensive compared with its peers.

• PER values of stock indices representing the market as a whole

If company A has a PER of 10 and the STI stock index has a PER

of 20, we can say that the stock is cheap compared with the

entire market.


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99Using the PER to Value Stocks

Th e PERs we see on the stock pages in newspapers are trailing PERs.

It uses the current stock price divided by a historical earnings fi gure

from the company’s latest annual report.

A forecast PER on the other hand uses the current stock price

divided by the stock’s forecast EPS. Forecast earnings are found in

company research reports generated by analysts. You should use

these individual forecast PERs with care because they are based

on the earnings estimates made by a few individuals from one

brokerage house.

What is generally more reliable are earning forecasts taken by

averaging the estimates of several dozen analysts who follow the

stock. One example is Zacks consensus estimates (called Zacks

Rank) for the U.S. market. Are these consensus estimates reliable?

Th e best stocks picked by Zacks Rank have outperformed the S&P

500 for 15 out of the last 16 years.1

Forecasting Stock Price with PERs

PER is very commonly used by investors to forecast the future price

level of stocks and the market.

Forecast price = Trailing PER X Forecast EPS

EXAMPLE:

Stock A is trading at $15 and its trailing EPS is $1 based on its

latest annual report. Given a trailing PER of 15 ($15/$1), what is

the forecast price of stock A if its forecast EPS is $1.20? Note that

stock A has an historical PER of between 15 and 20 times in the

last 10 years.

Forecast price = 15/1 X $1.20

= $18

1www.zacks.com


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100Since the current price of stock A is $15, and assuming the

forecast proves accurate, one can expect stock A to increase in

price by $3. It is thus a good buy because this stock at $15 today

is an undervalued stock.

In order to make such a conclusion, one has to have certain

beliefs:

• Th at the stock’s eventual PER will reach a level of 15, which

is at the low end of the range for the last 10 years.

• Th at the forecast EPS of $1.20 is generally reliable.

• Th at forecast prices are estimated from assumptions about

company growth, the economy and other factors, and that

these assumptions can be proven wrong in the end. In other

words, we are taking calculated risks when we rely on

forecast numbers.

In the end, investors buy a stock not for what it can do for them

today, but for what they hope it will do for them tomorrow. If it does

not live up to expectations, they will probably bail out of the stock.

Th ere are countless other fi nancial terms and ratios you can learn

and use. We have highlighted the most popular — the PER.

TRACKING THE MARKET THROUGH INDICESWe track the market because it has an overall eff ect on the

performance of individual stocks. Th is is an established fact. Th e

Straits Times Index (STI) is the most widely quoted index for the

Singapore market. It consists of a basket of 30 stocks and measures

the average price level of the market.

Th e STI is plotted for the period between June 1995 and July

2010. If you had invested your money in the Singapore stock market

sometime during this period, you would either be very happy or very

upset, depending on which period of time you were in the market.


101

Look at the self-explanatory volatility shown in Table 8.4 (STI

levels are rounded to the nearest 50):

TABLE 8.4. THE STI’S BIG JUMPS AND FALLS

Period STI Start STI End No. of months % change

Feb 96–Aug 98 2450 800 30 months -67%

Aug 98–Dec 99 800 2500 16 months 213%

Dec 99–Sep 01 2500 1250 21 months -50%

Sep 01–Mar 02 1250 1800 6 months 44%

Mar 02–Apr 03 1800 1200 13 months -33%

Apr 03–Oct 07 1200 3850 54 months 221%

Oct 07–Feb 09 3850 1600 16 months -58%


FIGURE 8.1. STI PERFORMANCE BETWEEN JULY 1995 AND JULY 2010

(Source: www.sgx.com)

4000

3500

3000

2500

2000

1500

1000

500

0

Jul-

95

Jul-

96

Jul-

97

Jul-

98

Jul-

99

Jul-

00

Jul-

01

Jul-

02

Jul-

03

Jul-

04

Jul-

05

Jul-

06

Jul-

07

Jul-

08

Jul-

09

Jul-

10

Th at is why the experts harp so much on diversifi cation. By

putting your money into several baskets, you reduce both risk

and anxiety.


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102Components of the STIWhat makes the STI go up and down? Th e answer is this: When

its component stocks go up and down. Singtel, Wilmar, DBS, UOB,

Jardine Matheson Holdings and OCBC typically occupy the top six

positions in terms of weight.

Th e top six weighted companies constitute about 50 per cent of

the index. If these top six stocks collectively rise 10 per cent, the

impact on the STI is 5 per cent (50% X 10%). A higher weight

therefore means a greater infl uence on the index.

Using the STI as a YardstickStock indices provide a good yardstick against which investors can

compare their portfolios. If you own a unit trust that is broadly

invested in Singapore stocks, you could compare its performance

with that of the STI.

FIGURE 8.2. BENCHMARKING A SINGAPORE EQUITY FUND AGAINST THE STI

Source: www.aberdeen-asia.com

141.3

80.7

175

150

125

100

75

50

25

0

-25

-501999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

5

1

0

5

0

5

0

5

0

5

1

5

0

5

0

5

0

5

Percentage Growth Total Return, Changes Applied (31/08/99 – 30/06/10)

Aberdeen Singapore Equity SGD (MF) Singapore Straits Time TR (IN)


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103Figure 8.2. is an excerpt from a factsheet of the Aberdeen

Singapore Equity Fund, a unit trust invested broadly in Singapore

stocks. Th e bottom line chart is the STI rebased to 100 for the period

September 1999 to July 2010. Th e top chart is the Singapore equity

fund also rebased to 100 for comparison. It shows the Aberdeen

fund outperforming the STI benchmark over this period.2

International InvestingInvestors looking for ways to diversify their portfolio have a world of

opportunity through international investing. Buying stocks from an

overseas market can earn you returns in three ways. For example, if

you buy Microsoft (a U.S. stock), you gain when:

• Th e stock rises in price.

• Th e stock pays dividends.

• Th e U.S. dollar rises against the Singapore dollar (when you sell

the stock, each U.S. dollar converts to more Singapore dollars).

But there are other risks as well. Besides the stock price falling,

dividends getting cut and the foreign currency falling in value, you

will have to contend with:

• Confusing accounting rules that may cause earnings to be

under- or overstated.

• Inadequate disclosure requirements.

• Language barriers or complicated trading rules, and others.

2We rebase in order to compare apples with apples. To rebase any data series, we

take each data point and divide it by fi rst data point minus 1. If the fi rst data point

of STI is 1200 and the second is 1500, the chart would plot 0 (1200/1200 -1) and 25

per cent (1500/1200 -1).


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How to Invest InternationallyTh ere are several ways for you to buy international stocks:

• Local brokerages with access to overseas markets — for example,

DBS Vickers provides access to Hong Kong and Th ailand stocks.

• Some foreign companies list their stocks directly on Singapore

exchanges such as Noble Group (Hong Kong) and Total Access

(Th ailand).

• Open an account directly through a foreign brokerage such as

Ameritrade and E*Trade.

• Unit trusts that invest in international markets.

Keeping Track of International MarketsTh ere are hundreds of indices that measure the broad market or

specifi c parts of it. Table 8.5 on the following page lists some of the

most important indices used around the world.

CURRENCY RISK AND REWARDS

Currency movements can accentuate your gains as well as

losses. If your U.S. investment was purchased at US$1,000

when the conversion rate was S$1.8 : US$1.0, a major currency

move when you sell the stock can bring very happy — or

unpleasant — results.

Suppose you sell the stock after one year for US$1,000, a

breakeven position in terms of price. If the US$ rises to S$1.9,

you will receive S$1,900 — a S$100 profi t. But if the US$ falls

to S$1.6, you will only receive S$1,600 — a S$200 loss.

Exchange rate risk is a major added risk you need to

consider when you invest overseas.


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105TABLE 8.5. IMPORTANT INDICES AROUND THE WORLD

Country or Region Index

SingaporeTh e Straits Times Index (STI) is the most widely quoted stock index in Singapore with 30 large-cap, highly liquid stocks.

U.S.

Th e Dow Jones Industrial Average (DJIA) consists of 30 blue-chip stocks such as General Motors, IBM and McDonald’s. Despite being the most widely quoted stock index in the U.S., unit trust fund managers seldom refer to it as their benchmark.

U.S.

Th e Standard & Poor’s 500 (S&P 500) consists of 500 large-cap companies quoted on the New York Stock Exchange (NYSE). Th ese companies make up 80 per cent of the NYSE’s total value. Most U.S. funds use the S&P 500 as their benchmark because it is a broader measure of the market.

EuropeTh e MSCI Europe consists of over 500 European stocks from 16 developed markets.

AsiaTh e MSCI Asia ex-Japan index consists of more than 500 stocks in 13 countries.

JapanTh e Nikkei 225 is based on the 225 common stocks traded on the Tokyo Stock Exchange.

WorldTh e MSCI World Index consists of more than 1,500 stocks in 23 countries globally.



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106PICKING A MARKETFund managers tend to analyse markets from a top-down perspective,

focusing on a region’s or a country’s economic environment fi rst and

then on individual companies. Among factors that make a country’s

stock attractive are the stability of the economy, exchange rate

movements and its interest rate environment. Th e best conditions

for an investor to fi nd in an overseas economy are that it is growing,

its currency is strengthening and its interest rates are low.

FIGURING OUT WHEN TO SELL A STOCKSelling a stock or bond often seems more diffi cult than buying one.

Th at is because every investor has sold a good investment too soon

or failed to get out of a bad one soon enough. Sounds familiar? Well,

it happens to the best of us, but you do not want to make a habit of

it. In the end, there really are not many clear-cut hard and fast rules.

Th at is why we begin watchfully with “Warning Signs”.

Warning SignsIf any of these warning signs appear, your stock is probably a good

sell candidate:

The Company is Embroiled in a Scandal

Th is is the most ominous of all warning signs. Do not wait around

expecting to see any silver lining or buying opportunity — sell

right away. Scandals are long-drawn aff airs. It may take many

months between the time the scandal is fi rst revealed, and when

investigations are complete and made known. Do not hang around

when the ship is sinking.

The Company is Not Doing Well

If your darling tech stock is showing negative or big drops in earnings

two years in a row and other tech stocks in the same industry are

registering record sales, something is probably very wrong with

your stock. You can be patient with a stock that does badly for one


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107year, but you should be impatient if it lags behind two years in a row

when the whole industry is doing fi ne.

You Made a Mistake

You bought a lemon from the start and you know it. You have a

strong sense of regret, but yet you are hanging on for a miracle. If

this happens to you, sell the stock right away.

You are Over-Exposed to One Stock in Your Portfolio

We know people who buy nothing but their company stock. Th ey say

it is plain loyalty and they are confi dent their company will prosper.

We say this is suicide. Remember to diversify. If any one stock grows

to occupy more than 20 per cent of your portfolio, you should start

thinking very carefully about how much risk you are taking on.

General Market ConditionsWhen economic indicators suggest that the economy is headed

towards a recession, then no matter how good your stock is, it is

probably going to decline as well. Here are some general guidelines for

predicting market declines, although, of course, the direction of the stock

market can never be reliably or consistently predicted. Th ese guidelines

are based on economic information that’s available in the newspaper.

Interest Rates are Rising to Historical Highs

When interest rates are high, companies face the prospect of high

borrowing costs and cut back on borrowing and business expansion.

Consumers cut back on spending as it gets too expensive to borrow.

Company stock prices fall as a result. Furthermore, bond returns

increase and become more attractive compared with stocks. High

interest rates are one of the worst enemies of any stock investor.

Stock Prices are Soaring and Economic Activity Does Not Seem to be

Picking Up

Strong economic activity justifi es strong stock market performance.


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108If economic activity is not robust, then it is diffi cult for any market

rally to sustain itself. For example, suppose the economy is coming out

of a recession and the stock market has raced ahead in anticipation

of increased economic activity. But you notice consistent poor news

— unemployment is high and is expected to increase, infl ation from

high commodity prices such as oil is pushing up the cost of doing

business, and consumers aren’t going out to spend money. Th is is

not good news for stocks.

SOME COMMON MISTAKES FOR NOT SELLINGIf you are still not convinced that the stock you own should be sold,

you probably own a good stock. Still, some of us may stubbornly

hang on even when there are obvious reasons for selling. Here are

some mistakes for not selling that you should avoid:

You are Emotionally Attached to the Company Maybe your grandparents worked there all their lives and left you

stock of the company. Th is and other sentimental reasons may be

valid reasons to hold and therefore not sell a stock. But you have to

accept that what you are doing makes little economic sense when the

stock is performing really badly.

You Hate to Take a Realised Loss Th is is classic. Your stock is trading at $7 and you bought it for $10.

You are making a 30 per cent paper loss. You have started to reject

fundamentals. Your good sense shifts to, “Let us wait until the price

rises back to the purchase price.”

MANAGING INDIVIDUAL STOCKS IN YOUR PORTFOLIOIndividual stocks are fl exible. If you plan to keep stocks for your

retirement portfolio, a selection of 5–10 blue-chip, high-quality

stocks across several industries should provide a good amount of

diversifi cation. Do not hold 20 or more stocks because it becomes

exceedingly diffi cult to follow your investments. Just so no stock has


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109a very heavy impact on the portfolio, each stock should constitute no

more than 20 per cent of the total stock portfolio.

You can also trade stocks speculatively. Just remember that you

should not have more than 20 per cent of your invested money in

individual stocks. Some investors are going to speculate and take

high risk anyway. Putting a cap on such investments is a sensible

way of taking high risk within a safe overall framework that should

not sabotage your retirement plans.


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110

Investing in Individual Bonds

Just about everyone knows that in the long run, stock returns do

better than bonds. Th en why would anyone invest in bonds? Bonds

have two main characteristics that stocks simply cannot match.

First, bonds return a known amount at the end of a stated period.

Unless the borrower goes bankrupt, a bond investor can almost be

certain that the capital originally invested will be returned. With

stocks, the loss of money is not only possible, but it can happen

quite frequently.

Secondly, bonds pay interest according to a fi xed schedule

(typically twice a year). Th is interest can provide valuable income

for retired individuals, or for those who want predictable cash fl ow.

Do you need bonds? You will need bonds if:

• You are a conservative investor and you cannot stomach the ups

and downs of the stock market.

• You have to set aside a fi xed sum of money, such as for your

child’s education, and you want the certainty of receiving known

and specifi c amounts in the future.

• You are retired and you want the certainty of income and your

capital protected from fl uctuation.

For example, suppose you invested in $100,000 worth of bonds

that pay eight per cent interest semi-annually and which mature in

10 years’ time. Th ese bonds would pay you $4,000 every six months

or $8,000 yearly, giving you money to live on or to invest elsewhere.

Finally at the end of 10 years, the principal sum of $100,000 is

returned to you.

As an investor, you are spoilt for choice because there are as many

types of bonds as there are ice-cream fl avours. Th ere are bonds that

09


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111pay regular interest, bonds that pay no interest, bonds that can

be called back by the issuer before maturity and even bonds that

convert to stock. Knowing what bonds to invest in and when to do

so can make a big diff erence to your bottom line.

BONDS ISSUERSBonds are issued by corporations and by the government.

Corporate BondsWhen corporate bonds are issued, they are normally sold at par,

usually in units of $1,000, and subsequently traded in the stock

THREE MAIN FEATURES OF A BOND

1. Face value

Th is is the original value of the bond that will be returned to the

investor upon maturity. Th e face value (also called par value) of

most bonds is $1,000.

2. Coupon

Th e coupon indicates the interest income that the bondholder

will receive over the life of the bond, usually payable in semi-annual

instalments. For example, an 8 per cent coupon bond with a par

value of $1,000 pays $80 annually or $40 semi-annually twice a year.

3. Maturity

Th e maturity indicates when the bond matures. At the time of

issue, the time to maturity is at least one year and can be as long as

30 or more years. At maturity, the issuer or borrower makes a fi nal

payment to the bondholder equal to the bond’s par value. In general,

the longer the maturity, the higher the interest rate to compensate

the investor for tying up his money for a longer time.


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112

TABLE 9.1. SAMPLE LIST OF BONDS TRADED ON SGX

Live Quotes from SGX Buy Sell

LTAn4.08%120521 10K 1.00 1.06

JTCn4.826%121024 10K 1.064 1.075

Source: : Extracted from www.sgx.com (29 July 2010)

exchange. Retail interest in corporate bonds is very low in Singapore

as investors prefer the stock market. Th ere are thus no more than

a handful of outstanding corporate bonds on SGX. Here are two

examples traded on SGX:

Th e LTA bond pays 4.08 percent coupon interest per year,

matures on 21 May 2012 and has a par value of $10,000.

Th e Buy price is the price being off ered for the bond, or what a

buyer is willing to pay. Th e highest price submitted was 1.00 or 100

percent of par value, that is, $10,000. Th e Sell price is the price at

which a seller wants to sell the bond. Th e best (lowest) selling price

was 1.06 or 106 percent of par value, that is, $10,600.

Government BondsGovernment bonds (called SGS or Singapore Government

Securities), on the other hand, are issued by MAS. SGS are not

listed on SGX, but are available through banks, fi nancial advisor

companies and Fundsupermart (an online distributor).

Governments are not profi t-making enterprises and do not issue

stock. Bonds are the primary way they raise money to fund daily

operations in running the country as well as capital improvements

such as building mass rapid transit systems and highways.

Th e Singapore government is the safest of all issuers because it

has taxing power, the ability to print more money if necessary, and

more importantly, has the highest credit quality assigned by the

major rating services (see Table 9.2.).


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113TABLE 9.2. CREDIT RATING OF SINGAPORE GOVERNMENT BONDS

Moody’s S&P Fitch

Rating Aaa AAA AAA

Source: www.sgs.gov.sg

MAKING MONEY WITH BONDSConservative investors use bonds to provide steady and predictable

income. Th ey buy a bond when it is issued and hold it till maturity.

Th ey expect to receive regular coupon payments during the term.

And at the end of the term, the principal is returned.

More aggressive investors may sometimes trade their bonds

before they mature, particularly when interest rates fall. When

bonds are issued at a high rate of interest, they become increasingly

valuable when interest rates fall.

For example, suppose you buy a bond for $1,000 when

interest rates are at 5 per cent. If interest rates fall to 3 per

cent, new bonds will offer 3 per cent interest. The older bond

which pays 5 per cent will become more valuable and hence

more expensive.

Th is means that an increase in the price of a bond, or capital

appreciation, can produce more profi ts for the investor than

holding the bond to maturity.

But you can lose money as well.

INVESTING IN BONDS IS NOT RISK-FREEInterest Rate RiskIf you sell the bond before maturity when interest rates have gone

up, the price of your bond will go down and you will incur a capital

loss. Th is is because buyers can buy new bonds that off er a higher

interest rate and the price of your bond off ering a lower interest will

have to go down to attract buying interest. Interest rate risk is one of

the three major risks bond investors face.


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114Inflation Risk Since the dollar amount you receive on a bond investment is fi xed,

the value of those dollars will be eroded by infl ation. At a rate of

infl ation of 2 per cent, $100 received in 10 years’ time is worth just

$82 today. Th at’s a loss of $18. In general, the longer the term of a

bond, the higher would be the interest rate off ered to make up for the

risk of tying money up for a longer period.

Default Risk Th is is the risk that the borrower fails to pay you interest and principal.

We will have more on this topic later.

WHAT IS A BOND WORTH?When you put $1,000 into a bond, the bond could be worth more or

less the very next day. While you know how much coupon interest

you will get in the future, your capital value or the current price of

the bond can fl uctuate.

Like everything else in life, bond prices too are driven by supply

and demand. When investors want to buy or sell, they consider two

main factors:

1. Interest rates in the economy.

2. Credit rating of the bond issuer.

Before we go on, we have to admit that investing in bonds can be

a daunting task for the new investor because of the mathematics.

Th ere are all sorts of calculations and terms to master, and many of

them seem diff erent from those of stocks. We urge you to devote

time and energy to learning the mathematics that drive bond prices

and returns. It will set you apart from most other investors.

Interest Rates in the EconomyWhen a bond is fi rst issued, the coupon rate is typically set to the


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115market rate of interest so that the issuer can receive an amount

equal to par value. For example, if the market interest rate is

6 per cent, the issuer sets the coupon rate at 6 per cent, making the

price of the bond on the day of issue exactly $1,000.

Market interest rates change as time passes by. As a result, bond

prices after the day of issue are seldom equal to par value. Interest

rates and bond prices move in opposite directions like two sides

of a see-saw. When interest rates fall, bond prices go up. And vice

versa. Let us go through an example:

Suppose KayOn Pte. Ltd. issues a new 10-year bond off ering

six per cent interest semi-annually. Lizzie buys a bond at the full

price or par value of $1,000.

Seller sells at par

Par value $1,000

Term 10 years

Coupon Interest 6 per cent

If Lizzie were to hold the bond to maturity, a period of 10 years,

she would receive 20 payments of $30 each every six months and

the return of $1,000 par value on maturity.

Buyer buys at par

Price $1,000

Holding period 10 years

Interest income 20 semi-annual payments of $30

At maturity $1,000

Her dollar return is $600 and her yield is 6%.

Return to buyer

Interest (20 x $30) $600

Par value $1,000

$1,600


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116 Less cost – $1,000

Return $600

Yield to buyer

Current yield $60 / $1,000 = 6%

Two years later, interest rates have gone up to 8 per cent. If new

bonds costing $1,000 are paying 8 per cent interest, no buyer will

pay you $1,000 for a bond paying 6 per cent. To sell her bond, Lizzie

would have to off er it at a discounted price that could wipe out the

interest she has earned so far.

Suppose Lizzie sells the bond for $840. She would incur a loss

of $40.

Seller sells at discount of $840

Market price $840

Interest received $120 (4 payments x $30)

$960

Less cost – $1,000

Loss -$40

Th e buyer pays $840 and if the bond is held to maturity, $1,000

will be repaid, or a capital gain of $160. Th e buyer can also expect

16 interest payments of $30 for the remaining eight years of the

bond’s life.

Buyer buys at $840

Price $840



At maturity $1,000

Return to buyer

Interest (16 x $30) $480


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117 Par value $1,000

$1,480

Less cost – $840

Return $640

Yield to buyer

Current yield $60 / $840 = 7.14 per cent

Of course, the reverse can also happen. If, in two years’ time, new

bonds selling for $1,000 off er 4 per cent interest, Lizzie would be

able to sell her 6 per cent bond for more than what she paid. Buyers

would be willing to pay more for a bond that pays a higher rate of

interest than that prevailing in the economy.

If she sells the bond for $1,200, the premium (or capital gain) plus

interest received of $120 will make her a nice profi t of $320.

Seller sells at premium of $1,200

Market price $1,200

Interest received $120 (4 payments x $30)

$1,320


Profi t $320

Buyer buys at $1,200

Price $1,200



At maturity $1,000

Return to buyer

Interest (16 x $30) $480

Par value $1,000

$1,480



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118 Return $280

Yield to buyer

Current yield $60 / $1,200 = 5%

MORE ON YIELDYield is what you actually earn. When interest rates fl uctuate and

cause bond prices to move, the investor’s yield changes as well.

When Lizzie buys the 10-year $1,000 bond paying 6 per cent

coupon and holds it to maturity, she earns $60 a year — an annual

current yield of 6 six per cent or the same as the interest rate.

Current yield remains the same throughout her ownership of

the bond.

Current yield = Coupon interest / Market price

= $60 / $1,000

= 6%

An investor who buys the same bond two years later in the

secondary market will be looking at a diff erent yield. Th at is because

the market price of the bond has changed. For example, if interest

rates had risen to 8 per cent:

Current yield = $60 / $840

= 7.14%

Th ere is an even more precise measure of a bond’s value called

Yield to Maturity (YTM). Compared with current yield, YTM

takes into consideration both coupon interest and capital gains/

losses. Th e investor of the $840 discount bond will earn $160

in capital gains at maturity, and this amount is not captured in

current yield.

YTM is the single most important calculation for a bond, but it

does have a complicated formula. But there is a simpler, albeit less

accurate, formula that helps to explain how YTM uses both capital

gains and interest income in its calculation.


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119Here it is. First, fi nd out the annual discount or premium over the

life of the bond. Th e KayOn bond has an annual premium of $20

($160 / 8 years).

Second, add the annual premium of $20 to the annual coupon

of $60 to get $80, which is the annual return from both the capital

gain and the income portions.

Th ird, divide the annual return of $80 by the average price of the

bond. Th e average price is obtained by adding the buying price of

$840 and the maturity price of $1,000 and dividing the result by 2.

From doing all this, the result is 8.7 per cent, which is slightly off

the actual result of 8.83 per cent:

YTM (approximate) = (160/8) + 60

(840 + 1000) /2

= 8.7%

You should know the actual YTM value when you invest,

although you need not kill brain cells to calculate it. It is best left

to a spreadsheet or your fi nancial adviser who is handy with a

fi nancial calculator.

BOND CREDIT RATINGS As a bond investor, you want reasonable assurance that you will get

your interest payments and principal back at maturity. It is impossible

for individuals to track the credit worthiness of individual bond

issues. Fortunately, rating services such as Moody’s Investors Service

(Moody’s) and Standard & Poor’s Corporation (S&P) provide this

valuable service.

Th ese rating services pore through voluminous fi nancial

statements and study the business prospects of bond issuers to

answer the question, “How likely is the issuer to default on its

payments on a particular bond issue?” Bonds that rank low in terms

of risk receive a higher quality rating.


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120

TABLE 9.3. RATINGS TABLE

Moody’s S&P Investment-Grade Bonds

Aaa AAAHighest credit rating, maximum safety

Aa AAHigh credit rating, investment-grade bonds

A AUpper-medium quality, investment-grade bonds

Baa BBBLower-medium quality, investment-grade bonds

Moody’s S&P Speculative Bonds

Ba BBLow credit quality, speculative-grade bonds

B BVery low credit quality, speculative- grade bonds

Moody’s S&P Junk Bonds

Caa CCCExtremely low credit quality, high-risk bonds

Ca CC Extremely speculative

C C Extremely poor investment

D D Bonds in default

Source: Authors’ own compilation from Moody’s and S&P

Bond ratings are assigned to a particular bond issue, not just to

the issuer of those bonds. For example, a secured bond issue gives

the investor a claim to specifi c assets in the event of default. Th is

gives a secured bond a higher credit rating than an unsecured bond

even when issued by the same corporation.

Th e top four grades (Aaa, Aa, A and Baa in the case of Moody’s)

are considered investment grades. All other grades are considered

high-yield or junk.


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121Ratings Influence YieldAs Figure 9.1. shows, credit ratings infl uence the interest rate an

issuer must pay to attract investors. Given the same maturity, the

higher a bond’s rating, the lower the interest it pays. On the other

hand, the lower a bond’s rating, the more an issuer must pay. Th at

is why the lowest-rated bonds are often described as high-yield

bonds.

In the next chapter, we will look at strategies for buying and

selling, and how you can manage your bond investments.


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FIGURE 9.1. LOW QUALITY SPELLS HIGHER YIELD

AAA AA A BBB BB B CCC CC C D



Individual Bond Investments

Some investors think that bonds are conservative, even boring

investments. Th ink again. A $1,000, 4 per cent coupon bond, with

10 years to maturity, could rise $149 or fall $180 in response to a

2 per cent change in market interest rates. Knowing about bonds —

when to buy them and how to select among a multitude of choices

— can reap huge rewards.

THE MANY FLAVOURS OF BONDSBonds have many diff erent features, which make each bond unique.

As you learn about each feature, bear in mind whom the feature

benefi ts — the issuer or the investor. If a feature benefi ts the investor,

then the bond has lower risk, its yield should be lower, and its price

should be higher. So once you know who benefi ts from a feature, you

will have a good idea about whether to pay more or less for such a

bond. Here are some of the most common bonds you will fi nd.

Government BondsGovernment bonds (called SGS or Singapore Government Securities)

are issued by the Monetary Authority of Singapore (MAS). At the

time of issue, government bonds have maturities of between one and

15 years.

Corporate BondsCorporate bonds are issued by corporations. Th ey are bought

and sold mainly by institutions. Th ere is limited interest from

retail investors.

Secured BondsSecured bonds are backed by specifi ed assets such as mortgages

10


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123and accounts receivables. In general, bonds have to be backed by

something for investors to be convinced to part with their money.

For example, a mortgage-backed bond bundles mortgages, and then

sells investors the right to receive the payments that consumers make

on those mortgage loans.

Unsecured BondsUnsecured bonds (or debentures) are the most frequently issued

type of bond. Th ey are backed by the credit quality of the issuer.

In general, the higher the credit quality, the higher the chance the

borrower will pay you as promised. Although unsecured bonds sound

risky, they generally are not. Debentures are issued by high-quality

corporations, and they are often more highly rated than secured,

asset-backed bonds.

Floating-Rate BondsFloating-rate bonds (or fl oaters) periodically adjust the coupon

interest according to a formula based on current market interest

rates. When market interest rates are going up, fl oaters adjust their

coupon interest upwards.

Zero-Coupon BondsZero-coupon bonds do not pay coupon interest during the term of

the bond. Instead, the interest is built up and paid in a lump sum at

maturity. Zero-coupon bonds are sold at a discount. For example,

if you buy a zero-coupon bond for $900 and you collect $1,000 on

maturity, you would have earned $100 in interest.

Callable BondsCallable bonds give the issuer the right to call back the bond and

repay its debt before maturity. For this reason, callable bonds do not

always run their full term. Issuers tend to call a bond if interest rates

fall, in the hope of paying off the original loan and reissuing another

bond at a lower rate of interest.


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124If you think that is unfair, it is the same idea as you refi nancing

a mortgage to get a lower interest rate to make lower monthly

payments.

Callable bonds are less attractive for investors because an investor

whose bond has been called now faces a lower, reinvestment

environment. Callable bonds are riskier for investors and hence

off er a higher rate of return than non-callable bonds.

Convertible BondsConvertible bonds are hybrid investments because they possess

some qualities of a bond and some of a stock. Hybrids are normally

safer than either a bond or a stock.

If interest rates rise and the bond falls in value, the investor can

still benefi t if the stock price has risen. If the option to convert

is not exercised, the convertible remains in existence until the

bond’s maturity and you continue to receive interest income.

Th is fl exibility is especially appealing to conservative investors

who seek regular income and downside protection against falling

share prices.

Because convertible bonds have a little something extra — the

right to convert to common stock, they cost more than straight

bonds without conversion features. Convertible bonds are less

risky for investors and hence off er a lower rate of return than non-

convertible bonds.

High Yield BondsHigh yield bonds are lower-grade bonds that pay higher interest

rates. High yield bonds are not inferior bonds at all except that

they are riskier than investment-grade bonds. They are often

just a grade below investment grade and are issued by emerging

market economies and by good companies that have fallen on

bad times.


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125CHOOSING THE RIGHT TYPE OF BONDTh ere are so many types of bonds that it can be confusing trying to

pick one over another. Here are some rules of thumb, depending on

what you want:

• Maximum current income — Choose high-yield bonds.

• Protection from rising interest rates — Choose high-yield bonds

or short-term bonds. Th e prices of short-term bonds are less

volatile because they are closer to maturity.

• Protection from default risk — Choose investment grade bonds.

• Take advantage of falling interest rates — Choose long-term

bonds and zero-coupon bonds.

• A worry-free investment in a bond — Buy bonds and hold them

to maturity. Th e closer the bonds are to maturity, the less worrisome.

MAKING A BOND INVESTMENTTh ere are two main ways you can have a bond investment:

1. Purchase individual bonds.

2. Purchase bonds through a unit trust.

Instead of buying individual bonds, many investors fi nd it easier to

invest in bonds through unit trusts, which off er a diversifi ed portfolio

of bonds for as little as $1,000. Th e typical bond fund has 50 to 100

individual bonds of diff erent maturities, yields and credit ratings.

Th is allows investors to diversify risk easily and inexpensively across

a broad range of bonds. What is more, bond funds come with a fund

manager and an investment team — they provide expertise that most

individual investors do not have access to.


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126

TABLE 10.1. CHOOSING BETWEEN INDIVIDUAL BONDS AND BOND FUNDS

Invest in Individual Bond Invest in Bond Fund

Maturity Defi nite maturity date.

Bond funds never mature. As some bonds mature or are traded away, new bonds take their place.

Capital Preservation

Capital returned is predictable. It is at par at maturity, regardless of prevailing interest rates (unless issuer defaults).

Capital returned is unpredictable — based on the price of underlying bonds (Net Asset Value), which are aff ected by prevailing interest rates, among other things.

IncomeIndividual bonds send you interest income on fi xed dates.

Interest income is usually not paid out but reinvested.

Interest Rate Risk

Less aff ected by interest rate risk. In fact, the risk diminishes as bond reaches maturity.

Constant exposure to interest rate risk.

Default Risk

Th e impact of a default is greater, especially when few distinct bonds are owned. Conservative investors should seek mainly lower-risk, investment-grade bonds.

Default risk is minimised because a fund typically holds 50–100 distinct bonds.

Management

You are on your own when it comes to managing your bonds. When the bonds are repaid on maturity, you will have to think about what you are going to do with the cash.

Unit trusts off er management expertise on an ongoing basis.


Here are some things to consider when making a decision about

whether to invest in individual bonds or in a bond fund.


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127BOND PICKING STRATEGIESAlong with your newfound knowledge of bonds, here are some

strategies on picking bonds that will help you become a successful

bond investor.

Buy Bonds When You Think Interest Rates are HighWhen you buy a bond, you are locking yourself into receiving a fi xed

amount of interest every year until the bond matures. If interest rates

are low, you should be fussier about what you buy. Look for short-

term bonds that mature in a few years and certainly give long-term

bonds a skip.

Buying when interest rates are high gives you two benefi ts. Th e

interest you receive on your bond will be higher. Second, if interest

rates are high, there is probably a good chance that interest rates

will fall and the price of your bond will go up.

Laddering MaturitiesLaddering means staggering the maturities in a bond portfolio.

Here is how it works. Suppose you have $20,000 to invest in a bond

portfolio. Buy 10 bonds each with $2,000 face value, maturing

annually for 10 consecutive years.

As time passes and the fi rst bond matures, invest in another

10-year bond. Continue this cycle, as long as you want to remain

in bonds. Th is approach means that you are never concentrated in

any one maturity. If there is a signifi cant change in interest rates,

you will have avoided putting a heavy portion of your money on a

single maturity. Laddering maturities reduces the eff ect of interest

rate risk on bonds.

Beware of Callable BondsCallable bonds can be called and retired by the issuer before

maturity. Th ey pay more interest because they are riskier than non-

callable bonds.


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128Be careful of callable bonds because bonds are often called when

interest rates have fallen. Calling a bond allows the issuer to reissue

the bonds at a lower interest rate. Th is does you no good because

you will reinvest your money in a lower interest rate environment.

What is more, callable bonds fi x the price that is paid to you. Just

when you think that lower interest rates point to higher bond prices,

you remember that callable bonds have a clause stating the maximum

price the issuer will compensate you in the event of a call. Th is price

is always lower than the price of a bond with no callable feature.

Buy Quality BondsBe careful about chasing after the highest yielding bonds. Such

bonds may be low quality and have a high chance of default. While

it is alright to allocate a small portion of your money to speculative

bonds, do not focus only on high yield bonds.

If you are buying individual bonds worth from about $10,000 to

$20,000, it is diffi cult to achieve a lot of diversifi cation. You should

therefore focus on high quality bonds.

Buy Bonds That You Expect to Hold till MaturityWhen you buy a bond and hold it till maturity, you will know the

rate of return because it can be calculated on the day you buy

your bond.

You may still hope to buy a bond and sell it for a nice profi t when

interest rates fall. But you have to ask yourself what you will do with

the proceeds of your sale. For example, you bought a bond when

interest rates were at 5 per cent, and which have now fallen to 3 per

cent. Sure, you can sell the bond and make a profi t (if you cash out

totally), but it would not make sense to use the proceeds then to

reinvest in another bond that pays only 3 per cent.

FIGURING OUT WHEN TO SELL A BONDSelling a bond before it matures is a big decision. We indicated in

the previous two chapters that one of the best reasons to buy a bond


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129is when you plan to hold it to maturity. Nevertheless, there may be

situations where selling makes sense:

1. Slipping of credit rating

While a drop in rating from AAA to AA is not such a big

problem, a bond falling into the junk or CCC and below

category is very risky and has a high chance of default.

2. You need the money

We hope you will never fi nd yourself in this sort of situation:

you have an emergency and your emergency funds are not

enough. Th e worst thing about forced selling is that it may be

the wrong time, especially when interest rates have risen and

bond prices have fallen.

3. Falling interest rates

Bond prices are rising as a result and you are now tempted to

cash in your profi ts. Th is is not a bad idea if you are thinking of

cashing out. But if it is to buy another bond, then realise that

other bonds are also paying lower returns. Th is defeats the

whole purpose of selling.

Still, there are two situations in which selling makes sense.

First, when interest rates fall, this is usually favourable to stocks.

You may move out of bonds when prices are high and move into

stocks as they benefi t from falling interest rates. But be careful that

you have really understood the fundamentals. It is easy to get the

signals wrong.

Second, falling interest rates is a good sign overall for the

whole economy as even shaky companies have a higher chance of

survival due to cheaper debt. Sophisticated investors do take such

opportunities to switch from safer bonds to higher-yielding bonds

of a lower quality in order to generate higher returns.


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130MANAGING INDIVIDUAL BONDS IN YOUR PORTFOLIOLike stocks, bonds are very fl exible investments. If you want

protection of capital and high liquidity, you can consider short-term

bonds, preferably of investment grade quality, that mature in one to

three years.

If you want to match a bond with your retirement, you can

consider a bond whose maturity closely matches your time of

retirement. For example, if you plan to retire in 10 years, then you

should go for investment-grade bonds that mature in 10 years.

Because the yield to maturity is known, this is a low risk strategy of

ensuring a certain return along with good protection of your money

as your retirement gets closer.


3PART

INVESTING IN ALTERNATIVE ASSETSInvesting in traditional assets in Part 2 showed you how to build a portfolio of unit trusts for a long-term objective such as retirement. It also showed you how, after setting aside your funds for this most important objective, you could add individual stocks and bonds to your portfolio.

In this section, we go beyond traditional investments to include products such as gold and hedge funds. This is not to say that the traditional products are inadequate, but some of us would like to go a little further. Remember to stick to the 20 per cent rule — no more than 20 per cent of all your invested funds can be allocated to individual stocks and bonds and alternative products.

The chapters in this section are shorter than the other sections because they build on what you already know. For example, a capital guaranteed fund is made up of bonds and derivatives.

We suggest that you plan your retirement portfolio before putting a single dollar to alternative investments.


Investing in Exchange Traded

Funds (ETFs) and Index Funds

An ETF is like a typical unit trust1 but it diff ers from it in two

fundamental ways:

• An ETF trades on a stock exchange such as SGX; and

• An ETF passively mimics an underlying index rather than

attempting to beat it actively.

Take the streetTRACKS STI Fund for example, which is listed on

SGX and passively mimics the Straits Times Index (STI). On the

other hand, a unit trust that focuses on Singapore stocks, such as

the Schroder Singapore Trust, looks actively for Singapore stocks

that together attempt not only to match, but beat, the performance

of the STI.

You probably have these questions:

• How is a portfolio of ETFs diff erent from a portfolio of actively

managed unit trust funds in terms of risk, performance and cost?

• Can you build a globally diversifi ed portfolio of ETFs where

each passively follows an index?

We’ll answer these questions about ETFs in this chapter and also

talk about how they are similar to index funds.

ETFsAn ETF trades like a stock on an exchange and so its price fl uctuates

during trading hours. By owning an ETF, you get the diversifi cation

1 What we mean by a typical unit trust here are those unit trusts whose objective is

to beat a specifi c underlying benchmark.

1 1


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133of an index as well as the fl exibility of trading it like a stock. Th is

means that you can sell short, buy on margin and purchase as few

as one share at a time. Your upfront cost of buying an ETF is the

brokerage fee, which is the same as that paid for stock trading. And

there is no 3 to 5 per cent front-end load, which is typical for a unit

trust.

Most ETFs fully replicate the underlying index by investing in

every stock in the index, weighted proportionately. It is because of

this passive approach to mimicking the index that ETFs are never

expected to beat or lose out to the underlying index in terms of

performance. If the STI goes south by 10 per cent, you can expect an

STI ETF to fall in the same direction by the same magnitude.

Its passive nature means the fund manager has to do far less

research and analysis to construct the ETF. As a result, ETFs have

lower expense ratios. In most cases, an ETF stays fully invested at all

TABLE 11.1. COMPARING ETFS AND UNIT TRUSTS

ETF Unit Trust

Objective

Passively tracks an index. Will not outperform or underperform the underlying index.

Actively attempts to outperform the underlying index.

Buying Charges

Based on what stock brokerages charge, typically measured by bid-off er spread.

1.5% to 5% of amount invested.

Recurring Fees

Typically between 0.75% and 1.5% per annum of amount invested.

Typically between 1% and 3% per annum of amount invested.

Trading Price

What you see on the trading screen is your paying or buying price.

Based on forward pricing. Investor will not know price paid or sold at usually till 1–2 days later.



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134times while actively managed funds may keep a portion of investor

funds in cash depending on market conditions. Table 11.1 (page 133)

summarises the key diff erences between ETFs and unit trusts.

INDEX FUNDSIndex funds are unit trusts based on an index and mirror its

performance. Index funds came about before ETFs did. In the U.S.

where index funds were fi rst launched, there are 2.5 index funds for

every ETF.

Th e thinking behind index funds has strong academic backing.

For a long time, many academics have been saying that it is

impossible to beat the market consistently without raising your risk

level — a theory known as the Effi cient Market Hypothesis (EMH).

In 1975, John Bogle of investment management company Vanguard

took the position that if you can’t beat the index, create a fund to

mimic it. Th at’s when the fi rst low-cost mutual fund was created

mirroring the S&P 500 index.

Index funds have been a hit in the U.S. because many investors

are disillusioned by the returns of actively managed funds. In study

after study, data show that the majority of active mutual funds fail

to outperform the S&P 500 and other indices. So why pay a fund

manager to look actively for the best investment opportunities for

you, when more likely than not, the fund manager will not be able

to do better than the index?

One of the reasons this is true in the U.S. is that the fund industry

is very large and well followed. Th e stocks of the world’s largest

companies are tracked by hundreds of analysts. Th e amount of

information sharing and effi ciency is very high. Th ere is little that one

manager can know that is of material signifi cance to his portfolio that

other managers would not know about.

In Singapore and many parts of Asia, this phenomenon is less

pronounced. Our markets are smaller, are followed by far fewer

analysts, and have a lower degree of information effi ciency in

the sense that fund managers are able to extract information and


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135analysis that is not commonly known. In fact, studies show that

actively managed funds in Asia do at least as well as, if not better

than, passively managed ones.

BUILDING A PORTFOLIO OF ETFs AND INDEX FUNDSTh ere are diff erences, of course, between ETFs and index funds.

But overall, they are more similar than diff erent in that both are

passive investing styles that track indices in terms of composition

and performance.

In chapter 5, we showed you how to build your own globally

diversifi ed portfolio using actively managed unit trusts by allotting

your money in the following regions:

TABLE 11.2. RECOMMENDED ALLOCATION OF EQUITY FUNDS

Type of Equity Fund Recommended Allocation

US Equity Fund 30%

European Equity Fund 30%

Asia ex-Japan Equity Fund 30%

Japan Equity Fund 10%

TOTAL 100%


You can do the same with a combination of ETFs and index funds

that are available today. Table 11.3 shows a sample of such funds:

TABLE 11.3. SAMPLE OF ETFS AND INDEX FUNDS AVAILABLE IN SINGAPORE

Focus Index Tracked Example Fund

Global Funds

Global Equity MSCI World Index DBXT MS World

Regional Funds

U.S. Equity MSCI USA Index DBXT MS USA

European Equity MSCI Europe Index DBXT MS Europe


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136Focus Index Tracked Example Fund

Asia ex-Japan Equity

MSCI AC (All Country) Asia-Pacifi c Ex-Japan Index

Lyxor Asia

Japan Equity Tokyo Stock Price Index (TOPIX)

Lyxor Japan

Single-Country Funds

Singapore equity Straits Times Index STI ETF

Singapore bonds iBoxx ABF Singapore Bond Index

ABF SG Bond

Hong Kong equity

Hang Seng Index Lyxor Hang Seng

Korea equity MSCI Korea Index Lyxor Korea

China equity Hang Seng China Enterprises Index

Lyxor China

India equity MSCI India Index IS MSCI India

Sector Funds

Commodities RJ/CRB Index Lyxor Commodity

Gold Gold Spot Price SPDR Gold Shares

Technology DJ US Tech Sector Index IS DJ US Tech


As indicated by Table 11.3, there’s enough out there for you to

create a globally diversifi ed portfolio as well as have some focused

investments in specifi c countries and sectors.

For example, if you had $10,000 to invest, you could build any one

of the following portfolios:

• Portfolio 1 — Put $10,000 all into one global stock ETF/index

fund for instant global diversifi cation.

• Portfolio 2 — Put $3,000 each into U.S., Europe and Asia ex-

Japan funds, and $1,000 into a Japan fund. Th is gives you instant

global diversifi cation, plus more control over the amount you

want in each region.


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137• Portfolio 3 — Put up to $2,000 into sector and single-country

funds, and the rest into a diversifi ed portfolio. Th is way you get

to have a long-term diversifi ed portfolio and are still be able to

have some fun and take more risk with more focused investments.

You may be wondering how come you don’t own such funds when

the cost of owning them is a lot lower. One reason is that you have

may not have been approached too persuasively to buy such funds.

ETFs do not earn fi nancial advisers any money and index funds are

less lucrative to sell compared with actively managed funds.

On the last point, lest you are fuming slightly, you must

understand that there is a cost to distribution. Th e bank and

fi nancial adviser who service and advise you need to earn their

keep too. Th ese investments work in the U.S. because the degree of

self investment there is higher — thanks to the much longer history

that U.S. investors have had with discount brokerages such as

Schwab and E*Trade. We in this region generally prefer to be helped

and advised.

Of course the other reason is, as we have mentioned, actively

managed funds in Singapore and the region do generally beat their

regional benchmarks.

In the end, you need to appreciate these diff erent dynamics

between a smaller market such as Singapore, and the U.S. market,

which is the largest in the world. ETFs and index funds will become

more important as the market expands, and you’ll have increasingly

more choices ahead.

Our advice is that if you are looking for a fund such as a Japan

fund, you need to challenge your fi nancial adviser by asking

whether an active or passive fund is better for you. And if your

interest is in the U.S. market, the question becomes even more

important because passive funds in the U.S. are the ones that

generally do better than active funds. Th ere are no straight answers,

of course, but it is important that you cover these angles when you

are buying.


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138

Investing in Real Estate

Once you own one home, as do most Singaporeans, the idea of

owning another home as an investment might pop into your head.

Whether you are looking at an investment property in Singapore,

Australia or Malaysia, pulling the trigger is something more and

more affl uent individuals are doing. In fact, according to the 2010

Merrill Lynch World Wealth Report, affl uent individuals have 18 per

cent of their investment portfolios in property.

Why is there such an age-old fascination with property? Th e most

obvious reason is that few things in life provide a greater sense of

security than having a roof over your head.

Th e second most attractive reason is that property prices rise over

the long term — as long as the underlying economy is growing.

Will Rogers once said, “Buy land. Th ey ain’t making any more of the

stuff .” How true especially if you live in Singapore. Look at Figure

FIGURE 12.1 PRIVATE RESIDENTIAL PROPERTY PRICES VERSUS GDP (1990 = 100)(

Source: “Residential Property Prices and National Income,” Economic Survey of Singapore, First Quarter 2001, pp 49

300

250

200

150

100

50

0

INDEX

REAL PPI

REAL GDP

1975 1978 1981 1984 1987 1990 1993 1996 1999

REAL PPIPIPI

REAL GDP

0

0

0

0

0

12


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13912.1,1 which shows a clear long-term correlation between property

prices and GDP from 1975 to 1999 (although there have been

periods of exuberance such as in 1981–84 and 1994–97).

Property costs hundreds of thousands of dollars and may be out

of the reach of some investors. Fortunately, buying directly into a

physical property isn’t the only way to invest. You can participate

in other ways including real estate investment trusts (REITs),

property funds and land banking. We start by looking at rental

properties.

INVESTING IN A RENTAL PROPERTYYou buy a property and rent it out to a tenant. As the landlord, you are

responsible for paying the mortgage, taxes and cost of maintaining

the property. Ideally, the rent paid to you will cover your monthly

expenses of that property. You can then sit tight till the mortgage

is paid off and you own the property exclusively, and then you can

enjoy the rent as profi t. Alternatively, you may sell the property when

its price has appreciated signifi cantly.

Th is all seems to make a rental property an ideal investment,

but landlords will tell you that there are always challenges. Unlike

a stock or a bond, a rental property requires you to devote time

to maintaining your investment. When the bath tub leaks or the

electricity gets cut in the middle of the night, it’s you who will get

the phone call.

You could also have trouble fi nding a tenant or end up with a bad

tenant who damages your property. You might receive poor rent

and have problems servicing your mortgage. It can get even worse

if the property’s valuation falls below your loan amount and you fall

into a negative equity position. Th at’s when the bank will demand

that you top up the diff erence.

1 http://app-stg.mti.gov.sg/data/article/21/doc/NWS_Property.pdf.

Also here: www.asiaone.com/print/Business/My%2BMoney/Property/Story/

A1Story20100426-212422.html


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140Some Strategies on a Recession-Proof Property InvestmentKnowing that property prices go hand in hand with economic growth,

how do you ensure that the price of your investment property does

not go south when the economic climate is rough?

Th ere are certain strategies you can employ to recession-

proof your investment. Since most homeowners will buy and sell

several times in their lives, you are likely to have a chance to use

these bulletproof principles the next time you buy. We will discuss

just two principles that we have found most critical in our own

experience.

Location, Location, Location You’ve probably heard it before, and it’s true: Location really matters.

Remember that homes are replaceable, but land is not. A mansion

in a poor location is a usually a worse off investment than a modest

apartment in a good location. If you’ve got a spot everyone wants,

your place will sell faster and for a better price than a similar house

elsewhere.

TABLE 12.1 GOOD PROPERTY LOCATIONS

City Good Property LocationsBangkok, Th ailand Sukhumvit, Lumpini, Silom

Hong Kong, China Happy Valley, Deep Water Bay, Mid-Levels

Jakarta, Indonesia Cilandak, Kebon Kacang, Pondok Indah

Kuala Lumpur, Malaysia Kenny Hills, Ampang, Bangsar

Singapore Bukit Timah, Orchard Road, Shenton Way

Sydney, Australia Chatswood, Rose Bay, Bondi

Tokyo, Japan Roppongi, Minato, Shibuya


A location is considered good when it is close to good schools,

the central business district, the beach, popular shopping malls, the

airport and railway stations. A home in a remote, far away location


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141has far less potential for attractive price appreciation even when the

rest of the economy is doing well.

Holding Power

Can you hold on to your property even when prices are spiralling

downwards?

Property investment needs your long-term commitment and

holding power. If you have little savings in the bank, and servicing

your loan takes up most of your monthly income, you probably

have taken on a larger loan than you can manage. Th is means your

holding power is weak, and a sudden drop in home prices could

force you to liquidate your investment suddenly at a loss.

For instance, our friend Dawn bought a semi-detached home

in 1997 for $3.2 million. It was her sixth property. Every property

she had bought till then had produced huge profi ts. Th e bank was

happy to loan her more and more.

However, when property prices crashed, she found herself in a

negative equity position for most of her properties, and she had

to sell fi ve of her properties at fi re-sale prices. Th e semi-detached

home was sold for less than $2 million. She was left with one

property, her matrimonial home, and a debt of close to $5 million.

Home prices later recovered and it pained her to think, “if only I

could have hung on.” Th us consider your holding power before you

invest in property.

INVESTING IN REAL ESTATE INVESTMENT TRUSTS (REITS)If you have always wanted to own your favourite shopping centre

such as Tampines Mall or Junction 8, but you do not have $500

million in spare cash, do not fret. For as little as $1,000, you can

invest in a piece of commercial real estate to call your own.

When you invest in a Real Estate Investment Trust (REIT —

pronounced “reet”), a group of real estate professionals buys and

manages real estate on your behalf. REITs allow people to invest

in real estate without buying property directly. Th e properties


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142are then leased and rented out, and the income is passed on to

investors.

REITs mostly specialise and do not mix and match the types of

real estate they own. For example, some REITs may focus their

investments geographically (such as by country or city), or in

specifi c property types (such as shopping malls, industrial buildings

or residential apartments).

Th e fi rst Singapore REIT is Capital Mall Trust, which debuted in

July 2002. Over 20 REITs trade on SGX today. Table 12.2 shows a

sample of those REITs.

TABLE 12.2. REITS AND WHERE THEY ARE INVESTED

Name of REIT Invests Mainly In

AscendasIndT Commercial buildings in India

AscendasREIT Industrial parks

AscottREIT Service apartments in Asia

Cambridge Industrial buildings

CapitaComm Commercial buildings

CapitaMall Shopping malls

CapitaRChina Shopping malls in China

CDL HTrust Hotels

First REIT Healthcare real estate in Asia

Fortune REIT Shopping malls in Hong Kong

FrasersCT Shopping malls

K-REIT Commercial buildings

LippoMapletreeIndonesia Shopping malls in Indonesia

MapletreeLog Commercial buildings

Parkway Life Healthcare real estate in Asia-Pacifi c

Saizen REIT Residential real estate in Japan

SuntecREIT Shopping malls



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143Why Invest in REITs?Many investors turn to REITs as an alternative to savings and fi xed

deposit accounts. And why not? REITs off er two attractive benefi ts:

1. Liquidity

REITs are traded on stock exchanges and are liquid compared

with buying real estate directly. Try selling a house in a hurry

and you will fi nd that it’s not easy to liquidate.

2. High dividend yield

REITs typically off er two per cent above 10-year government

bond yields. So if 10-year government bond yields are three per

cent, REITs can be expected to yield fi ve per cent.

But REITs have risks too. In fact, you should take extra

precaution, especially in times when there are many dollars chasing

after REITs:

1. Management risk

Unit trusts invest in companies in which each company has a

diff erent management team. With REITs, it is just one

management team that makes decisions not only on buying and

selling, but also on managing and operating the REIT properties.

2. Interest rate risk

When interest rates rise, the income from REITs will become less

attractive relative to other investments. For example, government

bond yields will rise when interest rates rise. Th e situation

becomes worse if the economy is coming out of a low interest

rate environment, and the upside for interest rates is strong.

Capital values are likely to be vulnerable as well. Higher

interest rates mean that the cost of borrowing goes up and

REITs will suff er from larger interest payments on mortgages

and bonds.


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1443. Industry risk

While a REIT may be less risky than an investment in an

individual property, the fund has all the risks associated with

sector funds because of its exposure to real estate. Th eir values

will fall in an economic downturn while savings and fi xed

deposits are virtually immune to economic downturns.

4. Depreciation

Because of depreciation, the capital value of REIT properties

decreases over time. Th is is especially true for REITs that invest

in industrial property that sits on leasehold and not freehold

land. For example, if a landlord leases industrial land for 30

years at a time, the property is returned to the landlord when

the lease runs out.

S-REITs in Strong Position in AsiaTh e U.S. REIT market is the largest in the world with over 50 per cent

of total global market value. In Asia, the Singapore REIT (S-REIT)

market is the second largest after Japan. Th e future looks bright as

investors are attracted by the number of choices available today.

S-REITs are well diversifi ed with interests in retail, commercial,

industrial, hospitality and healthcare.

S-REITs are also well stocked with off shore assets as they have

interests in more than 10 countries, thus providing geographical

diversifi cation.

Managing REITs in Your PortfolioREITs behave like fi xed income securities and one can rely on REITs

for income. However, the capital value of REITs can rise and fall

along with cycles in the property market.

If you plan to keep a REIT for retirement, do a serious evaluation

of the property sector as a whole every three to fi ve years. Even if

dividend yields remain strong, the capital value of your investment

can go down. Remember that an investment in REITs is fi rst and


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145foremost an investment in real estate. And we all know how volatile

that is.

INVESTING IN PROPERTY FUNDSCompared with REITs, property funds are more diversifi ed in their

investments in terms of geography. As seen in Table 12.2. (page 142),

such funds are typically invested broadly across Asia, Europe or globally.

Th ese funds may invest in one or a combination of the following:

1. Funds that invest in REITs.

2. Funds that invest in investment companies (holding companies

that buy properties and receive rental income).

3. Funds that invest in property developers (companies engaged in

building and land development activity).

TABLE 12.3. EXAMPLES OF PROPERTY UNIT TRUSTS SOLD IN SINGAPORE

Name of Unit Trust Launch Date

Amundi Asian Real Estate Dividend Fund April 2005

DBS Global Property Securities Fund March 2005

First State Global Property Investment February 2005

Henderson Asia-Pacifi c Property Equities

Fund

March 2006

Henderson European Property Securities June 1999

Henderson Global Property Equity Fund March 2005

IOF-Asian Property Securities March 2008

United Global Real Estate Securities Fund March 2005


If you would like to gain exposure to global and regional property

markets without having to buy physical property, such funds can

make a good addition to your portfolio.


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146INVESTING IN LAND BANKINGLand banking is the practice of purchasing raw land with the intent

to hold on to it until it is profi table to sell it. Th e intended increase in

value generally comes from the conversion of raw land to residential

or commercial use, or from the potential for extraction of natural

resources.

FIGURE 12.2. THE LAND BANKING PROCESS


Important Trends to Consider

• Population Growth

• Economic Growth

• Government Policy

Land Acquisition

Conduct due diligence on

the area before acquisition.

Important Considerations

• Exit strategy

• Transparency

• Taxes

Land Exit

Land sold to developers

with concept plan already

approved by the authorities.


• Zoning process

• Time horizon

• Growth requirements

Land Value Enhancement

Creating value by having

the concept plan approved

by the authorities.


• Safety of investment

• Holding period

• Expected Returns

Land Syndication

Dividing the land in

smaller units and selling it

to investors collectively as

co-owners.


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147Th e most desirable parcels of land for land banking are those that

lie directly in the growth path of developing cities. Th e goal is to

identify such “virgin” parcels well in advance of developers and wait

for the value to be realised. Some of the best known land bankers

are people like Donald Trump and the Rockefellers in the US, Li-Ka

Shing in Hong Kong and the late Ng Teng Fong in Singapore.

Figure 12.2 shows an overview of the land banking process. One

important diff erence between Donald Trump and far less famous

investors like ourselves is that we are investing in undivided units of

land rather than whole big plots of land. Th rough land syndication,

big plots of land are chopped up into investible pieces for sale to

investors like yourselves.

Look Before You LeapInvestors like the concept of land banking as it is a tangible asset

as opposed to stocks and bonds. Based on the advertising that you

have probably seen, you might expect that this investment would

produce attractive returns with little risk. Of course, this is not

always the case.

In fact, land banking has been in the Singapore news recently

because of the failure of a land banking company to honour its

fi nancial obligations on a certain project. Does this mean we should

avoid land banking altogether or was the company’s failure a once-

off event?

Land banking is not regulated by the Monetary Authority of

Singapore (MAS). MoneySENSE, a national fi nancial literacy

program launched by the MAS, issued a consumer article on land

banking in June 2010.2 Th e article explains what land banking

is, highlights the key risks and important questions you should

consider before deciding whether to invest in land banking.

Th e key risks highlighted are:

2 See: www.moneysense.gov.sg/publications/quick_tips/Consumer_Portal_Land_

Banking.html


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148• It could turn out to be a scam.

• What if plans to develop the land are derailed?

• What if you need cash urgently?

• Foreign exchange risks.

Some key questions to ask yourself are:

• What do you know about the land you are purchasing?

• What do you know about the company you are dealing with?

• What do you know about the law of the country where you are

investing in?

As an added note of caution, if you were to perform an Internet

search on “land banking,” you would likely see a fair amount of

negative views on the investment.

Land Banking — Not All Bad NewsLand banking has been available in Singapore for over 15 years and

enjoys a good following amongst many investors. Th ere are many

land banking investors who have earned good double-digit returns

over the years.

Still, we’d like to leave you with more advice on its risks from

our experience with the product. We believe that if you heed more

advice than less, you too can become a successful land banking

investor.

A few more words of caution:

• Remember that there is no guarantee that a land banking

company will repeat its success even if it has had a proper track


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149 record of past performances and its projected returns on land

bank investment look promising.

• If you do invest in land banking, make sure that it is no more

than 5–10 per cent of your total investment portfolio.

• Some land banking fi rms may stress that all their projects

resulted in profi ts for their investors. In such cases, you might

like to check on the duration it took for the investors to exit.

Investors might have waited for a long time before the

development approval took place or the company may have

simply have bought back the project.

• Do your homework because most land banking projects are in

foreign countries and you need to be aware of the rules and laws

in those countries. Th is is not to be taken lightly as any legal dispute

is likely to adhere to the laws and regulations of that country.

• Profi ts are realised when the investors collectively exit from

the project upon approval of the development proposal which

was off ered. Investors should check with the land banking

fi rm on their plans should the proposal fail to get the expected

approvals.

CONCLUSIONInvesting in property is exciting and rewarding, although it can

be fraught with dangers from bubbles to recessions to scams.

Fortunately, there is one fact that always works in our favour: as long

as the underlying economy is growing (and it usually is), chances are

that your property investment will bring you bountiful rewards.

Once you decide that property would be a good addition to

your portfolio, you have many choices. You can invest in a rental

property, property unit trusts, REITs, a land banking project or

other choices you may come across.


Socially Responsible Investing

Humanity is sitting on a ticking time bomb. If the vast majority of the

world’s scientists are right, we have just ten years to avert a major

catastrophe that could send our entire planet into a tail-spin of epic

destruction involving extreme weather, fl oods, droughts, epidemics and

killer heat waves beyond anything we have ever experienced.

~An introduction to the Oscar-winning documentary An Inconvenient

Truth by Al Gore (www.climatecrisis.net)

I don’t think any of you would want to retire a multimillionaire on a

planet where the air stinks with pollution, wars are going on across

continents, and the poor are not getting by with their most basic

food and medical needs. Is there another way?

Integrating your personal, social and environmental concerns

with your fi nancial considerations is called socially responsible

investing (SRI). SRI helps you meet your fi nancial goals while

ensuring that your investments have a positive impact on people

and the planet.

SRI describes an investment strategy that strives to maximise

both fi nancial returns and social good. Th is is also known as

having a “double bottom line”, because you are looking not only for

a profi table investment, but also for one that meets certain moral

criteria and lets you sleep well at night.

Th ere is a wide range of attitudes and values out there as SRI

investors screen companies and funds to check if they confl ict, or

are aligned with their beliefs. For instance, some will not invest in

those that pollute and damage the environment, use innocent mice

for research, or rely on cigarettes and alcohol to make a profi t.

Th ere are also investors who screen according to their religious

beliefs, such as Muslims who will not invest in the pork industry

and interest-bearing securities.

Various terms have been used to describe SRI. Some call it Ethical

13


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151Investing and Green Investing while others refer to the concept as

Environmental, Social and Governance (ESG) investing. Th ese

varying labels make it diffi cult to frame the market, but nevertheless

there are certain shared strategies that form the foundation of SRI.

HOW SRI CAME ABOUTSRI has been around for some time, and its beginnings can be

attributed to many people and places. Many believe social investing

began with the Quakers (a Christian religious denomination

founded in the seventeenth century) in the U.S. that in 1758 took

an offi cial stand against slavery. Religious institutions have been at

the forefront of social investing ever since.

Another early adopter of SRI was John Wesley (1703–1791), one

of the founders of the Methodist Church. A sermon of his, entitled

Th e Use of Money, outlined his principles on social investing that

included not harming your neighbour through your business

practices and avoiding industries such as chemical production that

could harm the health of workers.

Th e modern SRI movement probably began during the Vietnam

War. A photo in 1972 of a naked nine-year-old girl with her back

burning from napalm dropped on her village directed outrage

against Dow Chemical, the manufacturer of the napalm. Th is

prompted widespread protests across the U.S. against Dow

Chemical and other companies profi ting from the Vietnam War. In

the late 1970s, SRI activism turned its attention to nuclear power

and automobile emissions control.

Towards the end of the 1970s, an international outcry was raised

for South Africa to end apartheid, and some investors took their

money out of multinational companies that did business there.

Although economic sanctions against South Africa ended in 1993,

investors continued the practice by applying similar principles to

other companies.

Th e U.S. is the hotbed of SRI activity today. According to Th e

Social Investment Forum, a major national membership association


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152of social investment practitioners and institutions, SRI is growing

at a faster pace than the broader universe of all investment assets

under professional management. Roughly 11 per cent of assets

under professional management in the U.S. are now involved in

SRI. Between 2005 and 2007 alone, SRI assets increased more than

18 per cent while the broader universe of professionally managed

assets increased less than 3 per cent.

WHAT IS YOUR SRI PRIORITY?Before you put any money into SRI, decide what your socially-

oriented priorities are. Not all SRI investors agree on or have the

same priorities, and some issues are more popular than others. For

example, the top fi ve priorities of SRI investors are that they:

1. Reject companies that support the tobacco industry.

2. Reject companies that support the gambling industry.

3. Reject companies that support the alcohol industry.

4. Reject companies that support the defence industry.

5. Support companies that have a good environmental record.

On the lower-priority scale, SRI investors:

1. Support companies that demand human rights practices.

2. Support companies that support labour issues.

3. Support companies with a stance on abortion or birth control.

4. Support companies with a stance on animal rights.


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153Th ere are several approaches you can take to apply your second

bottom line, most of which relate to how strict you are about a

company’s “purity”. For example, how far along the supply chain

would you hold companies accountable? If the company you invest

in sells instant noodles to a casino, would you still invest in it, or

does the company have to be actively participating in the off ending

activity for you to screen it out?

Or you could take another more moderate approach and include

companies under certain conditions. One condition could be that

the company is the best in its industry for taking the most steps

to cut down on pollution, even though it still pollutes. As with

establishing your social issues, the standards to which you hold

companies are also completely up to you.

FINDING SRI OPPORTUNITIESHow do you go about fi nding appropriate SRI investments after

you’ve narrowed down your social priorities?

Th ere really are just two main strategies to consider —

exclusionary or inclusionary.

Exclusionary StrategyIn an exclusionary strategy, you create a list of companies that you

won’t invest in and exclude them from your portfolio. Th e only

thing you need to do with this style of investing is compile a list of

companies you want to avoid. Th is can be very time consuming and

expensive as you have to analyse whole groups of choices to fi nd the

social duds to avoid.

Exclusionary SRI can also become a slippery slope, where you

end up excluding an ever-growing number of companies from your

portfolio. For example, hotel chains are innocent enough, but they

sell alcohol in their cafés and many allow smoking in their rooms. If

you expand SRI investing too far, you could end up excluding large

segments of the economy.


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154When it comes down to the bottom line, few investors may be

willing to throw out traditional investment logic by sacrifi cing

investment opportunities in exchange for the satisfaction of doing

the right thing and sleeping well at night.

Inclusionary StrategyInclusionary investing, also called activist investing, is a more

proactive style. It involves either selectively investing in companies

that share your core beliefs, or purposely investing in companies that

violate them so you can become a shareholder and vote to change

company policy.

By investing in companies that meet your desired ethical values,

you are supporting their eff orts by increasing their stock price. A

good example is green tech companies that are working to provide

alternative energy sources, or fi rms that treat their workers well.

By investing in companies engaging in undesirable practices,

you establish yourself as a shareholder to which the company

management must answer. Th erefore, through activist investing, you

can use your shareholder rights to vote proxies in line with your goals

and attend shareholder meetings to propose appropriate changes.

It is impossible to have a completely “clean” company in the sense

that fi nding a company of any size that is 100 per cent in compliance

with every social and moral guideline all the time is unrealistic.

Nevertheless, the screening process is an honest attempt to fi nd the

truth and pick the best of the lot.

SACRIFICING PERFORMANCE FOR SOCIAL GOOD?As an investor, you cannot be completely philanthropic and expect

nothing in return for your investment other than that pure feeling of

having invested in a company that refl ects your own values.

How do you know if trusting your hard-earned dollars to a tree-

hugger or rainforest conservationist, no matter how earnest and

well intentioned, will actually do something positive for your net


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155worth? Th e reality is that there are no guarantees that your money

will even come back to you, let alone add to your net worth.

SRI advocates argue that screening helps eliminate companies

that have risks not generally recognised by traditional fi nancial

analysis. Critics take the stance that any approach that reduces

the universe of potential investments, will result in a sacrifi ce

in performance. No doubt the debate will continue, but there

are several reasons to be confi dent that investing in a socially

responsible manner does not equate to giving money away.

Here are some statistics to make you feel more at ease. Th e

record of the Domini 400 Social Index (DSI) is an indication that

socially responsible investors do not have to assume a sacrifi ce in

performance for sticking to their values. Created in 1990, the DSI

was the fi rst benchmark for equity portfolios subject to multiple

social screens. Th e DSI is modelled on the S&P 500 and has

outperformed that unscreened index on an annualised basis since

its inception.

Th e next question is, how does the performance of socially

responsible funds measure up to that of a regular portfolio?

Professor of Finance Meir Statman1 of Santa Clara University

reviewed 31 socially screened mutual funds and found that they

outperformed their unscreened peers, but not by a statistically

signifi cant margin. Th e bottom line appears to be that SRI funds do

not behave all that diff erently from regular funds and that investing

in a SRI fund does not negatively aff ect your returns compared with

choosing a conventional index fund.

INVESTING IN VICEIf investing in virtue off ers the possibility of superior returns,

should you focus on SRI and avoid “irresponsible” investments

altogether? In 2002, the Vice Fund was launched in the U.S. to

1“Socially Responsible Mutual Funds”, May/June 2000 issue of the Financial

Analysts Journal.


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156invest in companies that have signifi cant involvement in industries

such as tobacco, gaming, weapons and liquor. According to Daniel

Gross, a columnist for Newsweek who has been following the vice

versus virtue divide, both are eff ective investing strategies and have

handily beaten the S&P 500.2

Is it that investing in vice or virtue is a better investing discipline

than looking at P/E ratios, discounted cash fl ow and charts? Perhaps.

Th e folks managing such funds have clearly been good stock pickers.

As investors ourselves, we can safely say that SRI is a viable

investment strategy, and it’s not just fl uff and apple pie.

INVESTING IN SRIOnce you have established your second bottom line or social

priority, you have two main options: (a) invest in unit trusts or (b)

pick individual companies yourself.

Investing in unit trusts is a good way to begin as it is not easy

to screen companies on your own. Although there aren’t many SRI

funds in Singapore and those available don’t quite span the breadth

of SRI, there are more than a handful of attractive choices. We can

also look internationally for choices and to the future as well when

more choices become available in Singapore as it becomes a bigger

magnet for SRI.

Here are three funds you may consider:

1. Th e DWS Global Climate Change Fund by Deutsche Bank

invests mainly in companies that are active in energy-effi cient

technologies, renewable and alternative energies, and climate

protection. Between 35 and 40 per cent of its portfolio is

invested in the U.S. alone.

2. Th e DBS Mendaki Global Fund launched in September 1997

is one of the oldest SRI funds in Singapore. Th e fund invests in

2www.slate.com/id/2123644/


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157 listed equities anywhere in the world that harmonise with

Islamic philosophy and law.

3. Fortis L Green Future invests primarily in the shares of

companies whose technologies, products and services bring

solutions to environmental problems.

If you are a more active investor, do look at the individual

company investments that SRI unit trusts make. Th e DBS Mendaki

Global Fund, for example, has Apple Computer, BHP Billiton,

Hyfl ux and Keppel Corp among its top holdings (June 2010). If

these companies are already top performers in your books, then

you would be satisfying both your social and fi nancial bottom lines.

POPULAR SRI THEMESLet’s now turn our attention to some of the most popular themes

around today that you have probably been hearing about, such

as corporate social responsibility, green investing, biofuels, solar

energy, water and Islamic fi nance.

Corporate Social ResponsibilityCSR generally applies to company eff orts that go beyond what may

be required by regulators and involve incurring short-term costs

that do not provide immediate fi nancial benefi t to the company, but

instead promote positive social and environmental change.

Companies have a lot of power in the community and in the

economy. Th ey control a lot of assets, and may have billions of

dollars at their disposal for socially conscious investments and

programmes. Even smaller companies with a dozen staff can make

signifi cant contributions to the community in addition to expanding

their corporate bottom lines.

Many of America’s largest companies that had previously been

labelled polluters have adopted eco-friendly ways. Hewlett Packard


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158reports on its website that after 20 years, it has reached its long-

term goal of recycling one billion pounds of computer hardware

and supplies in 2007.

Singapore has its own CSR society called Th e Singapore

Compact. It is a non-profi t organisation whose membership

includes some of Singapore’s largest companies as well as SMEs

(small-medium enterprises). Th e Singapore Compact promotes

the idea that “Companies with positive CSR experiences that have

the support and respect of their stakeholders are more likely to

work better and be sustainable in the long run.” In October 2007,

it congratulated 26 winners of the “Inaugural CSR Recognition

Award for Good Corporate Citizens”.

Green Investing Th ere isn't a huge diff erence between SRI and green investing.

Green investing is actually a form of SRI and both terms refer to

investment philosophies that are backed by ethical guidelines. Th e

biggest diff erence is that green investing focuses on what’s good for

the environment.

Cleantech, or clean technology investing seeks to invest in

environmentally friendly technologies and includes six types of

industries: energy, water and waste water, advanced materials, energy

effi ciency and manufacturing, transportation, and agriculture.

Islamic FinanceLike green investing, Islamic fi nance is a subset of SRI. Islamic

fi nance is based on Islamic principles and jurisprudence (or

Shariah). Th e heart of Islamic fi nance lies in two defi ning principles:

Th e prohibition of riba (interest) and the sharing of profi t and loss.

Th ese principles help to ensure that funds are being channelled into

real business activities as opposed to speculative activities. Islamic

law also prohibits any participation in weapons, pork, gambling,

pornography and alcohol businesses.


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159It used to be that overcoming these prohibitions was very diffi cult

in the conventional fi nance system. Yet as the Islamic fi nance

industry progresses, many Islamic fi nancial institutions have

developed a vast range of products designed to serve the growing

market. Th ese products cater for housing and consumer fi nance,

business loans and project funding. Furthermore, these products are

increasingly providing both Shariah compliance and good returns.

Singaporeans have good access to Islamic fi nance products and

information. Th ere are over a dozen conferences on Islamic fi nance

in Singapore every year today. Singapore is a full member of the

Islamic Financial Services Board (IFSB), which was set up in 2002

to formulate international regulatory and prudential standards for

Islamic fi nance.

Singapore already has a well-developed capital markets

framework to allow our institutions to leverage its conventional

expertise to structure Shariah-compliant versions of their products

and services.

Looking at our neighbours, we have even more positive hope

that Islamic fi nance will reach mainstream channels. Malaysia is

one the world’s leaders in Islamic fi nance and of Islamic fi nance

education, all the way to PhD qualifi cations. And to the south,

Indonesia has the largest Muslim population in the world, who are

themselves actively growing their expertise and market in Islamic

fi nance.

KEEP A LEVEL HEAD BEFORE YOU INVESTIt is easy to let the green movement dictate your pocket book because

wanting good returns and promoting social good at the same time

is an ideal situation for any investor. Yet it is wise to maintain a

level head:

1. Get informed — Learn about socially responsible investing,

which funds qualify and where you can buy them.


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1602. Know your values — Everybody’s values are diff erent. Some

may feel strongly about environmental causes while others are

more concerned with social programmes. Rank your priorities.

3. Go beyond your values — Research the fundamentals and see

if you really feel comfortable. Ask tough questions — are some

of the green investments out there destroying the environment

that they are supposed to protect?

4. Diversify — Th ink of SRI as a focused investment that, together

with your other alternative investments, should occupy no

more than 20 per cent of your retirement portfolio.

Socially responsible investing suggests that you don’t have to

compromise your values to make money. If you approach socially

responsible investments like any other investment, you may be able

to put your money into something that both supports your values

and lines your pocketbook.


Not so according to commodities guru Jim Rogers, a former

partner of George Soros, who says that commodity bull cycles have

historically lasted between 15 and 23 years, and predicted that “the

current bull market will probably last until 2020.”

Investing in Commodities

We are in the midst of the biggest commodities boom in three

decades. Look at how the prices on this commodities index chart are

going through the roof. You can see and feel the commodities boom all

around — record prices reached on oil, rice, copper, platinum.

With such a sharp and swift rise in prices, the obvious question

is, “Is the bull run over?”

FIGURE 14.1. THE COMMODITIES BULL RUN AS SEEN THROUGH THE

THOMSON REUTERS/JEFFERIES CRB INDEX

500

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162WHY ARE COMMODITIES BOOMING?Many reasons. Let us cite three major ones.

The China EffectTh e China eff ect is real. Not only are there 1.3 billion people to

feed, but China has been growing at 9–10 per cent every year for

over 25 years and they now have a huge middle class of 100 million

people clamouring for all sorts of goods and services. Management

consulting fi rm McKinsey & Company expects 700 million Chinese

to have joined the consumer class by 2020.1 It’s not a revolution, it’s

a tidal wave.

Th ey are today the biggest users of mobile phones with 400

million subscribers. Th at’s only 30 per cent of the population. Th ink

of the growth ahead. Galanz, a Chinese company, is the largest

microwave oven maker in the world. It estimates that there are 200

million ovens in Chinese homes today and it is their dream to put

a microwave in every kitchen across China, just as Bill Gates had a

vision to put a computer on every desk and in every home.

China’s boom is also a refl ection of the Asian boom in general.

Forbes reported that the number of billionaires in Asia jumped

more than 30 per cent in 2007. In 2010, Forbes reported that a total

of 64 people from the China made the list of the world’s richest

billionaires, moving up to take second place behind the U.S. A lot of

the fortunes in Asia have been made in real estate and infrastructure

development. Global Property Guide reports that real estate price

increases in Asia-Pacifi c should continue to impress in the coming

years, while E.U. prices have moderated and the U.S. is mired in a

housing crisis.

Tight SuppliesTh ere are tight supplies across many commodity markets. Take oil

for example. Th ere have been no major oil discoveries in the last 40

1http://www.csmonitor.com/2007/0102/p01s02-woap.html


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163years according to Jim Rogers, while the reserves in Alaska, Mexico

and the North Sea continue to decline. Of the six top countries in the

world with the largest oil reserves, fi ve are in the Middle East, and

politically volatile Iran and Iraq are at numbers three and four, where

supply jolts can happen anytime and threaten production.

In 2006, the U.S. consumed more than twice as much oil as

did China, and we know that the gap can only decrease as China

becomes wealthier and more industrialised.

The Falling US$Th e falling U.S. dollar, combined with tight supplies across many

commodity markets, has fuelled the big run up in commodity prices.

If the dollar is falling, commodity prices have to go up just to keep

relative values the same. Th at’s because many non-U.S. commodity

producers still price their exports in dollars, and a weaker dollar

prompts them to seek higher prices.

Th e interest rate cuts by the Federal Reserve have also helped

push commodity prices higher. On the one hand, the cuts make a

recession less likely as companies would continue to borrow to fund

growth, thus bolstering demand for commodities. On the other

hand, the cuts have also further encouraged currency investors to

sell off dollars in the search for higher yield.

Well, enough of these present day trends for now. In the end, we

have to treat commodities as commodities whether the market is

going up or down. What we need to do is fi nd out if commodities

make a good addition to a long-term portfolio. So let’s get back to

some of the basics behind commodities.

WHAT IS A COMMODITY?A commodity is a basic, undiff erentiated good such as sugar or oil.

Whether a pound of sugar comes from a producer in the Philippines

or another producer in Brazil makes no diff erence in terms of

quality. A pound of sugar from anywhere in the world is pretty much

the same product, regardless of the producer. Th ey are generally


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164real assets with intrinsic value because they are consumed on a

regular basis.

Commodities are also often used as inputs in the production of

other goods or services. For example, sand, which Singapore buys

a lot of, is a major component of concrete, glass production, brick

manufacturing, landscaping and land reclamation.

Is a Mona Lisa painting a commodity? Not the original painting

by Leonardo da Vinci for sure. Th e reason is that the Mona Lisa is

unique and diff erentiated from all other paintings. Th e iPod whose

quality and features can be clearly diff erentiated from other MP3

products is also not a commodity.

Today’s Commodity MarketsTh ere are around 100 main commodities that are frequently traded

and they are generally classifi ed into three main groups:

A. Energy

B. Metals

• Base Metals

• Precious Metals

C. Agriculture

• Grains

• Softs

• Livestock

Energy encompasses a basketful of products used to provide

energy to heat and power homes and businesses. Th e most common

are petroleum and its byproducts: crude oil, heating oil, propane,

natural gas and coal.

Base metals refer to industrial non-ferrous metals, excluding

precious metals. Th ese include copper, aluminium, lead, nickel,

tin and zinc. Note: Ferrous metals contain iron while non-ferrous


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165metals do not. Ferrous metals are usually magnetic and rust.

Precious metals are rare and have high economic value. Th ey

include gold, silver, platinum and palladium. Chemically, they are

less reactive than most elements, have high lustre, are softer and

have higher melting points than other metals. Historically, precious

metals were important as currency, but are now regarded mainly as

investment and industrial commodities.

Grains or cereal crops are mostly grasses cultivated for their

edible grains or fruit seeds. Maize, wheat and rice account for

85 per cent of all grain production worldwide. Other grains that are

important in some places have little global production and do not

show up on exchanges. Th ese include durum (used to make pasta)

and wild rice.

Softs is a label for a set of commodities, usually including cocoa,

sugar, and coff ee, but also including cotton and orange juice.

Livestock refers to animals used for meat production, and

includes live cattle, pork bellies and lean hogs.

Non-Traditional CommoditiesMore recently, the defi nition of commodities has expanded to

include fi nancial products such as foreign currencies and indices.

Technological advances have also led to new types of commodities

such as carbon credits, weather and bandwidth.

THE TRADING OF COMMODITIES Th e trading of commodities is done mainly at commodity exchanges.

A commodity exchange is an entity, usually an incorporated non-

profi t set-up, that determines and enforces rules and procedures

for trading. It also refers to the physical centre where trading

takes place.

Th ree of the world’s top exchanges are:

1. New York Mercantile Exchange (NYMEX) —Founded in 1872,

NYMEX is the world’s largest physical commodity futures


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166 exchange for energy and precious metals. Th e prices quoted

for transactions on the exchange are the basis for prices that

people pay for physical commodities throughout the world.

2. Chicago Board of Trade (CBOT) — Established in 1848,

CBOT is the world’s oldest commodity exchange for trading

in futures and options. CBOT trades more than 50 diff erent

futures and options in agricultural commodities, fi nancial

derivatives based on U.S. Government bonds and notes,

mortgage-backed certifi cates, and more recently, South

American Ethanol futures.

3. Th e London Metal Exchange (LME) — Founded in 1877, LME

is the world’s largest market in cash and futures for non-ferrous

metals, including aluminium, copper, nickel, tin, zinc and lead.

COMMODITY INDICESCommodity indices provide investors with a reliable and publicly

available benchmark for investment performance in the commodity

markets, just as what the S&P 500 or MSCI Singapore indices do

for their respective markets. Several unit trusts and ETFs are

benchmarked against these indices.

Four of the most quoted commodity indices are:

1. Th e Dow Jones-UBS Commodity Indexes (DJ UBSCI) is

composed of futures contracts on physical commodities.

Nineteen commodities are included in the index representing

the following commodity sectors: energy, precious metals,

industrial metals, livestock and agriculture. Th e represented

commodities are traded on U.S. exchanges, with the exception

of three, which trade on the London Metal Exchange (LME).

None are based in Asia, which means that the index does not

include rice, a staple of a large percentage of the world’s

population.


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1672.Th e Reuters/Jeff eries CRB Index (TRJ/CRB) was launched

in 1957. Th e components of this index were, until 2005, equally

weighted. Th is resulted, for better or worse, in orange juice

having the same weight as crude oil. With the makeover,

component weights are assigned and rebalanced monthly. For

example, crude oil has a fi xed weighting of 23 per cent. If its

weight rises to 30 per cent because crude oil prices have gone

up relatively more than other commodities, the weight is

rebalanced back to 23 per cent.

3. Th e S&P GSCI Commodity Index (S&P GSCI) was created

in 1992 and is made up of 24 commodity components from

all commodity sectors: six energy products, fi ve industrial

metals, eight agricultural products, three livestock products and

two precious metals. Th is broad range of constituent

commodities provides the S&P GSCI with a high level of

diversifi cation, both across sub-sectors and within each sub-

sector. Th e goal of the GSCI is to measure commodities in a

way that refl ects their current importance in the global

economy. More weight is automatically allocated to

commodities that have risen in price.

4. Th e Rogers International Commodities Index (RICI) RICI

is the most diversifi ed commodities index available and tracks

35 commodities. Jim Rogers created the index in 1999 and

the index is weighted according to what he considers to be

each commodity’s importance to the global economy. Th e

index includes commodities that do not appear in other indices

such as: rice, rubber and lumber.

BUYING AND SELLING COMMODITIESSpot TradingBuying and selling commodities can be done on the spot through

“spot trading” where delivery takes place within a few business days.


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168Spot trading is not the main way in which commodities are bought

and sold. If you consider the fact that commodities are almost always

bought in large quantities, few buyers would want to take the risk

of accepting whatever the spot price is at the time of purchase, and

immediate delivery.

Futures TradingInstead, most commodities are traded on futures exchanges such as

NYMEX and CBOT. Th e prices of commodities are effi ciently and

transparently discovered through the participation of thousands of

buyers and sellers. Here are a sample of commodity contracts, where

they are traded and how they are quoted.

Not all contracts around the world are traded in US$ of course.

We are only showing you contracts traded on the main exchanges

we discussed earlier. At the Tokyo Grain Exchange, for example,

corn is traded in Yen while it is traded in US$ on CBOT.

TABLE 14.1. EXAMPLES OF COMMODITY CONTRACTS

Commodity Exchange Quote

Energy

Light Crude NYMEX US$ per barrel

Heating Oil NYMEX US$ per gallon

Natural Gas NYMEX US$ per mmBtu

Unleaded Gas NYMEX US$ per gallon

Metals

Gold COMEX US$ per troy oz

Silver COMEX US$ per troy oz

Platinum NYMEX US$ per troy oz

Copper LME US$ per tonne


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169

Trading StrategiesTh ose who participate in futures markets usually have two main

trading strategies. One may speculate by taking a position such as

buying a gold futures contract in the hope that gold would rise in

price.

Or one may hedge to mitigate the risk of a natural position in the

commodity. For example, a farmer can insure against a poor wheat

harvest by purchasing wheat futures contracts. If the wheat crop is

signifi cantly less due to bad weather, the farmer makes up for that

loss with a profi t in the futures contract, since the overall supply of

the crop is short everywhere that suff ered the same conditions.

For most investors, trading directly in commodities has a high

level of risk not only because of the volatility of commodity prices,

but also because it requires sophisticated skills and dedicated time

to follow a market that’s dominated by large commodity houses and

fi nancial institutions.

Commodity Index FundsFor investors looking to diversify their portfolios without wanting

to trade directly, commodity funds are a good choice. Some funds

specifi cally track commodity indices:

Commodity Exchange Quote

Agriculture

Lean Hogs CME US cents per lb

Pork Bellies CME US cents per lb

Live Cattle CME US cents per lb

Feeder Cattle CME US cents per lb

Corn CBOT US cents per bushel

Soybeans CBOT US cents per bushel



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170• Th e Lyxor ETF Commodities CRB, which is available in

Singapore, tracks the RJ/CRB index. Th is exchange-traded fund

began trading on SGX in January 2007.

Commodity Unit TrustsIn Singapore, there are about a dozen unit trusts available for retail

investors. Th ese unit trusts are managed by fund management

companies such as ABN AMRO, Deutsche Bank, Schroder, First

State, Prudential, Lion Capital and UOB.

Th ese unit trusts generally invest broadly across the major

categories of commodities or they focus on specifi c sectors of the

commodities market, such as gold, energy and agriculture.

Commodity StocksFinally, the investor can buy stocks that are linked directly to

commodities such as palm oil, iron ore and energy. Singapore-

listed Wilmar is the world’s largest processor and merchandiser of

palm oil, and also the largest palm biodiesel manufacturer in the

world. Australian company BHP Billiton is one of the world’s largest

diversifi ed producer of diamonds, coal, iron ore, aluminium, oil and

natural gas.

COMMODITIES AS PART OF YOUR LONG-TERM PORTFOLIOTh ere’s no doubt in our minds that an investment in commodities

makes sense for our bottom line for several reasons:

1. Infl ation hedge potential — Commodities has recognised value

all over the world, and this value does not depend on any

nation’s economy or currency. Over time, most commodities

have held their values against infl ation very well because

anticipated trends in infl ation are priced into them. Th e

Consumer Price Index in Singapore, which is the key indicator

of retail infl ation, has been rising along with price increases in

rice, bus fares, petrol and food at food courts.


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1712. Participation in global growth — Demand for commodities

keeps growing in industrialising and emerging markets

such as China, India and the Middle East. As these regions

grow economically, so will their demand for commodities

sourced from all over the world.

3. Portfolio diversifi cation — Commodities have been found to

have a low correlation to stocks and bonds. In fact, commodities

tend to do well when stocks and bonds are down. According to

one U.S. study that looked at the correlation between

commodities and various asset classes, it was found that each

asset class had a negative correlation with commodities during

the period 1970 to 2003.2 Th is means that commodities are a

good addition to a portfolio as they reduce overall volatility.

Two words of caution though. Commodities are highly volatile,

even more so than stocks. If you cannot stomach huge, sudden

losses, commodities should never occupy a large portion of your

retirement portfolio.

Our last word of caution is that commodities are subject to long

up and down cycles. We are no doubt in the midst of a strong up

cycle. As an investor in commodities, you cannot just buy, hold and

sit back. You have to be more active in your monitoring. Just as up

cycles can last 20 years, down cycles have been known to last just

as long.

2Th e asset compared with commodities were U.S. stocks, international stocks, U.S.

government bonds, U.S. Treasury bills and small-cap companies. “Commodities as

an Asset Class”, www.investorsolutions.com.


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172

Investing in Gold

Th inking to get at once all the gold the goose could give, he killed it and

opened it only to fi nd — nothing.

~Aesop (620 b.c. – 560 b.c.), Th e Goose with the Golden Eggs

Man’s fascination with gold is timeless. Gold is beautiful and scarce.

It does not rust or tarnish. It is easily shaped and easily divisible.

Gold will always have a value.

Over the years, gold has been recognised and accepted by almost

everybody as an ideal medium of exchange and store of value.

Th e reasons for investing in gold have remained much the same

throughout history. Gold is a safe haven in times of economic and

fi nancial instability. It is a proven asset-diversifi er that, when included

in a portfolio, reduces the portfolio’s overall risk. Gold is also an

excellent hedge against infl ation over the long term. And gold is one

of the few assets that are negatively correlated with the U.S. dollar.

Besides being a highly reliable store of value, gold is widely used

as jewellery and coinage, and in industries.

Like other precious metals, gold is measured by troy weight

and by grams and when it is alloyed with other metals, the term

carat is used to indicate the amount of gold present, with 24 carats

being pure gold. Th e purity of a gold bar can also be expressed as a

decimal fi gure, known as the millesimal fi neness, such as 0.995.

Th e price of gold is determined on the open market, but a

procedure known as Gold Fixing in London, originating in 1919,

provides a twice-daily benchmark fi gure for the industry.

Gold prices have been on a bull run. Prices rose to over US$900

in April 2008 from average prices of below US$40 in the early 1970s

(see Figure 15.1.). Why have gold prices suddenly shot up in the last

three decades? To answer this and other questions, we begin with a

short history of gold.

15


173

A SHORT HISTORY OF GOLDEgyptian hieroglyphs dating from 2600 b.c. have described gold as

being “common as dust.” Gold is mentioned several times in the Old

Testament. Exploitation is said to date from the time of Midas, and

this gold was important in the establishment of what is probably the

world’s earliest coinage in Lydia in 700 b.c.

Gold has thus long been considered one of the most precious

metals, and its value was used as the standard for many currencies

(known as the gold standard) in history. Th e gold standard is

defi ned as “a commitment by participating countries to fi x the

prices of their domestic currencies in terms of a specifi ed amount

of gold.” Money and near-money (bank deposits and notes) were

freely converted into gold at a fi xed price. A country under the

gold standard would set a price for gold, say $100 an ounce, and

would buy and sell gold at that price. Th is eff ectively sets a value

for the currency; in our example $1 would be worth 1/100th of

FIGURE 15.1. GOLD PRICE SINCE THE EARLY ‘70S

GOLD PRICE, $ PER OUNCE (LONDON PM FIX)

Jan 71 Jan 74 Jan 77 Jan 80 Jan 83 Jan 85 Jan 89 Jan 92 Jan 95 Jan 98 Jan 01 Jan 04 Jan 07 Jan 100

100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

1400

Source: Global InsightSource: Global Insight

Source: Courtesy of World Gold Council, www.gold.org


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174an ounce of gold. Other precious metals could be used to set a

monetary standard; silver standards were common in the 1800s. A

combination of the gold and silver standard, known as bimetallism,

also existed.

During most of the 1800s, the U.S. had a bimetallic system of

money. A true gold standard came about in 1900 with the passage

of the Gold Standard Act. Th e gold standard eff ectively came to an

end in 1933 when President Th eodore Roosevelt outlawed private

gold ownership (except for the purposes of jewellery). Th e Bretton

Woods System, enacted in 1946, created a system of fi xed exchange

rates that allowed governments to sell their gold to the United

States treasury at the price of US$35 per ounce.

Th e Bretton Woods System ended on 15 August 1971, when

President Richard Nixon ended the trading of gold at the fi xed price

of US$35 per ounce. At that point, for the fi rst time in history, formal

links between the major world currencies and real commodities were

severed. Th e gold standard has not been used in any major economy

since that time. Almost every country, including the United States, is

on a system of fi at money, which is money that is intrinsically useless

and is used only as a medium of exchange.

THE CONTINUING IMPORTANCE OF GOLDGiven that gold no longer backs the U.S. dollar and other major

worldwide currencies, why is it still important today? Th e reason is

that while gold is no longer in the forefront of everyday transactions,

it is still important in the global economy. Central banks and other

fi nancial organisations hold approximately one-fi fth of the world’s

supply of above-ground gold. In addition, several central banks have

focused their eff orts on adding to their present gold reserves as their

currency reserves soar.

Compared with paper money, gold has successfully preserved

wealth throughout thousands of generations. Th e same cannot be

said about paper-denominated currencies because the value of a

dollar is constantly being eroded by infl ation. And when investors


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175realise that their money is losing value, especially when infl ation is

rising, they will start positioning their investments in a hard asset

that has traditionally maintained its value. Th e 1970s testify to this

as gold prices largely rose as a result of soaring infl ation.

Demand and SupplyTh e supply of gold is fairly constant from year to year although

production has been slowing down slightly during the past few years.

Source: www.goldsheetlinks.com

TABLE 15.1. WORLD’S TOP FIVE GOLD PRODUCERS

Year 1 2 3 4 5

1995 S Africa USA Australia Canada China

2000 S Africa USA Australia China Canada

2005 S Africa Australia USA China Peru

2006 S Africa USA Australia China Peru

2007 China S Africa USA Australia Indonesia

2008 China USA S Africa Australia Peru

Source: www.goldsheetlinks.com

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FIGURE 15.2. WORLD ANNUAL GOLD OUTPUT

1995 2000 2005 2006 2007

2444

2356

2518

2252

2008

2600

2500

2400

2300

2200

2100

2000

2469

2573


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176One reason for the drop in world output is South Africa’s falling

production in the past few years. As Table 15.1 shows, South Africa

was the top producer year after year for over 100 years till 2007 when

China overtook South Africa to become the world’s top producer.

Most of China’s gold output stays in the country where it’s

transformed into jewellery and industrial items. Along with China’s

demand, which makes it the largest consumer in the world, India is

the world’s number one importer as its increasingly wealthy middle

and upper classes continue to buy and adorn gold.

Gold’s role as a safe haven is indisputable as investors typically

run to it during times of political and economic uncertainty —

especially today amidst the subprime crisis, the falling U.S. dollar,

Middle East tensions and rising infl ation. During such times,

investors in the past who held on to gold were able to protect their

wealth successfully, and, in some cases, even use gold to escape

from the turmoil. Consequently, whenever there are news events

that hint at some type of uncertainty, investors will often buy gold

as a safe haven.

Th e cost to mine gold varies from US$150 to $400 per troy ounce,

with South African mines at the higher end (10,000 feet or more)

and Canadian mines at the lower end (1,000 feet or so). Added to

the high cost of mining are the hundreds of millions of dollars and

amount of time (three to fi ve years) it takes to start a new mine.

All these above factors help ensure that supply is unlikely to

increase any more than 1 to 2 per cent each year and that demand is

very likely to expand because of economic uncertainty and the rising

wealth in gold-hungry countries such as China and India.

HOW TO INVEST IN GOLDInvestors who wish to invest in gold can do so in fi ve ways:

1. Gold bullion bars and coins,

2. Gold certifi cates,


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1773. Gold mining shares,

4. Gold unit trusts and ETFs, and

5. Gold derivatives.

Prices for all these investment options are available daily from

banks and brokerages.

Gold Bullion Bars and Coins You can buy physical gold bars in a variety of weights ranging from

1 gram to the popular kilobar (32.15 troy ounces) to the international

“London Good Delivery” bar (400 troy ounces). Gold coins are

legal tender in the country of issuance and their gold content

is guaranteed.

Th e bullion coin bears a face value that is largely symbolic. Its

true value depends on its gold content and its numismatic value (or

collector’s value). An example is the Singapore Lion Gold Bullion

Coin, which ranges from one to 1/20 ounce.

One disadvantage of buying physical is that you’ll have to pay

GST, which is currently 7 per cent.

Gold CertificatesIf you do not want to hold gold physically, especially if you have a

large investment, you can invest in gold certifi cates, usually of one

kilobar each, up to a maximum of 30 kilobars. Th ere is no GST on

certifi cates. Th e gold is kept in the bank’s vault.

Th ese certifi cates can easily be exchanged for physical gold or

cash. However, the bank charges an annual administrative fee of

typically $30 per kilobar per annum, and $5 for each certifi cate.

Gold Savings Account You can buy and sell gold through a passbook at prevailing market

prices. UOB introduced the fi rst gold savings account in Singapore


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178in 1981. Gold savings accounts allow those who want to trade

frequently to buy and sell in 1g lots.

Gold Mining Shares Some investors may be comfortable accessing the gold market by

buying stock in gold mining fi rms. Th e capital appreciation potential

of a gold share is dependent not only on the future price of gold, but

also on the future prospects of the company, based on its management

and operating strengths. Where these companies make the most is

exploration, but that is also where one fi nds the highest risk.

Some of the most established gold mining companies in the world

are found on the NYSE. Denver-based Newmont Mining is one of the

world’s largest companies producing eight million ounces annually,

with a diversifi ed number of mines in several parts of the world,

including Nevada, South America, Australia, Russia and Indonesia.

Gold Unit Trusts and ETFsWith gold unit trusts, investors are buying general industry and

market risk instead of company-specifi c risk. Funds diversify their

holdings among dozens of companies. Th e United Gold and General

Fund is one such fund in Singapore. Th e United fund was launched

in 1995 and is globally diversifi ed across the industry. Not the entire

portfolio is in gold as about one-third of the fund is typically in base

metals (such as iron ore and copper) and about two-thirds are in

gold and precious metals.

Another way to invest in gold is through the SPDR Gold Shares

ETF listed on the Singapore Exchange, where your ETF shares

can be bought and sold at any time. Th e ETF is benchmarked to

spot gold, which means that it is as good as buying physical gold,

minus the fund’s expenses, and the transaction cost involved is

lower than the cost of buying and safekeeping physical gold.

Gold DerivativesGold futures and options are traded on established exchanges


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179around the world. At COMEX (New York Commodity Exchange,

the leading U.S. exchange for metals futures and options trading),

for example, each gold futures contract is for 100 troy ounces of

not less than .995 fi neness, and bears a serial number and the

identifying stamp of a refi ner approved and listed by the Exchange.

A similar contract is available through SGX-DT, but trading is not

very active.

THE RISK OF GOLD INVESTINGAs a tangible investment, gold is often held as part of a portfolio

because over the long term, gold has an extensive history of

maintaining its value. Still, gold, like all investments, involve risk.

Gold prices have historically seen strong fl uctuations that saw it hit

a 20-year low in 1999.

One reason for fl uctuating prices is that the value of a bullion coin

or a gold unit trust is directly aff ected by the current spot or market

price of bullion. Th is price fl uctuates daily and can be aff ected by a

multitude of factors, such as the perceived scarcity of gold, current

demand, market sentiment and economic factors. Th erefore, the

price of your gold investment can go down as well as up in value.

Second, like all prices, the gold price refl ects not only the

inherent value of gold, but also the relative strength of the currency

in which it is quoted. For example, the dollar price of gold may

increase more in percentage terms than the sterling price, to the

extent that the change in price is a refl ection of dollar weakness

(in this case, against the sterling), rather than an intrinsic change

in gold market fundamentals. So if you purchase a gold investment

in U.S. dollars and the U.S. dollar has increased 20 per cent by the

time you sell it 12 months later, your investment would have fallen

in value by 20 per cent — regardless of any change in gold market

fundamentals.

Th e strength of the U.S. dollar in the two decades between 1980

and 2000 was an important reason for gold prices not performing

well during those years. It was in part the rapid rise in the dollar


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180that hurt the dollar gold price. Another reason for gold’s poor

performance between 1980 and 2000 was the success of the world’s

central bankers in fi ghting infl ation. Gold’s role as a hedge against

infl ation is one of the main reasons people buy it.

MANAGING GOLD IN YOUR PORTFOLIODespite the volatility of gold prices and its sensitivity to fundamental

factors, the diversifi cation benefi ts of gold in a portfolio are backed

by strong evidence. Ibbotson Associates, a leading authority on

asset allocation, performed a study with respect to the portfolio

diversifi cation benefi ts of gold, silver and platinum bullion,

covering a 33-year period from February 1971 to December 2004.

Ibbotson determined that of the seven types of assets covered

in the study, the precious metals asset class is the only one with

a negative correlation to other asset classes. What this means is

that precious metals perform best during the years that traditional

asset classes, such as stocks and bonds, had negative returns.

Ibbotson determined that investors can potentially improve their

portfolio risk-reward performance by including precious metals

with allocations of between 7.1 and 15.7 per cent for conservative

to aggressive portfolios respectively.

Historically, gold has produced excellent long-term gains during

up cycles; however, it may not be suitable for everyone. You should

acquire a good understanding of gold products before you invest

in them. Since all investments, including gold, can decline in value,

you should have adequate cash reserves and disposable income

before considering a precious metals investment.

In the end, speculating in gold should be avoided at all cost by

conservative investors. Speculating involves short-term trading

and the early withdrawal from accounts or securities can result in

substantial penalties or fees — in addition to any decrease in gold

prices due to fundamental factors.


Investing in Hedge Funds

How would you like to invest in a fund that makes money in a bear

market as well as in a bull market? Hedge funds aim to do just that, and

as consistently as possible, regardless of market conditions. What’s

more, hedge funds can be very good for your portfolio. Th ey can

reduce overall risk and quite often, they can also increase returns.

Look at Figure 16.1 (below), which compares three major indices.

While the S&P 500 and Dow Jones World Index went on major

roller coaster rides between Dec 1993 and Dec 2000, the Credit

Suisse Hedge Fund Index (indicated by the arrow) chugged along

very smoothly throughout the 17-year period. Compared with both

indexes, the hedge fund index was not only less volatile, but it also

provided higher returns, at lower risk.

FIGURE 16.1. COMPARING PERFORMANCE OF THE S&P 500, DOW JONES

WORLD INDEX AND CREDIT SUISSE HEDGE FUND INDEX

Th is is the stellar reputation of hedge funds that many of you

may have heard about. In this chapter, we will help you examine

whether hedge funds are right for you, and how they can fi t into

your portfolio.

Copyright 2010, Credit Suisse Hedge Index LLC. All rights reservedC ii htght 20201010 CC didit St S ii H dH dg I dI d LLCLLC AAllll iightht dd

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182WHAT ARE HEDGE FUNDS?To most investors, hedge funds are shrouded in mystery. When

considering if a fund is a hedge fund, MAS looks at whether:

• Non-traditional investment strategies such as leverage, short

selling and arbitrage are used; or

• Investments are in non-mainstream asset classes, that is,

investments other than listed equities, bonds and cash.

Leverage Leverage is used to increase risk. It refers to the degree to which the

fund is using borrowed money to invest. If a fund is leveraged 100

per cent, it means that it has borrowed $1 for every $1 that it actually

has. Profi ts as well as losses are magnifi ed 100 per cent as a result.

Short Selling Th is is an aggressive strategy of sell-high, buy-low rather than the

traditional strategy used by unit trusts of buy-low, sell-high (called

a long strategy).

Short selling has unlimited risk. Here is an example that will

help you understand how short selling works. Suppose you enter a

contract to deliver a Toyota you do not own for $50,000. In other

words, you are short-selling the Toyota. What you hope will happen

is that Toyota prices will drop and you can buy a Toyota for a lower

price of say, $40,000, and deliver the car to make a $10,000 profi t.

However, what happens if the price of the car goes up instead?

Technically, prices could go up to $60,000, or $80,000 or beyond.

You see, price, in theory has no ceiling, and that is why short selling

is an unlimited risk strategy.

Arbitrage Hedge funds use arbitrage to exploit mispricings between related

securities. For example, one can take a long position in Company


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183A’s convertible bonds and short its stock. An example would help.

Suppose Sri Lankan crabs are selling at $50 a kilogramme at the Pasir

Panjang Wholesale Centre. Over at the Telok Blangah wet market,

the crabs are going for $80 a kilogramme. If you are able to buy crabs

from Pasir Panjang and sell them at Telok Blangah, you would have,

in essence, made a profi t by exploiting a mispricing situation.

Th is suggests that hedge funds are not for everyone. A retail investor

who is just starting out to invest, or a retiree wishing to protect her

income, should not be placing money in hedge funds. Th ese funds

employ aggressive strategies and are exempt from many of the rules

and regulations governing unit trusts. Individuals who buy hedge

funds are usually deemed “sophisticated” and they usually have to

pay high minimum investment amounts.

In the U.S., an investment fund can be exempt from direct

regulation if it is open to accredited investors only, and only

a limited number of investors can belong to it. Because of an

exemption from the types of regulation that apply to mutual

funds, hedge funds can invest in more complex and more risky

investments than a retail fund might.

HEDGE FUND STRATEGIESA wide range of investment styles and strategies are available to

hedge funds. Table 16.1 lists some of the most popular.

What makes hedge funds diff erent is their diversity. Th e variety

of hedge fund strategies far exceeds anything off ered by traditional

unit trusts.

TABLE 16.1. POPULAR HEDGE FUND STRATEGIES

Strategy Objective

Convertible ArbitrageExploit price ineffi ciencies between convertible securities and stock.

Dedicated Short BiasEquity and derivatives portfolios with net short, “bearish” focus.


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184

Classifying Hedge FundsSome funds employ only one strategy; others may use several. Some

funds are more speculative and comb the world for opportunities;

others are less risky and off er protection for your invested capital.

We can hence classify hedge funds in a broader way:

1. Single strategy funds,

2. Fund of funds, or multi-strategy, and

3. Capital guaranteed and protected hedge funds.

Single Strategy Funds

If a hedge fund adopts one main strategy, it is called a single strategy

Strategy Objective

Emerging MarketsEquity and fi xed-income investments in emerging markets worldwide.

Equity Market-NeutralOff setting long and short equity positions that are beta-neutral, currency neutral, or both.

Event DrivenCorporate strategies focused on distressed securities, high-yield debt, and risk arbitrage.

Fixed-Income ArbitrageExploiting price ineffi ciencies between related debt securities.

Global Macro Directional macroeconomic strategies.

Long-Short EquityDirectional equity and equity derivative strategies.

Managed FuturesListed futures strategies often driven by technical or market analysis.

Multi Strategy Multiple strategies.

Source: www.hedgeindex.com


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185hedge fund. Single strategy funds clearly come with higher risk

because if the strategy fails, the entire fund loses money.

Fund of funds

A fund of funds invests in other hedge funds as a means of

diversifying strategies and managers. Th e risk for such funds is

generally lower than that of single strategy funds. For these funds

to succeed, the manager’s ability to choose good funds is more

important than his ability to execute any single strategy.

Fund of funds do have some disadvantages. For one, investors

have to pay two layers of fees — one for the individual funds and

another for the fund of funds manager.

Guaranteed Hedge Funds

Th ese funds work like their retail cousins. Th ey invest a high

proportion of their assets (say 70 per cent) in bonds that mature

to provide 100 per cent of the capital guarantee and the rest of the

money (30 per cent) is invested in other hedge funds, derivatives and

other speculative securities to provide the upside kicker in returns.

Guaranteed hedge funds have a fi xed maturity of typically fi ve

to 10 years. If you invest in one of these funds, be prepared to stay

the course. Asking for your money back after two years will cost

you in terms of likely capital losses and redemption fees.

Th ey diff er from retail guaranteed funds in two ways. Th e

bonds invested in tend to be higher-yielding and are often not of

investment-grade quality. While retail funds may have 90 per cent

in bonds, guaranteed hedge funds may have 80 per cent or less

because of higher yields.

Th e second diff erence is that guaranteed hedge funds tend to

make use of leverage. For example, a guaranteed hedge fund that

has borrowed 40 per cent can be invested at 140 per cent of its

capital: 80 per cent into bonds and 60 per cent into derivatives.

Retail guaranteed funds in comparison would only have the

remaining 20 per cent to invest in derivatives.


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186Should You Invest in Hedge Funds?Investors are drawn to hedge funds for many reasons, but are

hedge funds right for you? Your decision should take into account

these factors:

1. Diversifi cation

At the most basic level, hedge funds can be thought of as just

another investment alternative, as are bond funds and REITs.

For investors with the means and appetite, hedge funds can

certainly help diversify a portfolio.1

Th ose strongly in favour of hedge funds often cite statistics

that show hedge funds not only reduce portfolio risk, but also

increase portfolio returns because of spectacular performance.

Th ose who are fearful about hedge funds cite fudged statistics

and underhand tactics.

2. Th e best talents are drawn to hedge funds

Th e compensation of hedge fund managers is mostly tied to

the fund’s performance. Th is attracts the best talents. Also,

hedge fund managers themselves are usually one of the key

investors in the fund. Th ese are two very strong incentives for

fund managers to perform. Unit trust managers, on the other

hand, make money whether the fund goes up or down in price.

Investing in Hedge Funds in SingaporeInvestors can choose between domestic hedge funds and off shore

hedge funds. Domestic hedge funds are organised within Singapore.

Investors are protected by Singapore regulations.

MAS has set guidelines for the minimum subscription amounts

for hedge funds:

1Th e CSFB/Tremont Hedge Fund Index has a 0.47 correlation with the MSCI

World Index. Source: www.hedgeindex.com.


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187• Single strategy funds — $100,000

• Fund of funds —$20,000

• Capital protected and capital guaranteed funds — no minimum

subscription where certain criteria are met

MAS in April 2010 announced that new regulations will require

hedge-fund fi rms in Singapore that manage more than S$250

million to be licensed. Hedge-fund fi rms were previously exempt

from holding a license provided they manage funds on behalf of

no more than 30 qualifi ed investors.2 Th ose that manage less than

S$250 million would not need a license although they will have to

maintain a base capital of at least S$250,000.

Off shore hedge funds are structured under foreign law and are

available only for accredited investors and not for retail investors.

Since such funds are managed outside Singapore, they are regulated

under foreign laws. While this does not mean no recourse for the

investor should fraud or scandals occur, it does make things a lot

more diffi cult for investors should something go wrong.

DIFFERENCES BETWEEN HEDGE FUNDS AND UNIT TRUSTSIn considering whether hedge funds are right for you, there are a few

important diff erences between them and unit trusts that you should

be aware of (see summary in Table 16.2. on page 168):

1. Absolute performance

Unit trusts are mainly measured on relative performance based

on a relevant benchmark such as the S&P 500 index. Hedge

2A “qualifi ed investor” is an accredited investor, or a fund whose underlying investors

are all “accredited investors”. An accredited investor is defi ned under the Securities

and Futures Act as one earning at least $300,000 for the last 12 months or one

who owns at least $2 million in net assets, or her aggregate consideration for the

acquisition is not less than $200,000 for each transaction. An accredited investor may

also be a corporation with net assets exceeding $10 million in value.


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188 funds on the other hand are expected to deliver absolute returns

— they attempt to make profi ts in diff erent market conditions,

even when the relative indices are down.

2. Hedging risk in a downturn

Hedge funds can protect against declining markets by using

hedging strategies such as shorting. Unit trusts are not able to

protect portfolios eff ectively against declining markets.

3. Performance-based remuneration

Hedge fund managers are rewarded with performance-related

incentive fees as well as fi xed fees. Unit trust managers are

generally rewarded based on the size of the assets under their

management.

HOW MUCH DO TOP HEDGE FUND MANAGERS MAKE?

Hedge fund managers can make a scary amount of money.

John Paulson, founder of New York based Paulson & Co,

was paid an estimated US$3.7 billion in 2007, according to

Institutional Investor’s Alpha magazine.

Th e average compensation for the top 25 fund managers

was US$892 million in 2007. Th e “poorest” fund manager in

the top 50 made US$210 million.

TABLE 16.2. SUMMARY OF DIFFERENCES BETWEEN HEDGE FUNDS AND

UNIT TRUSTS

Unit Trust Hedge Funds

Performance measurement Relative Absolute

Asset classes permittedCash, bonds and stocks

Unrestricted


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189Unit Trust Hedge Funds

Regulations Highly regulated Less regulated

Investment strategy Buy and sell only Unrestricted

Performance fee Usually none Very likely

Liquidity (ability to sell easily) Daily Usually monthly

Target investors Retail High-net-worth

Expenses ratio Lower Higher

Leverage Prohibited Allowed

BE CAREFUL WHEN YOU INVEST IN HEDGE FUNDSTh e assets under management of a hedge fund can run into many

billions of dollars, and this is usually magnifi ed by leverage. Th eir

infl uence over the markets and even entire economies, whether they

succeed or fail, can be substantial and there is an ongoing debate

about how much they should be regulated or unregulated.

When hedge funds fall, they fall hard and often take others along

with them. Take the collapse of the U.S. hedge fund Long-Term

Capital Management (LTCM) in 1998 for example. LTCM made a

huge and wrong bet on interest rates in the form of Russian debt

and caused the U.S. Federal Reserve to step in to negotiate a US$3.6

billion bailout plan.

Investors should also be wary of potentially infl ated returns.

According to a study by Burton Malkiel, a Princeton University

professor, hedge fund returns are infl ated because failed funds that

have been liquidated are often not included in key fund indices.

Th is “survivor bias” means that dead funds such as LTCM are not

refl ected in the major indices. Th e study estimates that fund results

are overestimated by an average of 3.74 per cent.

For these and other reasons, investing in hedge fund can be tricky

and here are a few guidelines you should follow to protect yourself:

Source: Authors' own compilation


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190• Remind yourself that although the rewards can be tremendous,

you take on substantial risk when you invest in hedge funds.

Your due diligence and monitoring must be top-notch. Never

place a major portion of your investment funds into hedge

funds. Up to 20 per cent is about right.

• When examining hedge fund returns using an index, make sure

the index includes dead funds. If the index includes dead funds,

subtract 3.74 per cent (based on Professor Malkiel’s study) from

the illustrated returns to compensate for any potential infl ation

of returns.

• Look for funds with at least 10 years of return information. Do

not trust slick brochures that show only recent performance.

• Seek a knowledgeable fi nancial adviser to give you advice. Ask

your adviser how he is compensated by the hedge fund

managers he is recommending.

MANAGING HEDGE FUNDS IN YOUR PORTFOLIOIf you want to invest in a hedge fund for retirement, look for lesser-

risk fund of funds and capital guaranteed funds. Avoid single strategy

funds. Make sure that hedge funds comprise no more than 20 per

cent of your overall portfolio.

If you wish to enhance risk in your overall portfolio, any type of

hedge fund will do. We recommend you consider single strategy

funds only if your total invested assets equal $500,000 or more

(since one single strategy fund priced at $100,000 amounts to

20 per cent of a $500,000 portfolio).


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Investing in Art and Collectibles

We hear more and more these days about art and collectibles

being auctioned for hundreds of thousands of dollars, or someone

discovering that grandma’s stamp collection in the storeroom is

worth a fortune.

Whether you have a passion for Coca Cola bottles, vintage

cars or Picasso paintings, you do need specialized knowledge to

determine the value of a specifi c collectible. It is easy to pay too

much for a collectible if you do not have the needed experience and

knowledge.

Unlike a stock exchange where thousands of buyers and sellers

congregate electronically to provide the latest transacted prices, the

collectibles market is informal, is illiquid (not easily convertible to

cash) and has high transaction costs. Th ere is no updated price list

or regulatory authority to ensure that transactions are carried out

in an orderly way. Many collectibles are bought and sold in auctions

in which the prices for similar items can vary widely.

Ultimately, when a collectible (even for something as seemingly

mundane as a toy or a comic book) is highly desirable, splurging

is not uncommon. Hello Kitty celebrated its 35th anniversary in

2009 with a limited edition platinum doll that sold for around USD

170,000 each. Th e fi rst issues of Superman and Batman have sold

for over USD 1 million each in 2010.

In this chapter, we look at the glamorous pursuit of collecting

paintings followed by some sensible rules on buying and selling

collectibles.

PAINTINGS — GOING, GOING, GONEExpensive paintings seem to always take the spotlight when compared

with other collectibles. It is understandable if you look at the highest

prices paid at auctions (see Table 17.1. on page 192):

17


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192TABLE 17.1 LIST OF 10 HIGHEST PRICES PAID AT AUCTIONS1

Painting Artist Year Painted

Year of Sale

Original price (in millions)

Adjusted price (in millions)

No. 5, 1948 Jackson Pollock

1948 2006 $140 $151.2

Woman III Willem de Kooning

1953 2006 $137.5 $148.5

Portrait of Adele Bloch-Bauer I

Gustav Klimt

1907 2006 $135 $144.8

Portrait of Dr. Gachet

Vincent van Gogh

1890 1990 $82.5 $139.0

Bal du moulin de la Galette

Pierre-Auguste Renoir

1876 1990 $78.1 $131.6

Garçon à la pipe

Pablo Picasso

1905 2004 $104.2 $119.9

Nude, Green Leaves and Bust

Pablo Picasso

1932 2010 $106.5 $106.5

Portrait of Joseph Roulin

Vincent van Gogh

1889 1989 $58 plus exchange of works

$101.3

Dora Maar au Chat

Pablo Picasso

1941 2006 $95.2 $102.3

Irises Vincent van Gogh

1889 1987 $53.9 $101.6

1 Th is list, which is adapted from Wikipedia, is infl ation-adjusted in US dollars. A

list in another currency may be in a slightly diff erent order due to exchange rate

diff erences. Paintings are only listed once, for the highest price sold.

Irises by Vincent van Gogh is tenth in the list valued at an

astonishing USD 101.6 million. To give you an idea how prices

have risen the last few years, consider that just fi ve years ago,


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193the “cheapest” painting on the top-10 list was just a little over

USD 50 million. Prices of the top-10 paintings have doubled in the

last fi ve years.

Table 17.1 is a list of the highest prices paid for paintings. Very

valuable paintings, if sold, are usually not sold at auctions. Most of

the world’s most famous paintings are owned by museums, which

very rarely sell them. As such, they are quite literally priceless. If

a painting like the Mona Lisa were to become available, it would

almost certainly sell for much more than any of the paintings listed.

Long ago in 1962, the painting was already assessed at US$100

million.

IF YOU CANNOT OWN ONE, STEAL ONESome art thieves may have been inspired by Pierce Brosnan in the

movie Th e Th omas Crown Aff air where he orchestrates an elaborate

New York museum heist to steal a Monet painting. Although

Brosnan’s character does it for the thrill of it, most art thefts are

performed for monetary gain.

Which is the most expensive art theft in history? According

to the Art Loss Register, a fi rm that maintains the world’s largest

database of stolen and missing art, that may be the 1911 theft of the

Mona Lisa.

A more recent and embarrassing theft occurred in May 2010

when fi ve paintings were stolen from the Paris Museum of Modern

Art. Th e stolen pieces included ones by Henri Matisse and Picasso.

It was embarrassing because it was a one-man heist. Dressed in

black and wearing a mask, the thief merely cut a padlock on the

gate, smashed a window to get inside and then carried off a stunning

haul worth hundreds of millions of euros. While the thief ’s image

was captured on CCTV, the museum’s security system had failed

terribly as the break-in triggered no alarm. Th e guards were alerted

only when they noticed the smashed window.

While this may make art robbery seem like a good career

choice for some people, art thieves rarely make big money off


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194their crimes. Th at’s because the stolen pieces of art are easily

recognisable, and diffi cult to offl oad at their actual value on the

open market.

ART AND COLLECTIBLES CAN BE RISKY INVESTMENTSUnlike an investment in stocks, an investment in collectibles cannot

be measured by time. In fact, the variables that govern price can be

very unpredictable and volatile. One factor that can drive up the

value of art is the artist. General interest caused by an exhibition,

conference, the publishing of a book, or even the production of

a major fi lm (as in the case of Mexican painter Frida Kahlo and

Amedeo Modigliani who was a struggling rival of Picasso), will

bring with it a new wave of people wanting to know more about

the particular artist and the necessary demand can cause a hike in

price.

It’s often said that if the artist is alive, her new fame might allow

the artist to become more prolifi c by satisfying the demand while

keeping the price at the same level. But when an artist dies, there is

a tendency to see a sharp increase in price for works of her creation

due to the publicity generated by the death of the artist, as well as

what we might call the close of her artistic production.

In the months immediately following Andy Warhol’s death, a

frenzy developed for anything Warhol. Even his personal property

was bid into the stratosphere at the famed 1987 Sotheby’s auction

where his vintage cookie jars sold for thousands of dollars. But

this posthumous popularity is not always the case. Some artists

have a huge following only during their lifetimes because of their

big personalities. Th e paintings of Pascal Cucaro, a colorful San

Francisco artist for example, sold for around US$50,000 while he

was at his peak in the 1950s. Today, those same paintings may sell

for no more than US$1,000.2

2 www.artbusiness.com


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195What we often do not hear is that collectibles are risky

investments and may be diffi cult and expensive to liquidate.

Investing in arts and collectibles is rife with risk and, for most

investors, doesn’t off er the returns aff orded in the equities or

traditional markets. Th e value of art rises and falls sharply with the

economy and what’s considered valuable to one collector could be

worth far less on the open market. If growth is an investor’s sole

motivation, she will likely do much better investing in stocks or

bonds than buying paintings, phone cards or antiques. Here are

three other challenges investors may encounter:

1. Low price transparency — Buying securities usually occur at

fair market value in large market places. But when buying a

piece of art, it is much more diffi cult to confi rm that a fair

price is being paid.

2. Security — Investors are responsible for the safekeeping

of the collectible. If the piece gets damaged or lost, its value is

compromised.

3. Liquidity — Securities can be sold much more easily than

art and collectibles because securities are traded more readily

on organized networks and exchanges.

MAKING SENSIBLE INVESTMENTS IN ART AND COLLECTIBLES Most authorities agree that we should buy art and collectibles

primarily because we like them. Th eir profi t potential should be a

secondary consideration. Here are a few sensible strategies to bear

in mind when investing:

1. Buy from reputable dealers — Find a reputable dealer who has

been in the business for many years, long enough to know

about quality, market trends and pricing practices in the type


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196 of art and collectibles to be collected or invested. Th e dealer

should also provide a written appraisal or certifi cate attesting

to the quality and authenticity of the item.

2. Buy quality — Like buying homes in good locations, buying

top-quality items while expensive, provide price protection

even in poorer market times.

3. Maintain the item — provide appropriate environmental

conditions and regular maintenance as well as insure the item

adequately.

4. Limit the amount invested — Avoid putting more than 10 to 15

per cent of an investment portfolio into art and collectibles.

Collecting things is a very satisfying pastime when you are

passionate about the things you collect. But collecting for the sake

of profi t is seldom a productive activity unless you have pockets

deep enough to invest in the rarest collectibles. So for many people,

the collectibles they acquire may never provide much profi t at all or

are likely to decrease in value over time.

Between ourselves, we collect coins, stamps, photos and books.

Some cost us a few thousand dollars while most cost just a couple

of dollars. In the end, we subscribe to what television producer

Norman Lear said, “Life is made up of small pleasures. Happiness

is made up of those tiny successes. Th e big ones come too

infrequently. And if you don’t collect all these tiny successes, the big

ones don’t really mean anything.”

Happy collecting!


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Understanding Basic Derivatives

Over 92 per cent of the world’s largest 500 companies use

derivatives to manage their corporate risk, according to a survey

by the International Swaps and Derivatives Association (ISDA) in

2003. Th e percentage is probably even higher today. Derivatives are

widely used today and this is why it is important that you have a

good understanding of them and how each of the main derivative

products diff ers.

If you’ve ever owned a capital guaranteed product or just a unit

trust, chances are that you too own or have owned derivative

instruments although you may have done so indirectly. Th at’s

because guaranteed products have a sizeable portion of their

structure made up of derivatives, and unit trusts use derivatives to

manage risks such as currency fl uctuations.

Th ese days there are many new products that just a few years

ago didn’t exist — such as protected funds, contracts for diff erence

(CFD), currency-linked notes and call warrants. Why has there

been such an increase in the use of derivatives and structured

products by both companies and individuals? You guessed it. It’s all

about risk and return.

WHY DERIVATIVES ARE EVER SO IMPORTANT FOR YOU TO KNOW TODAYThe markets are very volatile these days. You saw in Chapter 8

how the STI tripled in value from 800 to 2500 in the 16 months

between August 1998 and December 1999, then lost half its value

in the next 21 months. You saw in Chapter 15 how gold went

from US$270 in 2001 to over US$1,200 per ounce in 2010. You’ve

seen the subprime crisis bring about shocking losses for many of

the world’s largest banks, some of which have lost tens of billions

of dollars. Now imagine you are two years from retirement and

you have a portfolio of Singapore stocks worth $300,000 that you

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198plan to use for travelling and cruises. Bad economic news and a

likely recession then destroy over 50 per cent of your portfolio’s

value.

Volatility can bring about returns that can be very good for your

portfolio — or very bad. Th e problem is that you’ll never know for

sure which direction the market is headed.

In this chapter, we will to bring you through some of the most

common derivatives and structured products around today so

you’ll know that there are many more options available for you to

consider when managing your portfolio. We will go over some of

the foundation topics on derivatives that we covered in Chapter

2, but we will do so at a very conceptual level. We will not look

too much under the hood of these very technically demanding

instruments. Our advice is that you should leave those daunting

details to your fi nancial adviser and just focus on how these

instruments may be important for your fi nancial future.

IT ALL STARTED WITH FORWARDS 5,000 YEARS AGOIf you had lived 5,000 years ago in Sumeria, which was situated in

modern day Iraq and western Iran, you might have had the honour

of participating in one of the fi rst derivative transactions known to

mankind called a forward. Let’s suppose that you did.

Suppose it is June and you are a goat farmer hoping to sell one

of your goats in three months’ time in September. While goats are

selling at 100 gold coins today, and you would be happy with that

price, your goat is not quite mature yet. You have what is called a

natural position — you own a goat — which exposes you to risk

because the price of goats could fall sharply by September.

Now suppose there is also a shish kebab maker who wants to

buy a goat for a village feast taking place in September. Like you,

he doesn’t mind the price of a goat at 100 gold coins today, but he

doesn’t want to look after a goat for three months. Like you, he is

also exposed to price risk, but on the opposite side. He is worried

that the price of goats will rise in three months’ time.


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199What you and the shish kebab seller can do is to have a forward

agreement with these terms:

I, goat farmer, agree to sell one of my goats to shish kebab maker

for 100 gold coins in three months’ time.

I, shish kebab maker, agree to buy a goat from goat farmer for

100 gold coins in three months’ time.

In three months’ time, if the market price of goats rises to 140

gold pieces, you are obligated by the contract to sell the goat for

100 gold coins. You would, of course, be upset for letting the goat

go so cheaply at 100 gold coins when you could have sold it at 140

if you had not gone into the forward contract. But then, the market

price of goats could just as easily have fallen to 50 gold pieces, in

which case you would be happy because the shish kebab maker is

obligated to buy it from you for 100 gold coins.

Th e point of the forward contract is that you and the shish kebab

maker are able to lock in a price three months ahead of time. By

doing so, both of you have removed your price risk. As you have

seen, removing your price risk also removes any chance of taking

advantage of price movements that would have been in your favour

had you not agreed to lock in a price.

Forward contracts have three key features:

1. Th ey can be customised since it is usually between one buyer

and one seller, a special type of goat, a specifi c weight or colour

can be specifi ed.

2. Both buyer and seller are obligated to buy and sell at the

specifi ed price.


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2003. Forward contracts are traded over-the-counter (OTC) rather

than on a formal exchange such as SGX.

Th ese features of forward contracts do point to some

challenges. Because forward contracts are agreements between

two parties, counterparty risk can be high. If the market price

of goats rises to 200 gold coins, the goat farmer may decide to

scupper the agreement in order to sell it in the marketplace for

200 gold coins. Second, it is hard to guarantee the quality of the

goat. It may arrive with a disease or one leg missing. And third,

what if either the buyer or seller decides to get out of the contract

for legitimate reasons? For example, the designated goat dies one

month before delivery.

FUTURES CONTRACTS Futures markets began as a response to some of these challenges

experienced with forward contracts. In a futures market, there

are thousands of buyers and thousands of sellers who converge

their interests into one marketplace (see Figure 18.1). As a result,

the trading of futures contracts is diff erent from that of forward

contracts in the following ways:

Th ousands

of Buyers

Th ousands

of SellersClearing House

FIGURE 18.1. A FUTURES EXCHANGE



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201Futures contracts have standardised terms to facilitate trading. A

corn futures contract would have specifi c details of contract size,

origin of the corn, delivery times and acceptable moisture quality.

Forward contracts do not have standardised terms and that is why

they are diffi cult to get out of as it requires another buyer or seller

who is willing to accept customised terms.

Second, a clearing house sits between the buyers and the sellers.

Th e role of the clearing house is to guarantee the trades that come

through. If a buyer puts in a buy order and it is accepted, the

clearing house guarantees that the order will be fi lled. Th is gets rid

of counterparty risk, which is the risk that accepted orders are not

fi lled for one reason or another.

Like a forward contract, a futures contract obligates the buyer

and seller to buy and sell. However, one diff erence is that because

the contract terms are standardized and the exchange is open to

thousands of buyers and sellers, it is very easy for someone to get

out of a position before the contract matures. In fact, over 95 per

cent of all futures contracts are “unravelled” in this manner.

Futures in Your PortfolioWe often hear about the high risk nature of derivatives (especially

futures). China Aviation Oil in 2004 ran up US$550 million in losses

from oil futures. Nick Leeson’s trading of Japanese futures made

his employer Barings Bank bankrupt in 1995 with losses of US$1.4

billion. But this occurred when futures were used for speculating

with huge bets on the direction of the market.

When used for hedging an existing physical position, they do a

wonderful job of reducing, not increasing, risk. Take the case of the

shish kebab maker who hedged against price rising in the future by

agreeing to a price today.

Now suppose you have $300,000 invested in ten Singapore

stocks that you have held for many years. It is January, and you are


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202concerned about a market decline over the next two months. You

do not wish to liquidate your portfolio but you don’t want to suff er

losses either should the market decline.

What you can do is sell2 a number of STI futures contract so

that if the market does fall, your profi ts from your futures position

would off set your losses from your actual portfolio. (Note that the

operational details of trading futures can be easily obtained from

www.sgx.com and from other exchanges, and we are not focusing

on those details here. What we are focusing on is the important

concept that you can hedge (or protect your portfolio) with the use

of futures.)

Let us return to our example. Th e March STI futures contract is

trading at 3,000 points. With a multiplier of $10 per point, the price

of one March contract is:

Price per contract = 3,000 X $10

= $30,000

To protect the portfolio against a market decline, the number of

futures contracts to sell is:

Number of contracts = $300,000 / $30,000

= 10 contracts

By hedging, you have greatly reduced or even eliminated the

possibility of a loss from a decline in your Singapore portfolio. If the

market indeed falls, the losses from your stock portfolio would be

off set by the gains from the futures contracts. For example, if the STI

index falls 50 points, your gain from your futures position would be:

2 Selling or shorting is useful when you have a pessimistic view of the market. For

example, you agree to sell a car to John for $20,000 today to be delivered a week

from today. Assuming you don’t already have the car, you hope to buy a car in a

week’s time at a price lower than $20,000 in order to make a profi t.


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203 Gain = 50 points X 10 contracts X $10 per point

= $5,000

However, you would have also eliminated the possibility of a gain

from a price increase. Th at’s because if the market went up instead,

the gains from the market would be off set by the losses from your

futures position.

Finally, there are details on the STI futures contract that we have

intentionally skimmed in order to focus on the concept of hedging.

However if you are new to the STI futures contract, here are a few

things to note:

• Futures contracts generally have specifi ed future expiry dates

often going into 12 months or more into the future. For the

STI contract, we chose the March contract because it still has

two months remaining before expiry.

• Futures contracts have to be “monetized.” Because the

underlying asset is the STI with a points value, a $10 per point

multiplier is used to give the contract a monetary value.

TRADITIONAL OPTIONS CONTRACTSBoth forwards and futures obligate the buyer and seller to buy and

sell. If you buy an options contract, you have a choice. Th is is the

most important diff erence between options and futures/forwards.

We’ve already discussed in Chapter 2 what call and put options

are. To review, if the goat farmer and shish kebab maker were to

agree to an options contract, it might look something like this:

I, shish kebab maker, pay goat farmer two gold coins for the

right to buy a goat from goat farmer for 100 gold coins anytime

in the next three months.


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204I, goat farmer, accept two gold coins from shish kebab maker

and give him the right to buy my goat for 100 gold coins anytime

in the next three months. If shish kebab maker exercises his

right to buy, I must sell. If he does not, I keep the two gold

coins.

You can see that the option to buy the goat is valuable, and for

that, a price has to be paid. Th is is called the option premium, the

calculation of which won its creators the Nobel Prize in Economics.

It’s that sophisticated.

We need to get more specifi c about the type of options that we

are talking about because there is actually quite a variety of them.

Th e options that we discuss here are traditional exchange-traded

options. Th ey give you the option to buy or sell a number of shares

at a specifi ed price (called the exercise price) within a period of

usually three to nine months. Th ey are issued by third parties such

as a bank, rather than by the company itself. Th is means that if an

option to buy is exercised, the third party delivers the shares to you

from its own inventory of shares. New stock is not issued by the

company. In fact, the company whose shares are being bought and

sold is usually not at all involved in such transactions.

Traditional stock options are popular in the U.S. and Australia,

but they are not popular in Singapore. Stock options have been

created on a few blue-chip companies in the past, but the options

have been dormant because of lack of interest.

Th e short-datedness of the option does have an impact on the

exercise price in that it shouldn’t be too far away from today’s

market price at the time of issue. To understand what this means,

suppose we have the following:

Today’s price of XYZ shares = $10

Strike price of call option = $16

Price of call option = $0.20

Expiration = 3 months


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205Does this make sense? Would you pay 20 cents for an option to

buy XYZ for $16 when its price is trading at $10 today? If you buy

the option, it means that you have very gigantic hopes that XYZ

would rise at least 60 per cent during the next three months.

Despite whatever optimism you have about XYZ, you can see

that the strike price of $16 is not reasonable. So, the exercise price

should be closer to, rather than farther away from, today’s price.

TRADITIONAL WARRANTSContinuing with the last example, we now ask what if the expiration

is fi ve years and not three months? Does a strike price of $16 seem

more reasonable to you if you had fi ve years to wait this out? Th e

answer should be yes, and this is one of the main diff erences between

traditional options and warrants.

At the time of issue, warrants have a lifespan of up to fi ve years.

Warrants are in fact often called “long-dated options” for this

reason. Th e exercise price is usually far away from today’s share

price at time of issue.2

One other diff erence with traditional options is that traditional

warrants are issued by the company itself. When such company-

issued warrants are exercised, new shares are released.

Th ere are two diff erent types of warrants: call warrants and

put warrants. Like a call option, a call warrant is what we just

described. It gives its holder the right to purchase a number of

shares from the issuer at a specifi c price, on or before a certain

date. A put warrant represents a certain amount of equity that

can be sold back to the issuer at a specifi ed price, on or before a

stated date.

Warrants issued by companies entitle the holder to buy a

specifi c number of shares in that company at a specifi c price at a

specifi c time in the future. For example, AsiaWater Tech W110818

2Th is is true more so when the company’s share price is considered low.


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206is an SGX-listed warrant issued by Asia Water itself. It listed on 23

February 2010 and expires on 18 August 2011. It had the following

details in July 2010:

Price of warrant = 3 cents

Exercise price = 4.5 cents

Underlying Stock Price = 6.5 cents

Conversion Ratio = 1 share: 1 warrant

Analysing this is not diffi cult at all. To own Asia Water, you have

a choice of buying it directly at 6.5 cents or you can pay 3 cents

for the warrant and exercise it by paying another 4.5 cents for a

total of 7.5 cents. Th e conversion ratio of 1:1 means that it takes

one warrant to purchase one share.

Is this a good deal? First, by buying the warrant and exercising

it, you’re paying 7.5 cents, which is 1 cent more than buying the

stock directly. Why in the world would you want to do that?

A good reason is that you’re paying a premium of 1 cent to be

able to sit tight for over one year and hope that the underlying

stock price shoots sky high. For example, if you buy the warrant

at 3 cents and Asia Water stock rises to 10 cents in a year, you can

cash in for a nice profi t of 2.5 cents per share (10 minus 7.5 cents).

And what if the underlying stock price falls to 1.5 cents or even

lower? Th en your maximum loss will always be limited to just the

initial investment of 3 cents per warrant.

Warrants Compared with OptionsWarrants are similar to long-term options where they off er the

opportunity for capital gain, which makes them interesting for

speculative investing. Th e price movement of warrants tends to

refl ect the price changes in the underlying equity — but in an

exaggerated fashion. For example, if the price of a share increases

10 per cent, the price of an associated warrant may increase 30 per

cent. Th at is the bottom-line attraction for speculators.


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207But warrants are not exactly like options; there are a few

diff erences, which are summarised in Table 18.1 for call warrants

and call options.

TABLE 18.1. DIFFERENCES BETWEEN WARRANTS AND OPTIONS

Warrants Options

How long they last

Long dated. Usually issued with a 3-5 year life.

Short dated. Ranges from 1 month to 12 months.

Issuer

Issued by the company itself with a promise to issue new shares if the warrant is exercised.

Usually not issued by the company itself. A promise is made to deliver existing shares if the option is exercised.

Dilution

New shares are issued by the company when warrants are exercised. Th is results in earnings dilution for shareholders.

When an option is exercised, existing shares are delivered. Th is does not cause earnings to dilute.

Where they are traded

On an exchange. On an exchange.


The Lure of WarrantsBecause warrants exaggerate the movements of the underlying

equity, they tend to be more volatile than shares, which is why

speculators love them. Warrants thus off er the opportunity for

greater price gains than do the associated shares.

Th is feature of warrants is called gearing and this is found

commonly in fi nancial markets. An example of gearing is if you

borrow money from the bank and invest the money in the stock

market, you are said to be “gearing up” your exposure to stocks.

Similarly, if you arrange a mortgage from a bank to buy a house,

you are gearing up your exposure to the property market.


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208Th e major attraction of warrants is this feature of gearing —

they track, and magnify, share price movements. In bull markets,

speculators will often fl ow into warrants, instead of shares, to gain

from the turbo-charged performance of warrants.

Hence, in bull markets, warrants will easily outperform most

shares, and have the greatest price increases among securities.

Th e advantages of gearing can also be its greatest danger, as

gearing works both ways. While warrants can rise spectacularly

fast, they can plummet just as quickly.

Warrants are very speculative, capital gain plays. Warrant-holders

get no dividends or any other type of income. Th ey are therefore

not appropriate for investors who are interested in income.

Structured WarrantsStructured warrants and company warrants have many similar

features. Th eir values are linked to an underlying asset. In the case

of company warrants, the underlying asset is the company’s shares.

Structured warrants are more fl exible as their underlying asset is

usually either a stock or an index. Both types of warrants are listed

on an exchange and off er leveraged trading.

Compared with company warrants that are issued by the company

itself, structured warrants are issued by third-party fi nancial

institutions. Th is and other diff erences are summarised in Table 18.2.

(page 209).

Here’s an example of how a structured warrant is listed on the

stock exchange and what each term means:

STI 3,700 ABC e CW 120328

STI 3,700 ABC e CW 120328

STI is the underlying asset Straits Times Index

3,700 is the Strike Price*

ABC is the name of the issuer


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209E refers to a European maturity which means that the warrant can

only be exercised on the day the warrant matures**

CW means Call Warrant while PW means Put Warrant

120328 is the maturity date — that is, 28 March 2012

* Strike price is the price at which the warrant holder is entitled to buy

(for calls) or to sell (for puts) the underlying asset at maturity.

** Warrants with American maturity can be exercised at any time

before maturity.

TABLE 18.2. DIFFERENCES BETWEEN STRUCTURED WARRANTS AND

COMPANY WARRANTS

Structured Warrants Company Warrant

Warrant issuer Issued by third parties such as fi nancial institutions.

Issued by the company itself.

Underlying asset Any index or company shares that are not related to the fi nancial institution.

Shares of the listed company.

On exercise Does not result in dilution of the underlying shares.

Company will issue new shares, which results in share dilution.

Maturity period Short term, likely to be 12 months or shorter.

Long term, can be as long as 5 years.

Source: Adapted from http://sg.warrants.com


Understanding Structured

Products and Other Derivatives

CFDs, structured deposits and equity-linked notes — these are just

some of the names of securities that you might have heard of in the

news, and have no doubt been intrigued, confused and enlightened

by all at the same time. Th at’s probably because derivatives are such

highly fl exible instruments.

Th ey can stand on their own as a leveraged investment for

speculators. Th ey can be structured to mimic the behaviour of

another asset. Th ey can be added to your portfolio to provide

temporary protection from an anticipated market downturn. And

as you will see in this chapter, they can be attached to traditional

investment assets such as bonds to become structured products.

In fact, the number of combinations is limitless and like in the

previous chapter, we will focus on some very technically challenging

investment products at a conceptual level without digging too much

into the details.

In this chapter, we will touch on some of the most popular

products in the market:

• Contracts for Diff erence (CFDs).

• Structured products such as guaranteed funds, structured

deposits and equity-linked notes.

In the end, your conceptual understanding will allow you to

diff erentiate one product from another, and hopefully we will

help you not only make informed decisions, but also ask the right

questions to enhance and protect your bottom line.

19


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211CONTRACTS FOR DIFFERENCE (CFDS) If you love BreadTalk and can’t seem to get enough of their buns and

pastries, you might want to think about a CFD. A CFD allows you

to take a leveraged position on a security such as equities or indices.

Th is means that by taking a leveraged CFD position on a stock such

as Breadtalk, and putting down $1,000 with a broker such as Phillip

Securities1 you are able to hold a $5,000 position.

CFDs are a very simple type of derivative that off ers all the

benefi ts of trading shares without actually having to own them.

A CFD mirrors exactly the performance of the underlying stock

where the profi t or loss is determined by the diff erence between the

purchase price and the selling price.

A CFD is an over-the-counter (OTC) derivative that represents

an agreement between two parties (you and the broker) to exchange

at the close of the contract the diff erence between the closing and

opening prices of the contract. A CFD thus allows you to trade on the

outcome, or performance, of Breadtalk and other securities without

owning the stock or security. You would not have voting rights or

ownership entitlements such as warrant issues and rights issues.

Because CFDs are leveraged, you trade on margin like what you

would do with futures contracts. Margin trading gives you the

ability to purchase, or gain an exposure to, a stock without putting

up the full principal value. Th is lets you multiply your profi ts if the

price moves in your favour. Th e opposite is true as well. If price

moves against you, your losses are multiplied as a result.

Margin is made up of two parts. Th e fi rst is the initial margin,

which is the initial amount required to open the position. In

Singapore, the initial margin level is typically 20 per cent, which

means a leverage of fi ve times — every dollar you put down allows

you to hold fi ve dollars of assets. If the price of the stock moves in

your favour, no additional margin will be required, but if the balance

1Phillip Securities is one of the top CFD brokers in Singapore, providing hundreds

of CFDs in several markets, including Singapore, Malaysia, Hong Kong and even

the U.S.


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212goes below a maintenance margin (for simplicity, let’s assume it is

also 20 per cent), then you will get a margin call to top up so your

balance returns to at least the 20 per cent level.

Th is principle is no diff erent from buying a home with a loan.

When you buy a home, you put down a deposit (for example, 20 per

cent) and you borrow the rest (80 per cent). If the property market

goes up in your favour, your profi ts are multiplied a few times

relative to your initial deposit. Or if it goes against you, you can lose

more than what you put down. CFDs can be risky and speculative,

and you should know what you’re doing.

Let’s look at a simplifi ed example in Table 19.1 of a long trade

in which you open a CFD position in XYZ stock which is trading

TABLE 19.1. SAMPLE CFD POSITION IN XYZ STOCK

Opening Position:

Price of XYZ $10.00

Number of shares $5,000

Value of shares $50,000

Margin Required (20%) $10,000

Commission (0.30%) $150.00 (GST excluded)

Total Value of Transaction $10,150 (margin plus commission)

Closing Position (5 days later)

Price of XYZ $10.50

Number of shares 5,000

Value of shares $52,500

Commission (0.30%) $157.50

Financing (5 days) $50.00

Profi t ($)$2,142.50 ($52,500 minus commissions and fi nance charges)

Profi t (%) 21.1% ($2,142.50 / $10,150)



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213at $10.00 per share. You put down an initial margin of $10,000

for a $50,000 position. Five days later, when XYZ has gone up to

$10.50, you close out your position for a profi t of $2,142.50 after

subtracting commissions and other expenses.

Since CFDs are margined instruments, any positions held overnight

are subject to fi nancing. Th is is to take into account that your broker

is actually lending money to a client or borrowing money from him.

Long CFD positions are required to pay fi nancing since you are

eff ectively borrowing 80 per cent of the total position like in a home

mortgage. To simplify the example, we assume this is $50 for fi ve days.

Th e above example shows a 21.1 per cent return on the initial

investment, given a fi ve per cent move in XYZ’s stock price. Bear in

mind again that as profi ts are magnifi ed, so too will your losses be,

if the price goes in the opposite direction instead.

CFDs in Your PortfolioTh ere are two main ways you can use CFDs:

• You can speculate — if you are convinced about the direction of

a stock’s price, you could speculate by longing (you are bullish)

or shorting (you are bearish) the CFD.

• You can hedge — Suppose you own actual shares of XYZ that

you don’t want to sell because your grandmother gave them

to you. Even if you expect its value to decrease from a market

downturn, you can maintain your fi lial duty by opening up a

short position using a CFD on the individual share. If, in fact, the

stock goes down from $10 to $9, you can compensate for the

losses from your actual shares by the profi t made with the short

CFD position.

CFDs are bad for your nerves if you are a risk-averse investor. If

you can’t even stomach a 10 per cent drop in your favourite stock,

imagine a 50 per cent drop as a result of the leverage feature.


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214CFDs aren’t very good for long-term investing either unless you

are one of those investors who can stay on the roller coaster for six

hours at a time without a break. Because of leverage, your returns

can swing very wildly.

STRUCTURED PRODUCTSSuppose you have $1,000 to invest. You buy a high-quality AAA-

rated zero-coupon bond for $864. Th e bond matures in three years’

time whereupon you will receive $1,000. Since your capital has been

“guaranteed”, you now venture to take a huge risk with the remaining

$136 or 13.6 per cent of your investment money. You invest the

entire $136 on stock options that are tied to the performance of a

technology index.

In three years, if the technology index does poorly, you walk away

with $1,000. Your return is zero per cent. Still, you are comforted

by the fact that you did not lose any money.

If the technology index does really well and your stock options go

up 30 per cent, you earn a return of 4.1 per cent:

Return =13.6% x 30%

= 4.1%

Congratulations! You have just created your own technology

capital guaranteed fund, a type of structured product. Structured

products are very popular with retail investors, and we will look at

three — capital guaranteed funds, structured deposits and equity-

linked notes.

The Appeal of Guaranteed FundsA basic structured product such as a guaranteed fund has a very

simple structure:

Capital Guaranteed Fund = Bonds + Higher-risk Investments


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215You can create a similar structure on your own. Now imagine

if you had to pay a commission to someone to create the above

structure. Would you ever buy a capital guaranteed fund?

It is understandable if your answer is “no” since theoretically you

can just do this yourself. However, the cost and transaction volume

requirements of many derivatives are beyond most individual

investors.

As such, structured products were created to meet specifi c needs

that cannot be met from traditional fi nancial instruments. Structured

products can be used as an alternative to direct investment, as a way

to reduce portfolio risk, or to exploit a current market trend.

In Singapore, billions of dollars have been invested in capital

guaranteed funds. Th ey were the rage when the fi rst funds appeared

at the end of 2000. At the time, the STI was in a slump. It fell from

2500 in December 1999 to lower than 1300 points 21 months later

in September 2001. Hungry investors seized what was a great

investment, an investment in which capital is guaranteed (net

of commissions) and there was the potential of an upside tied to

markets recovering in three to fi ve years’ time.

Defining Structured ProductsTh e term “structured products” in the market is somewhat unclear

and frequently refers to the packaging of derivative products with

traditional ones. A good defi nition comes from Michael Fraikin,

Director of the Global Structured Products Group at INVESCO,

who defi ned a structured product as “a systematic way of investing

rather than one that centres on the use of derivatives”. In other words,

structured products express an investment strategy.

A guaranteed fund, for example, is an investment strategy that

provides the investor with protection from a downturn, yet gives

the potential of profi ts should the market go up. Th is is appealing to

not only a risk-averse investor, but also one who has the view that

while the market could weaken, there is hope of an upturn.


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216Structured DepositsTh e most serious risk associated with many structured products

is that many investors buy them when they don’t quite understand

their risk-return characteristics. Take structured deposits for

example. Th ey appeared around end-2001 and work just like capital

guaranteed funds in that capital is often guaranteed and there is

also the potential kicker in returns from risky investments. What is

diff erent is that structured deposits were sold as alternatives to fi xed

deposits. While capital guaranteed funds appeal more to investors,

the appeal of structured deposits lies with depositors.

Billions of dollars too have poured into structured deposits. It is

easy to see why when we look at how low fi xed deposit and savings

rates have fallen over the years (see Figure 19.1).

At the start of 2002, 12-month fi xed deposit rates were around

2.46 per cent. Around mid-2010, the rate was 0.14 per cent. Th is is

a very depressing rate for depositors.

FIGURE 19.1. BANK FIXED DEPOSIT AND SAVINGS RATE (1995 TO 2010)

Jan

95

Jan

96

Jan

97

Jan

98

Jan

99

Jan

00

Jan

01

Jan

02

Jan

03

Jan

04

Jan

05

Jan

06

Jan

07

Jan

08

Jan

09

Jan

10

6

5

4

3

2

1

0

Bank 12Month FixedDeposit RateP

erce

nt

(%)

Bank 12Bank 12Month FixedDeposit Rate

BankSavings

Rate


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217What many structured deposits off er are high early payouts. For

example, a structured deposit may off er 8 per cent returns in eight

months. If you are thinking that this is a great deal, so are thousands

of depositors. Here are a few characteristics about structured

deposits that you should know about:

• Th ere is often a high early payout (the earliest versions off ered

lower, regular payouts)

Whatever the amount or the regularity, remember that this is

just the income portion.

• Th e capital is usually protected

Capital protection is a little diff erent from capital guarantee.

A capital guarantee is a guarantee that you will get your capital

REMINDER — TWO BASIC TRUTHS ABOUT INVESTING

First, the most sacred investment truth of all — the lower the

risk, the lower the returns. And the higher the risk, the higher

the returns. If an investment makes guarantees, it does so by

off ering lower returns.

Second, returns consist of two components:

Return = Income + Capital Gains

So, if you are getting a lot of “returns” upfront, for example

8 per cent or $80 for every $1,000 invested, do not be too

happy yet. Th at is just the income portion of your returns.

Please ask the salesperson about the capital gains portion.

Chances are that if the income portion is guaranteed, the

capital gains portion is not. And very often, you could even

suff er capital losses.


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218 back. If the bank buys a bond and the issuer defaults, the bank

will pay you your money. With the guarantee, the bank takes

on the risk. With protection, the bank passes the risk to you if the

issuer defaults. So while capital protection is still low risk to you

(the bonds purchased are usually good quality), it is not risk-free.

Th e next time you read a product brochure and you

are confused, think about it this way. If the income portion is

guaranteed, the capital portion is probably not guaranteed. Or,

if the capital portion is guaranteed, the income portion is

probably not. If they are both guaranteed, which is unlikely, you

can't then expect the returns to be great.

• Long lock-in period

Some funds lock you in for up to 10 years and there is a penalty

for early withdrawal. Th e worst that can happen is when you get a

high early payout and get locked in for 10 years. And then at the

end of the period, you fi nd out that you would not be getting any

extra returns because the options and other higher risk

investments failed to perform.

Th ere have been plenty of complaints by investors about structured

deposits and how they were being sold. Some investors complained

that they were lured by the high early payouts. But when they learned

that they needed cash and wanted to liquidate, they got upset by the

penalties for early withdrawal.

Th ere were also complaints that banks were selling structured

deposits as if they were simple deposit products. Th ey are not. MAS

has issued a notice that “Unlike traditional deposits, structured

deposits have an investment element and returns may vary.”2

Equity-Linked NotesAn equity-linked note (ELN) is a structured product. It starts

with a debt instrument, usually a bond. It is diff erent from a bond,

2MAS Guidelines on Structured Deposits, www.mas.gov.sg, 7 October 2004.


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219however, in that the fi nal payout is typically based on the return of

an underlying equity instrument, which can be a basket of stocks or

an equity index. A typical ELN is capital-protected, which you now

know, is diff erent from being capital-guaranteed.

A common feature is that the fi nal payout is the amount invested,

times the gain in the underlying stock basket, or index times a

participation rate, which can be more or less than 100 per cent.

For example, if the underlying basket gains 50 per cent during

the investment period and the participation rate is 60 per cent,

the investor receives 1.30 dollars for each dollar invested. If the

underlying basket remains unchanged or declines, the investor still

receives one dollar per dollar invested as long as the issuer does not

default. You can see that this payoff is no diff erent from that of a

capital-guaranteed fund.

MANAGING STRUCTURED PRODUCTS IN YOUR PORTFOLIOStructured products may be suitable for you if you have suffi cient

cash elsewhere so that the possibility of an early withdrawal is

remote. If you want to enhance returns on your fi xed deposit, which

you have set aside for emergency funds, you can consider putting up

to 30 per cent of your emergency funds in structured products that

mature in no more than three years’ time.

Capital guaranteed/protected investments are generally low risk

and should not really occupy a large proportion of your retirement

portfolio. However, if you strongly believe in a market recovery,

but you still want some returns from income payouts, you might

consider such funds. Invest no more than 20 per cent of your

retirement portfolio in such funds.


Figure 20.1 shows that in 2002, US$1 exchanged for S$1.85. In

mid-2010, the exchange rate had gone down to less than S$1.40, a

drop of over 25 per cent for the US$.

INCREASING INTEREST IN CURRENCY INVESTINGInvesting in currencies is becoming quite popular these days.

Everyone from housewives to doctors seem to have a view of where

Understanding Currency

Currency movements seem to be favouring Singaporeans these days.

Th e US$ is weak. Th e SGD is strong. Suddenly, we hear many of our

friends wanting to visit, eat and shop in the U.S. It’s a great time, but

that’s true only if you’re buying and shopping, and bad if you own

U.S. assets or you are selling goods to the U.S. (you may be forced to

raise prices which would make your customers unhappy).

If you hold lots of U.S. assets or US$-denominated assets such

as real estate and unit trusts, your investment would have gone

down 25 per cent between 2002 and 2010 from just the currency

movement itself.

FIGURE 20.1. USD VS SGD MOVEMENTS BETWEEN 1994 AND 2010

1.9

1.8

1.7

1.6

1.5

1.4

1.3

1.2

Jan

94

Jul

95

Jan

97

Jul

98

Jan

00

Jul

01

Jan

03

Jul

04

Jan

05

Jul

07

Jan

09

Jul

10

Ex

cha

ng

e ra

te

4

USD / SGD

20


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221the S$ or US$ is headed, and every other person we know seems

to have traded currencies or bought currency-related investments.

Currencies can be considered an alternative investment because

their returns are not well correlated to stocks and bonds, but they

can be very risky investments too; hence they should fi t into your

supplementary bucket.

Each country has its own currency. Singapore’s offi cial currency

is the Singapore dollar. Switzerland’s offi cial currency is the Swiss

franc, and Japan’s offi cial currency is the yen. An exception would

be the euro, which is the currency for several European countries.

In this chapter, we will look at several ways in which we

commonly deal with currencies, whether to invest, speculate or

simply exchange on the spot for a vacation.

CHANGING ON THE SPOTWe Singaporeans are quite seasoned when it comes to exchanging

Sing dollars for a foreign currency. Many of us love to travel and

we can take off from Changi airport and land almost anywhere in

the world.

If you are going to the U.S. in a few days’ time and you want

US$10,000 exchanged to spend on luxurious spa treatments, the

money changer would quote you a “spot exchange rate”, so called

because the exchange is made on the spot for immediate delivery.

Th e price you pay to buy US$ is the US$/S$ rate or “the price of

US$ based on S$”. For example, if the US$/S$ rate is 1.5, then you

would pay S$15,000 for US$10,000.

Now suppose you are going to the U.S. in one year’s time instead.

As you know, exchange rates change all the time and are actually

quite volatile. Which would work more in your favour — a stronger

or weaker US$ when you need to exchange your S$ for US$ in a

year’s time? Th e answer is that you would want a weaker US$

because it means US$ are cheaper to buy using S$. For example, if

the US$/S$ rate goes down to 1.3, then you would pay S$13,000 for

US$10,000 — a savings of S$2,000.


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222Of course, the exchange rate could work against you too. If the

rate goes up to 1.7, then it means you’ll have to pay S$17,000 for

US$10,000. You may be asking whether or not it is possible to “fi x”

the rate you pay one year ahead of time? By doing so, you will know

ahead of time what rate you will pay exactly, thus removing the

uncertainty of rates moving against you.

Fixing Rates Ahead of Time Th ere are a few common ways to fi x rates ahead of time. One way

is to open a 12-month foreign currency time deposit by accepting

the spot exchange rate that the bank is off ering today. Of course,

you would opt for this only when you are comfortable with today’s

exchange rate and you don’t mind locking this in today.

So if the US$/S$ exchange rate is 1.5 today, you would pay

S$15,000 for a US$10,000 time deposit that pays interest in US$. In

12 months’ time when you need the money for your holiday, there

will be no surprises — whether positive or negative. You will get

exactly US$10,000 plus interest.

If you did not fi x the rate, then you would face the risk of the US$/

S$ going against you in the next 12 months to 1.7 or even higher,

which means you would have to fork out more S$ for US$.

Banks typically off er time deposits based on maturities of between

one week and 12 months. If you need a more fl exible time frame, you

may consider a customised contract called a forward contract where

you and the bank can agree to a schedule of fi xed exchange rates,

even for several periods into the future. Of course, the amount that

you are dealing with should be big enough to interest the bank and

you are also willing to accept whatever rates the bank is off ering.

For example, if you have a recently deceased wealthy relative

from Australia who left you A$5 million and her will instructs that

A$500,000 be transferred to you every six months for a total of

10 payments, then this might be a good situation in which to

approach the bank to structure a forward contract to lock in a series

of 10 exchange rates.


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223What we just discussed is called hedging your currency risk,

where you manage your risk by locking in an exchange rate today to

buy or sell a currency in the future.

WHAT AFFECTS EXCHANGE RATES?

Th e most fundamental factor that aff ects exchange rates is

demand for the currency. If the demand for a currency is high,

then the currency tends to be strong. So when you are trying

to fi gure out whether the US$ is going to strengthen in the

next 12 months, you need to fi nd out if demand for the US$ is

going to be strong or weak.

Here are some rules of thumb on what cause currency

rates to rise and fall. Bear in mind that rules of thumb work

and make sense in general, but not all the time. We will use

Singapore as a reference point:

1. Interest rates — If interest rates in Singapore go up, the

demand for Singapore bonds, especially from overseas

investors, would go up as well. Th is increases demand for

S$ as overseas investors sell their currencies to buy S$ in

order to invest.

2. Trade balance — If Singapore experiences a trade

surplus, it means that it is selling (exporting) more goods

and services than it is buying (importing). A trade surplus

causes a strengthening of the currency as S$ is bought up

in order to buy Singapore exports.

3. Commodity prices — Major commodities such as oil

have a strong infl uence on currencies. A rise in the price

of oil will positively aff ect the currency of an oil-exporting


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224

SPECULATING IN FOREIGN CURRENCYIf instead you want to speculate and take on risk because you have a

certain view about where a currency is headed, then you may wish

to open a currency trading account. But do be very careful because

currency trading institutions such as banks and brokerages are

usually very happy not only to accept your application (typically if

you have at least US$50,000 to start), but also to grant you a trading

line that is fi ve, 10 or more times what you deposit.

For example, suppose your bank off ers you a currency trading

account with a trading line of up to 10 times the size of your initial

investment deposit of a minimum of US$50,000. Th is means that

you will receive a US$500,000 trading line. Such accounts are called

leveraged accounts because you are able to trade using “borrowed”

money. Th e risk of leveraged accounts is that they magnify your

gains as well as your losses by the amount of leverage. If you obtain

a trading line with a leverage of 10 times, then your losses and gains

can be magnifi ed 10 times.

To see how this works, suppose you have a trading account with

an initial deposit of US$50,000 and a leverage of 10 times. On

country such as Saudi Arabia and Canada, and negatively

aff ect oil-importing countries such as the U.S. High

global demand for non-oil commodities such as iron ore

and wheat has also benefi ted major commodity exporters

such as Australia.

4. Stock market performance — Th e overall direction in

stock prices has an impact on currencies as money fl ows

into countries with rising stock markets. Th is makes sense

as a rising stock market is an indication that the country’s

economic prospects are positive, and hence the greater

the demand for the country’s assets and currency.


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2251 June, you have the view that US$ will weaken against the Japanese

Yen. You decide to buy Yen against US$500,000 based on a rate of

JPY 100 = US$1 to be settled one month later on 1 July.

On 19 March, you commit to buy US$ 500,000 and sell YEN for

settlement on 19 April (1 month forward).

Exchange Rate Buy Sell

JPY 100 / US$1 JPY 50,000,000 US$500,000

Two possible outcomes can happen:

Outcome 1: US$ Strengthens — You lose money

On 1 July, the US$ strengthens to JPY 110. US$1 now buys more

JPY or said another way, more JPY are now needed to buy US$1.


JPY 110 / US$1 US$454,545.45 JPY50,000,000

Your loss is US$45,454.55 (US$500,000 minus US$454,545.45).

Th is represents a loss of 91 per cent on your initial deposit of

US$50,000. Had your account not been leveraged, your loss would

be 10 times less or 9.1 per cent.

Outcome 2: US$ Weakens — You make a profi t

On 1 July , the US$ weakens to JPY 95. US$1 now buys fewer JPY

or put another way, fewer JPY are now needed to buy US$1.


JPY 95 / US$1 US$526,315.79 JPY50,000,000

Your gain is US$26,315.79 (US$526,315.79 minus US$500,000).

Th is represents a return of 53 per cent on your initial deposit of


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226US$50,000. Had your account not been leveraged, your profi t would

be 10 times less or 5.3 per cent.

Your potential losses and profi ts in foreign currency trading can be

substantial because of the volatility of exchange rates and the leverage

off ered on trading accounts. And in certain cases, the losses can be

extreme, a case in point being the foreign currency trading losses

of SembCorp of US$248 million, which came about from just one

individual. Not only were there exchange losses but also, its mother

SembMarine shares, fell more than 15 per cent when the news broke.

CURRENCY UNIT TRUSTSIf you still want to take on risk and benefi t from currency movements,

you can consider unit trusts that take positions on currencies. Th ese

funds are managed by currency specialists who follow the market

very closely with research and analysis. Th ey generate absolute

returns in the sense that their returns are not correlated with stock

market returns because currency movements can be independent

of stock market movements. So, whether the stock market is headed

up or down, currency funds are able to generate positive returns.

DUAL CURRENCY INVESTMENTSSuppose for the last few years, you’ve travelled to Hong Kong

several times a year to shop, and each time you go, you visit the

money changer to get HK$ for whatever the spot HK$/S$ rate is.

Th e actual dates on which you travel are not known ahead of time

and you’ve travelled on short notice a few times. You’ve set aside

S$50,000 in your savings account for this purpose, separate from

your other monies.

You’re fi ne with this arrangement except that you get a very low

return on your savings account. Also, you have to accept whatever

the exchange rate is at the time you travel and the risk each time is

that if the S$ falls in value, the HK$ becomes costlier to buy.

Th e relationship manager (RM) at the bank calls you one day

about a dual currency investment (DCI). From what she described,


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227the DCI seems to fi t your needs. First of all, it provides an attractive

return of 4.8 per cent, which is far higher than what you are getting

from your savings account. Th e interest earned based on a S$50,000

investment would be:

S$50,000 X 4.8% X 1/12 = S$200

You next invest by choosing two currencies, one as the base

currency (in this case, S$), and the other as the alternate currency

(the HK$). You then select a suitable maturity date, ranging from a

few weeks to up to six months; you choose one month.

On maturity, you get paid in either the base or alternate currency,

depending on which is the weaker currency when measured against

a pre-determined exchange rate (called the strike price). To see how

this works, say you invest S$50,000 at a strike price of HK$/S$ = 0.20.

Note that this strike price is a value that you agree with the bank, and

one that you are comfortable with if you had to exchange S$ for HK$.

On maturity, suppose the S$ weakens or strengthens as follows:

TABLE 20.1. S$ SCENARIOS

Scenario 1 Scenario 2

Rate on maturity date S$ weakens to 0.25S$ strengthens to 0.15

Payout currencyPrincipal & interest to be paid in S$

Principal & interest to be paid in HK$

Principal + interest received

S$50,200HK$251,000(S$50,200 / 0.20)


In sum, if the S$ weakens against the HK$ as in Scenario 1, you

would get an attractive S$200 worth of interest, which is far more

than you would have achieved leaving it in your savings account.

If the S$ strengthens as in Scenario 2, you get HK$251,000, based

on an exchange rate of 0.20, which was an exchange rate you were


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228comfortable with at the start. And if you want to take advantage of

the fact that the HK$ is now cheaper, you could buy more at S$0.15.

Note that if you had not gone into the investment, you could have

exchanged your S$ at a more attractive rate of 0.15. Based on an

amount of S$50,200, you would have obtained HK$313,750 rather

than HK$251,000, a huge diff erence of HK$62,750.

With Scenario 2, you can actually lose quite a lot of money if you

decide to convert the HK$ back to S$:

HK$251,000 x 0.15 = S$ 37,650

Th is translates to a loss of S$12,350 or nearly 25 per cent. But

again, since you do plan to have HK$ anyway, converting the HK$

back to S$ is not a consideration for you.

Some fi nancial commentators have written against DCI, calling

them attractive investments that are without much bite. While the

high interest rate is attractive, the rest of the deal is not attractive. If

your foreign currency goes down (the HK$ weakens as in Scenario

2), you must take all the losses — but of course, only if you choose

to convert the HK$ back to S$. But if the S$ weakens (the HK$

strengthens as in Scenario 1), you don’t get all the profi ts except a

higher-than-market yield, 4.8 per cent in our example.

So the bottom line is that if you are planning to speculate because

you have a view on a pair of currencies, you would get limited

profi ts with unlimited losses. But if you are comfortable holding

money in either currency, and wish to earn an attractive return on

your principal, then DCI may be suitable for you.

FINAL WORDAs you have seen from the examples above, currency investing

can be mind-boggling. But if you are a maturing and increasingly

sophisticated investor, understanding currency products is a must.

Having a globally diversifi ed portfolio means that most of your money

is invested outside, not inside Singapore. Th e reason you may not see


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229this is that, if you are a unit trust investor, the currency translations

and movements are hidden away from you for convenience.

Singaporeans are becoming more interested in direct investments

in other countries and alternative investments such as real estate

and wine. As you make more of such investments, you will need to

deal with foreign currencies. Having a good understanding of what

makes foreign currencies move is absolutely necessary.


SPECIAL TOPICSWe have covered a fair bit of ground in the first three parts, from basic investment concepts to investing in traditional and alternative products.

In this last section, we turn our attention to special topics such as investing for kids, during retirement, your rights as an investor, and whether or not you should get professional financial advice.

In the final chapter, we discuss what we can do to protect our portfolios more actively whether the market is in an upturn or downturn.

4PART


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Investing for Kids

If you have young children like we do, you have probably already

tried to get a sense of how much it will cost to send them to

university. Unfortunately, by the time our children are ready for

university, it is usually about the time we retire. Th ere will be a

tussle for money — should you provide for your kids fi rst or for

your own retirement?

Parents have this perpetual set of worries:

• How to pay for their kids’ university education?

• How to teach kids about money and investment? We want to

teach them to be fi nancially responsible so that we won’t have to

support them in our old age.

GOLDEN RULE OF INVESTING FOR KIDSBack to the question above — in the tussle for your money, who will

win? Your kids, or yourself? Most of the time, you will give in to your

kids and that will mean less for your retirement.

Many people often go the distance for family members and

forget to take care of themselves. When 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 at is a

big mistake. Saving for retirement always comes fi rst. Your child’s

education comes second.

You and your child can fi gure out ways of getting him through

school when the time comes, whether this be through loans,

co-payment or some other means. What you want to avoid is

fi nd yourself broke after having taken care of all your children’s

educational needs, thereby placing yourself in a position of

dependency. So when putting together a strategy for your child’s

education, consider these three steps:

21


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2321. Set a goal to save for up to two years of university expenses,

and no more.

2. Every month, set aside the minimum needed for education

funding and no more.

3. Th e rest of your savings should go into your retirement account.

Remember: Do not give them everything. Make them work

for part of it. By teaching them fi nancial responsibility, you

will be doing them a favour. So set them up for some personal

accountability and let them learn how to fend for themselves.

HOW MUCH IS NEEDED? Whenever the newspapers report on how much it will cost to

educate our kids, we get depressed. As far we can see, it will cost

the equivalent of half a three-room HDB fl at to educate one child in

Singapore today, and one entire four-room fl at if your child furthers

his/her studies overseas. If you have two or more children, it will

require putting aside more money than you could possibly aff ord.

Tertiary expenses include tuition, books, travel and

accommodation. How much does a basic four-year science degree

cost all-in? Based on our compilation,1 the cost of a four-year

science degree from a Singapore university was S$140,000 dollars

in the 2010 academic year. Going to Canada, the cheapest overseas

location popular with students, would cost $185,000.

If we project an education infl ation rate of six per cent, the cost of

educating your child in Singapore starting in 2020 is $250,000. To

send your children overseas, you’ll have to be a millionaire probably

a few times over.

1 Basic cost information was taken from the 13 April 2010 Straits Times article “Fee

hike unlikely to deter foreign students,” and then projections were made.


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233It’s not possible to project what it will cost exactly. But you can

at least use the fi gures in Table 21.1 to obtain an idea of what your

children’s education would cost, and it is hoped this will stir you

into action.

TABLE 21.1 COST OF FOUR-YEAR SCIENCE DEGREE

Country 2010 2020

Singapore $140,000.00 $250,000.00

Canada $185,000.00 $330,000.00

Britain $220,000.00 $400,000.00

Australia $230,000.00 $410,000.00

USA $320,000.00 $570,000.00

Source: Authors’ own compilation.

Note: Figures are rounded to nearest fi ve thousand and includes cost of living expenses.

Investing for UniversityHow you invest depends on when the money is needed. Assuming the

university going age is 18, the nearer your child is to university, the

less risk you can aff ord to take. Let us assume traditional investments

such as unit trusts and bonds are used in the following examples:

1. Investing for pre-teens

If your child is under 13, invest your money aggressively with

as much stock funds as your risk tolerance allows.

2. Investing for teenagers

By this time, you would have begun to switch gradually out of

stocks and into bonds. You do not want to have too much

money to stay in stocks in case there is a market tumble just

before the money is needed.

Table 21.2. (page 234) shows a framework for managing your

asset allocation as time moves forward.


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234 TABLE 21.2. ASSET ALLOCATION IN RELATION TO CHILD'S AGE

CHILD'S AGE <9 9 10 11 12 13 14 15 16 17 18

Stock funds %

80 80 70 70 60 50 40 30 20 10 0

Bond funds %

20 20 30 30 40 40 30 20 10

Short-term bonds %

10 20 30 50 70 70

Cash % 10 20 20 20 30

TOTAL 100 100 100 100 100 100 100 100 100 100 100

Source: Authors’ own calculations

Table 21.2. shows:

• Th e exposure to stock funds gets lower and lower as time passes.

• Bond funds fi ll the diff erence initially, but start to be drawn

down as short-term bonds and cash increase as time passes.

• We suggest short-term individual bonds that are held to

maturity. Holding bonds to maturity off er a known yield and

certain cash when the money is needed.

SOME OTHER MATTERS TO CONSIDERHere are some other options and matters to consider:

Borrow From Your CPF (Ordinary Account) Your child can borrow against your CPF, and pay it back as soon as

he starts working. Th e scheme only covers full-time courses off ered

locally. What if your child decides not to pay up? Well, the CPF

Board will actually take action to recover the money borrowed, plus

interest. Th ere are many conditions to satisfy, however, so please do

your homework, or get fi nancial advice.


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235Investments to AvoidCash value life insurance serves a great purpose in providing

protection for the whole of your life. But as a savings tool, it just

does not generate suffi cient returns. Real estate is too risky for

such a near-term objective. If you take a large loan and the market

collapses, you may not even have money to cover the fi rst year of your

child's education.

Teaching Your Kids about Investing In the old days, parents used to be able to rely on their children to

support them in their old age. Th ings have changed. Because we

marry later and have children later, it is entirely possible that by the

time we retire, we will still be supporting our kids. We fi gure that

the more fi nancially literate our children are, the better off everyone

will be.

YoungstersWe have a friend Ken, who bought his eight-year-old daughter

Sarah a piggy bank. Ken told Sarah that her university tuition cost

is going to be shared 50-50, so she should start saving up part of

her allowance. To give Sarah the incentive to save, Ken deposited

twice what Sarah managed to save each day. So if Sarah saved $1,

Ken would put in $2.

When the piggy bank was full, Ken opened a POSB account. With

the interest from POSB, Sarah learned that money that is wisely put

away can grow. Th is was an important lesson. It took Sarah some

time to get used to the new habit, but very soon, she was fi lling the

piggy bank happily, jiggling it ever so often to hear if it was full.

Th ink how absolutely thrilling it is for children to be able to watch

their money grow!

TeenagersMost teenagers, if they have been exposed to the mechanics of

saving, will sooner or later show an interest in investing. If your son


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236has $2,000 in the bank, try signing up for a joint benefi ciary account

with one of the online fund distributors and buy a unit trust or two.

Better still, let him choose which fund to buy and ask him why. Do

not discourage him. Investment, like any other skill, is best learnt

while young.

You will soon see them going to the newspapers for the latest

prices. Even if the chosen fund bombed out, they would have

learned one of the most important rules in investing: that even the

best investments may hit a snag.

ONE LAST THOUGHTWhether your child is fi ve, 15 or 30, always discuss family investments

in their presence. You don’t need a huge portfolio, but regular

discussions will show the next generation that fi nancial planning is

fun and should be part of everyday life.


Investing During Retirement

Contrary to what many people think, retirees need not make major

changes to the way they invest. As they move towards retirement,

they will have started to adjust their portfolios along the way by

switching to bonds and withdrawing from riskier instruments.

What is really important now is to fi nd ways to satisfy their need

for both income and growth, in order to meet their near-term

and long-term needs. It is a balancing act. How is one to achieve

growth, which is essential to meet rising future income needs,

without taking too much risk?

Th ere are three main questions on their minds:

• How much money can I safely withdraw?

• How can I make my nest egg last forever?

• How can I hedge my portfolio against infl ation?

HOW INFLATION CAN CREATE AN UNHAPPY RETIREMENTWhen I hear retirees talk about how their portfolios consist mainly

of fi xed deposits, we cringe. Why? Because we know infl ation will

cause them to end up with less money to spend. Looking at history,

we know that infl ation has frequently been higher than fi xed

deposit rates.

Th e fact is that while retirees need income and safety from their

investments, they also need growth. Take a look at Table 22.1. (page

238) which shows how much living costs can increase over a long

retirement, based on an infl ation rate of 2 per cent. If you are not

growing your money during retirement, how will you have enough

to last you through your retirement years?

22


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238 TABLE 22.1. LIVING EXPENSES DURING RETIREMENT ADJUSTED FOR INFLATION

Age Annual Living Expenses Adjusted for 2% Infl ation

60 20,000 30,000 40,000 50,000 60,000 70,000 80,000

65 22,082 33,122 44,163 55,204 66,245 77,286 88,326

70 24,380 36,570 48,760 60,950 73,140 85,330 97,520 75 26,917 40,376 53,835 67,293 80,752 94,211 107,669

80 29,719 44,578 59,438 74,297 89,157 104,016 118,876

85 32,812 49,218 65,624 82,030 98,436 114,842 131,248 90 36,227 54,341 72,454 90,568 108,682 126,795 144,909

95 39,998 59,997 79,996 99,994 119,993 139,992 159,991

100 44,161 66,241 88,322 110,402 132,482 154,563 176,643


Let us go through an example. Suppose Daniel, aged 59, is getting

ready to retire and he estimates that his living expenses in his fi rst

year of retirement will be $40,000. By age 80, Daniel will need

$59,438 a year or 50 per cent more than he started out with. While

infl ation in Singapore has been low, it can quickly add up over a

long retirement.

HOW LONG WILL YOUR MONEY LAST?Th is is the big question. Let us consider Table 22.2. (page 239) which

shows the number of years money will last at a given rate of return,

and a withdrawal rate.

Table 22.2 shows that if your retirement dollars can earn 5 per

cent a year and you withdraw 10 per cent of your money each

year, your money will last 13 years. If you have $300,000 in your

retirement fund, you can withdraw $30,000 per year for 13 years.

Now suppose your buddy Joe invests his money at 8 per cent. He

could withdraw 12 per cent or $36,000 per year for 13 years. Th at

is $500 more per month. Keeping most of your money in a fi xed

deposit is not a good long-term retirement plan.


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239TABLE 22.2. HOW LONG WILL YOUR MONEY LAST?

Rate of Capital Withdrawal (% per year)

6 7 8 9 10 11 12 13 14 15 16

5% 35 24 19 15 13 11 10 9 8 8 7

6 32 22 17 14 12 11 10 9 8 7

7 30 20 16 14 12 10 9 8 8

8 27 19 15 13 11 10 9 8

9 25 18 15 12 11 10 9

10 24 17 14 12 10 9

11 22 16 13 11 10

12 20 15 13 11

Source: Authors' own computations

SHOULD YOUR PORTFOLIO HAVE ZERO EQUITIES?Bonds are less risky than stocks. But that does not mean the retiree

should invest 100 per cent in bonds. In fact, studies show that retirees

should have a healthy amount of stocks in their portfolios, or about

20 per cent.

While bonds are less volatile, they are not totally immune to

volatility. A sudden rise in interest rates near the time you need the

money can ruin your retirement party. By adding equities to your

portfolio, you obtain:

1. Lower overall portfolio risk

Th is sounds weird, but it is true. When you add riskier

investments such as equities to your bond portfolio, you can

reduce your portfolio’s overall risk. Th e reason is that equity

and bond prices do not move together. Th e volatility of equities

balances out the volatility of bonds. Together, they usually lead

to a reduction of overall portfolio risk.


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2. Higher overall portfolio returns

Equities will off er you the growth to counter infl ation as well as

increase your income for a nice, long retirement.

BEGIN YOUR RETIREMENT PLAN TODAYNow that you have some idea about what it means to retire, let us

formulate a plan of action.

First, begin by stating your number of retirement years. You

obviously would not know how many years of life you have after 60.

To be safe, expect to live till 90. So if you plan to retire at 60, you

will have 30 years of retirement.

Second, what lump sum will you have at retirement? Let us

suppose you expect to have one million dollars. Th is amount

invested at 6 per cent will last 30 years if you withdraw 7 per cent

or $70,000 annually.

FIGURE 22.1. HOW EQUITIES AND BONDS TOGETHER REDUCE PORTFOLIO RISK


Portfolio becomes

less volatile

Bonds

Equities


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241Th ird, save and invest like crazy. None of us wants a scaled-down

lifestyle during retirement. Stash the money aside today so that you

can live it up during your retirement.

IF YOU HAVE NOT INVESTED MUCH — HOW TO CATCH UPYou had wanted to start investing for retirement years ago. But

monthly bills, unexpected expenses and your children’s education

got in the way of a regular savings plan.

Or maybe you are counting on your CPF money. But you now

know that your CPF funds are not going to be enough to support

you comfortably through 30 years of retirement. If you are now in

your 40s or 50s and have yet to start building a retirement nest egg,

you cannot aff ord to wait any longer.

Avoid “Get Rich” TrapsTh e newspapers and internet are fi lled with get-rich, low-risk

schemes. We have seen more than a few of our middle-age friends

get hoodwinked by these schemes. Even when you are anxious, do

not dispose of your common sense.

With only 10 to 15 years till retirement, you need to choose

investments that will provide growth potential as well as security.

A balanced portfolio of 40 per cent in equities and 60 per cent in

bonds would be a good start. If you are on a late start, don’t further

endanger your future.

Consider Getting Professional AdviceIf choosing investments that strike the right balance between growth

and protection seems too daunting for you at this time, you could

benefi t from the advice of a fi nancial adviser. A fi nancial adviser can

help you choose funds, stocks and bonds, and help determine the

most appropriate asset allocation to meet your retirement goals.


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242Finding the MoneyFinding the money to invest is a big challenge because you do not

have the luxury of time. Most likely, you would have to cut back on

your current spending to fi nd money to invest.

Make a commitment to live more frugally. You do not have to

go hungry, but you can go to fewer expensive restaurants, go for

cheaper holidays and look out for bargains when you shop.

If one of your challenges is funding your children’s university,

consider getting them to take a loan instead. Th ey will have

a long time to pay it off , while you have a short time to prepare

for retirement.

If cutting your expenses is not fi nding you enough money,

consider selling your car. It is one of the most fi nancially draining

things to own. You could also consider a second job. Th e income

from a second job for a few years could get you back on track. And

fi nally, consider postponing your retirement by fi ve years. Working

past your 65th birthday is nothing to dread when you need money.

It can be fun especially when you have a job you enjoy.


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Protecting Your Wealth

with Insurance

You might be asking why we are talking about insurance in an

investment book. Well the reason is simple. You have worked hard

to build wealth and put your fi nances in order, and you don’t want

to leave your fi nancial security to chance. Saving, investing and

planning for the future won’t mean much if an unforeseen event such

as an accident or business failure leaves you fi nancially devastated.

Th is is where protection is needed.

Like most people, you probably already have a fair amount of

insurance to protect your home, income, health and life. You

understand that while insurance may seem like an added expense

in your budget, it’s necessary to your fi nancial plan.

You can insure almost anything under the sun, but certain

things absolutely need to be properly insured. Th ese include your

life, health, car and home as indicated by the bottom layer of the

pyramid shown below (see Figure 23.1.) We will assume that you

have already taken proper care of those basic insurance needs.

FIGURE 23.1 INSURANCE: THE FOUNDATION OF FINANCIAL SECURITY

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Principal not guaranteed

Diversify your Investments

Principal is safe

Save 6 months’ salary for emergencies

Foundation of your Financial Security

Protect your life, health and wealth

Higher

possibility of

loss

23


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244Th e type of insurance we are discussing in this chapter deals with

protecting wealth that you already have acquired. Th at’s right. We

are assuming that you are affl uent with a fair amount of wealth

accumulated or you are steadily on the way to becoming fi nancially

comfortable. In fact, even if you are still busy building wealth for

your fi nancial security, the insurance concepts in this chapter will

be useful to you too.

CAN YOU IDENTIFY WITH SALLY?Sally has spent years taking risks and attaining wealth, and now at

age 50, she is looking for ways to preserving her wealth while earning

a good return without incurring major losses.

Affl uent individuals can easily identify with Sally’s situation.

After achieving success in their careers and businesses, they

begin to have this increasing desire to protect what they have

accumulated. Th e reasons for protection usually range from

wanting to pass on as much wealth as they can to their families to

funding a charity. Th ey want to meet these goals without causing

a huge drain in their wealth or aff ecting their ability to continue

their present lifestyles.

For these reasons, affl uent individuals like Sally should consider

life insurance; a vital component of their long-term planning.

INTRODUCING UNIVERSAL LIFE Th ese days, affl uent individuals have an insurance tool called

Universal Life (UL) insurance. One of the best ways to understand

UL policies is to compare it to Term and Whole Life (WL) policies,

which you are likely to be familiar with — see Table 23.1 (on page

245) for a summary of diff erences.

Universal life insurance is a form of “interest sensitive” type of

WL that off ers a death benefi t, and because of its fl exible premium

feature, it provides the opportunity to build cash values that the

policy holder can borrow from or withdraw. Th e policy cash values

earn interest at a declared rate, which may change over time. Most


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245UL plans guarantee a minimum interest crediting rate. Within

certain limits the policy holder can choose the amount, method

and timing of the premium, payments.

Th ere are three areas where UL diff ers from WL. Firstly, UL

insurance off ers a more transparent fee structure. Th at means you

will be make known of the cost and how much you are paying. It

also allows you to know how much you will be earning from the

policy. Secondly, the policy can be surrendered at any time and

access to cash values that grow at competitive interest rates. Th irdly,

UL policies have sums assured typically in the millions of dollars.

For families of the affl uent, the only thing more challenging than

attaining wealth is protecting it, keeping it for a lifetime and for

the next generation. Th is is where UL can help you by providing a

solid tool in preserving your wealth. UL is a relatively predictable

asset since the amount of death benefi t is usually guaranteed. It also

serves as form of diversifi cation to other investment assets. Th is

means that despite the occasional declines in the stock and bond

market the value held in a UL policy may remain unaff ected.

TABLE 23.1. SOME DIFFERENCES BETWEEN TERM, WHOLE LIFE AND

UNIVERSAL LIFE INSURANCE

Term Insurance Whole Life Universal Life

Duration Fixed such as 10 or 20 years.

Permanent, all of life.

Permanent, all of life.

Premium Usually fi xed. Guaranteed fi xed.

Flexible.

Cash Value

None. Projected cash value.

Guarantee minimum interest crediting rate.

Suitable for Whom

For those who seek pure protection for a fi xed period and because it’s aff ordable.

For those who are conservative savers and want protection all of life.

For those who want a large amount of protection and access to cash values that grow at competitive interest rates.


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246Let’s now turn to two situations in which affl uent individuals

can use UL insurance to protect their wealth. We look at Kim,

a business owner, and John, who wants to leave a donation to his

favorite charity when he passes away.

Kim the Business Owner

Kim left her IT job when she was 35 years old to strike out on her own.

She set up SoftTech to sell IT services to multinational companies.

Fifteen years later, Kim’s company has an annual turnover of $50

million and a healthy looking balance sheet with $15 million in net

assets.

TABLE 23.2. SOFTTECH’S BALANCE SHEET

ASSETS (in Millions) LIABILITIES (in Millions)

Cash 5 Accounts payable 5

Accounts receivables 10 Property loan 20

Commercial property 25

TOTAL ASSETS 40 TOTAL LIABILITIES 25

NET ASSETS 15

SoftTech has total assets of $40 million of which $5 million

is in cash and $10 million is owed by customers. Kim bought a

commercial property worth $25 million a year ago. It has a $20

million loan outstanding against it. SoftTech owes its suppliers $5

million. Overall, the company has net assets of $15 million.

With such a glowing set of fi nancials, Kim felt at ease since

$15 million would surely take care of her family, employees and

the business should something happen to her. What’s more, she

exercised regularly, ate well and was very healthy.

One day while driving to work, Kim became physically disabled

from an accident. Her mental abilities deteriorated and she was

unable to run the company like before, and subsequently died from

the accident. She had not appointed or trained a successor. Th e


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247company’s creditors and customers lost confi dence in the company.

Suppliers demanded to be paid. Th e commercial property market

sank, and the property’s valuation fell below the loan amount — the

bank called for $5 million to be topped up.

In this situation, there may be little choice but to sell the

company’s assets very quickly at fi re-sale prices in order to generate

liquidity to pay off creditors.

Business owners like Kim really do need to have business

continuation plans in place from day one, and life insurance is one

of the most cost-eff ective ways of funding such plans. Yet business

owners often shy away from insurance.

When Kim fi rst took out a loan to buy the commercial property,

her fi nancial adviser recommended life insurance to pay off the loan

in case she passed away or became disabled before the loan was paid

off . Kim not only felt she had enough money, but that life insurance

was expensive and an unnecessary cost to incur. She believed that

should she pass away, her family could sell or liquidate the business

to cover the loans and provide fi nancial security for them.

In reality, this rarely happens. When the family is forced to sell

the business quickly, they may have to sell at a discount or may

experience poor market conditions that make the business less

attractive. In most cases, the business is worth very little without

the founding owner around.

Individual life insurance can protect your family by providing

funds to cover debts, ongoing living expenses, and future plans in

the event that something happens to you. Insurance can also protect

the business by helping to make up for lost sales and earnings, and

to cover the cost of fi nding and training a replacement.

John Leaves a Legacy to His Favorite Charity

Affl uent people are some of the most generous givers to charitable

causes. To them, giving back can be one of the most fulfi lling

experiences of their lives, but they want to do so without wrecking

their retirement plans. Th is is where life insurance can help.


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248Suppose John wants to give away a sum of $1 million to his

university but does not have the liquidity to do so today. He can

buy a life insurance policy and make his university the benefi ciary

of his policy.

Th e price of a $1 million UL policy for a 40-year-old male non-

smoker would typically cost a one-time premium of around

$250,000. In other words, John’s university will receive his desired

donation of $1 million upon his death and he need only fund his

donation with about 25 cents to the dollar today.

CONCLUSIONUL policies have a place in your portfolio even when you are affl uent.

But before you buy a UL policy, there are a few questions you should

keep in mind.

1. Do you need such a policy? Go through a thorough fact fi nd

with your fi nancial adviser to examine your fi nancial situation

and life goals.

2. What happens to your policy if market conditions become

extremely poor? Are there guaranteed returns or might you be

expected to pay higher premiums?

3. Where is the policy is administered? Is it onshore in Singapore

or off shore in another country? Some people prefer UL policies

administered in Singapore so that they are subject to the

rigorous regulations of the Monetary Authority of Singapore

regarding the arrangement of life insurance policies. If

your policy is administered off shore, you need to be aware

of any jurisdictional risks found in that country. You also have

to consider the proximity to after-sales services. Remember

that it’s a permanent policy and you will probably use the

fl exibility of UL policies to make adjustments as your

circumstances change.


1 Visit MoneySENSE at www.mas.gov.sg

When Things Go Wrong

You went to the bank to deposit money into your savings account.

While there, a relationship manager tried to interest you in an Asian

unit trust. Despite being new to investing, you were won over by

the relationship manager’s convincing presentation. You decided

to invest the money that was meant for your savings account. One

month later, the price of the unit trust falls 30 per cent. You’re very

upset. You feel you should not have bought the unit trust. You think

the relationship manager pressured you into buying.

Th is is a common story — investors losing money from investments

that have gone sour. What can you do when things go wrong?

While there will always be cases of unscrupulous salespersons

who take advantage of unwary consumers, the fact is that many of

us are capable of making appropriate investment decisions. Th ere

are countless opportunities to pick up investment tips, including

the many educational programmes and seminars sponsored by the

government as well as investment companies. You can learn more

from consumer guides, TV programmes, newspaper articles, web

tools and other seminars.1

Fortunately for consumers, most fi nancial services companies —

banks, fi nancial advisers, insurance companies and stock brokerages

— are fair and even-handed in their dealings with the investing

public. Constant scrutiny by the media and regulatory watchdogs

such as MAS have contributed to this practice of fair dealing.

In this chapter, we will discuss your rights as an investor and what

you can do when things go wrong.

24


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250YOUR RIGHTS AS A SHAREHOLDERAs a shareholder, whether you own 1,000 shares or 10,000 shares, you

have certain rights. You own part of the company and the company’s

management board is answerable to you.

The Right to InformationOne of your most important rights is that the management keeps

you informed about the progress of, and the material developments

that aff ect the company as it is required by law to do. Of course, the

law has to strike a balance. You should understand that disclosure

aims to put you on equal footing with every other investor, big or

small, and that even the most transparent disclosure provides no

guarantee against loss.

The Annual General Meeting (AGM)Th e annual general meeting (AGM) is an important occasion for

shareholders, especially minority ones, to meet and ask questions.

Attending the AGM is something few investors do although it is

one of the basic rights that come with stock ownership in a public

company. Every investor should attempt to attend annual meetings

as they give a clearer insight into how the aff airs of companies

are conducted.

Looking at the glossy pages in an annual report or the numbers

in the fi nancial statement seldom gives a clear understanding of the

management’s style and objectives. If you are investing a large sum

of money in a company, it makes sense to meet the management

team face-to-face for they are the ones who will ultimately

determine the returns on your investment.

The Proxy StatementTh e proxy statement is a document that a company is required by

law to provide to shareholders containing information that will be

brought up at the AGM.


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251Th ere is usually a section on the voting of resolutions, which may

include issues such as approval for fi nancial statements, declaration

of dividends, proposals for additions to the board of directors and

remuneration for auditors.

In essence, a proxy statement is a ballot sent to a company’s

shareholders whereby the company requests that shareholders vote

in favour of its offi cers and directors continuing in their positions. A

proxy also provides for a negative vote. As a shareholder, you can vote

against re-electing the present management. It is generally diffi cult

for individual shareholders to get rid of the existing management

unless it has openly performed fl agrant acts such as fraud. Hence,

it is not uncommon for a law-abiding, but mediocre management

to continue running a public company for a number of years,

particularly if ownership of the company’s shares is fragmented.

So unless you own a substantial amount of shares (5 per cent or

more), your best option, if you feel a company’s management is

doing a poor job, is to walk away by selling your shares.

WHEN SOMETHING GOES WRONGMost problems investors face fall into one of two categories. Th e fi rst

consists of outright criminal activity such as stealing and cheating

of money through some sort of scam or phony transaction. If

the investment was related to securities, you should contact MAS

or the police.

Th e second and more common category of problems encountered

by individual investors has to do with the execution of a trade, or

the way an account was handled. For example, you may be surprised

to receive a confi rmation via e-mail about a stock you have sold,

although you never gave such an order. Or you may be surprised at

the price at which your unit trust was sold when you had told your

fi nancial adviser to transact at a distinctly higher price.

Most fi nancial advisers and institutions are honest and fair in

their dealings with investors. Errors that occur are simply errors


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252and there is rarely an intention to cheat. Such errors are generally

corrected as soon as they are brought to the attention of the

company representative who sold you the investment.

Where to Turn for HelpShould you still feel that you have been unfairly treated, there are

several ways to seek redress. You can submit an offi cial letter of

complaint to the fi nancial institution. If this does not resolve your

problem, you can consider a dispute resolution scheme.2

Th e Financial Industry Disputes Resolution Centre Ltd. (FIDReC)

is an independent institution specialising in the resolution of

disputes between fi nancial institutions and consumers. FIDReC

was created from the merger of the Consumer Mediation Unit

(CMU) of the Association of Banks in Singapore and the Insurance

Disputes Resolution Organisation (IDRO) to streamline the dispute

resolution processes across the entire fi nancial sector of Singapore.

FIDReC provides an aff ordable and accessible one-stop avenue

for consumers to resolve their disputes with fi nancial institutions

without having to go to court, which is a costlier and more time-

consuming option. For example, consumers can go to FIDReC in

the following situations:

1. For claims between insured consumers and insurance companies:

up to S$100,000.

2. For disputes between banks and consumers, capital market

disputes and all other disputes (including third party claims

and market conduct claims): up to S$50,000.

At present, FIDReC’s services are available to all consumers

who are individuals or sole-proprietors. Consumers pay a

2For a more detailed explanation on dispute resolution, please see “Getting it

Right: How to Resolve a Problem with your Financial Institution”, a MoneySENSE

Consumer Guide at www.mas.gov.sg.


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253nominal administrative fee of S$50 when their cases proceed for

adjudication, and the fi nancial institution pays S$500.

You may even go one step further by seeking the help of a panel

of mediators appointed by FIDReC. Th e panel will give you access

to a pool of industry experts and professionals. Th e panel has the

authority to order the fi nancial institution to do certain things, such

as perform their contractual obligations or make monetary awards.

Its rulings are binding on the fi nancial institution, but not on you.

If you do not accept the panel’s ruling, you can choose to pursue

legal action or approach the Consumers Association of Singapore

(CASE), the Singapore Mediation Centre (SMC) or the Small

Claims Tribunal (SCT). Th ese organisations handle disputes across

all types of products and services, and not just those on fi nancial

matters. In general, taking legal action should be the last resort as it

is usually time-consuming and costly.

If you have a problem with your remisier, you can approach

Securities Investors Association of Singapore (SIAS) Disputes between

retail investors are handled by the Dispute Resolution Committee

whose members meet from time to time when complaints are

received. Not every complaint is heard by the committee. If the

complaint is justifi ed, the committee will seek a cordial settlement

with the broking house concerned. If the complaint is serious and it

contravenes the bye-laws of SGX, the matter is referred to SGX. As

with FIDReC, legal action is avoided.3

3For more information, please visit these websites: www.mas.gov.sg; www.case.org.

sg; www.sias.org.sg; www. sgx.com; and www.fi drec.com.sg


As the market rose, people started to liken the market to a money-

making machine. In such an euphoric environment, according to a

survey, investors felt that fi nancial advisers were unlikely to be able

to add further value.

Getting Financial Advice

Are you a DIY (do-it-yourself ) investor? Or do you prefer to work

with a fi nancial adviser and let him help with the analysis?

As it turns out, your answer could very well depend on market

conditions. If you were invested in the U.S. market between 1995

and 2000, your answer would have been “no”. Th at is because during

that time, the S&P 500 tripled in value, from 500 to 1500 points,

off ering a very nice return of 25 per cent annually over fi ve years.

FIGURE 25.1. S&P 500 BETWEEN 1985 AND 2010

2000

1500

1000

500

0

1985 1990 1995 2000 2005 2010

Source: Standard & Poor’s

25


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255By 2003, when the S&P fell 50 per cent, many investors lost

large fortunes. A second survey done by the same company then

found that over 90 per cent expressed interest in working with a

fi nancial adviser.

DO YOU NEED A FINANCIAL ADVISER?Before deciding whether you need a fi nancial adviser, answer these

two questions:

1. Are you worried about how to handle market volatility? Markets

will sometimes go crazy. Have you a game plan when that

happens?

2. How much time are you willing to spend constructing and

monitoring your portfolio, as well as following the market and

reading up on new products?

If these questions make you feel uneasy, or suggest that you could

use some help, a fi nancial adviser can be a great ally. Working with

a fi nancial adviser off ers three important benefi ts:

1. Time

Investing on your own takes time. Th is is time that is taken

away from your family, your work and hobbies. Some of the

smartest people around have fi nancial advisers. Daniel

Kahneman, who shared the Nobel Prize in Economics with

Vernon L. Smith in 2002, admits that he gets advice from his

fi nancial adviser.

2. Discipline

Financial advisers use a structured process to manage your

investments. Every six months, or at some fi xed interval, your

adviser will meet you to update you on your portfolio and the


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256 market. If your adviser is worth his salt, he will also consistently

nag you to invest smartly to keep you on track.

3. Expertise

Financial advisers have the expertise that most investors may

not have to do an eff ective job. Th is is not to say that investors

are not capable of attaining this expertise. We have spent

chapters of this book saying you can. But the fact is that

fi nancial advisers have made the commitment to attain a level

of expertise that most investors are not willing to make.

Financial advisers go through rigorous exams to get licensed.

Some fi nancial advisers even take professional exams to get

more expertise. As a result, they have the latest knowledge of

the markets, products and solutions to help you.

ARE ALL CERTIFICATIONS CREATED EQUAL?

If you have trouble sifting through the alphabet soup to tell the

diff erence between a CFA, ChFC and CFPCM, here is some help.

Below is a list of fi ve popular designations and what each one does:

Chartered Financial Analyst (CFA)

Th is is the Rolls-Royce designation for investment

professionals. A CFA holder is a specialist and he has to

demonstrate competence by passing exams on accounting,

economics, money management and security analysis.

CFAs tend to work with institutions rather than directly

with individuals.

Certifi ed Financial Planner (CFPCM)

A CFPCM holder has overall expertise in personal fi nancial

planning in these areas — risk management, insurance, tax,


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How Meaningful are These Letters?Certifi cations are a mark of professionalism. A professional has

gone the distance to acquire expertise. He conforms to a strict code

of ethics to provide advice for your benefi t rather than his own.

Certifi cations are conferred on individuals with a certain number

of years of relevant work experience. Th is ensures that the ChFC or

CFP sitting across the table is not fresh out of school.

While certifi cations are not everything, you should give credit

to an adviser who has any of these designations. Many of these

certifi cations require many hours of study to meet high standards.

WHERE DO FINANCIAL ADVISERS COME FROM?Th ere are some 13,000 fi nancial advisers in Singapore and they come

from two main sources:

estate planning, investments and retirement planning. Unlike

a CFA holder, a CFPCM holder has not obtained the knowledge

to be a specialist in any one area.

Chartered Financial Consultant (ChFC)

Th e ChFC is similar to the CFPCM. Th e ChFC holder has

also not demonstrated specialist knowledge in any one area.

Where they diff er is that the ChFC requires the candidate

to pass two more exams compared with the six the CFPCM

candidate has to take. Th e two exams deal with planning for

business owners and wealth management.

Chartered Life Underwriter (CLU)

Th is designation is for a specialist in insurance.

Certifi ed Public Accountant (CPA)

CPAs are specialists in tax and accounting. Th eir title does not

indicate training in other areas of fi nancial planning.


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2581. Financial advisers who are “tied” to a specifi c company and its

products

Tied advisers such as those from Prudential and AIA can only

sell fi nancial products created or distributed by their

companies. If you are looking for an investment product,

your AIA adviser can sell you only products that AIA

distributes. Tied advisers usually come from four large

companies — besides Prudential and AIA, there is also Great

Eastern and NTUC Income. Th ere are about 12,000 tied

advisers in Singapore.

2. Financial advisers who are not tied to a specifi c company and

its products

Th ese untied fi nancial advisers can advise and sell you products

from several product manufacturers. So if you are looking for

an investment product, an untied FA will have access to many of

the fund management houses in Singapore. Th ere are around 30

untied companies in Singapore with about 1,000 advisers in total.

Does this mean that you should only go with untied fi nancial

advisers who can off er you products from many companies rather

than a tied fi nancial adviser who can off er products from only his

company? Th is is a huge, ongoing debate that is not about to cease.

Depending on which side of the fence an adviser sits — tied or untied

— you will hear an impassioned endorsement for the side he sits on.

Th is is the bottom line — products do not make the valued

adviser, good advice does. If you take the trouble, you can buy many

investment products directly on your own. Products are always

available, but not good advice.

One study by CEG Worldwide in 2003 by Russ Alan Prince, a

renowned researcher on the wealthy in the U.S., showed that

investors are generally starved of good advice and that a mere

26.7 per cent of investors surveyed were very satisfi ed with

their current advisers. Th e remaining three-quarters regard


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259their advisers as “fair” or “poor” and are willing to work with

someone else.

FINDING A GOOD ADVISERJust what should you look for in a good adviser? Here are three

“must-have” factors to look out for.

The Adviser is Licensed Financial advisers are licensed by the Monetary Authority of

Singapore when they pass the required regulatory exams and are

registered as advisers with a fi nancial advising company.

Registered financial advisers have a fiduciary responsibility

to provide financial advice that is in your best interest. They

typically have to sit you down and take you through the

seemingly tedious process of answering questions from a form

called the Financial Needs Analysis. It would be silly of you to

take this lightly.

Th e questions help you and your adviser learn about your

fi nancial objectives and risk profi le — two critical components

to fi nding suitable investment products for your portfolio. Just as

your doctor would not know what is wrong with you unless you

tell him, your fi nancial planner will not know how best to help

you if you do not tell him your fi nancial goals.

Comfort ZoneIf you come across an adviser who annoys you no matter how

clever he is, you might want to drop the fellow. While you and your

adviser need not be soul mates, you need a basic level of comfort

and rapport to get anything done.

When we present lectures to fi nancial advisers on investing, we

convey this important message — it is not worth the money to work

with a client that you do not like, or do not get along with.


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260Making SenseDo you generally agree with how your adviser thinks? Or are you

always arguing with the recommendations your adviser makes?

Th e fact is that if you are always in disagreement with him, there

is probably some fundamental diff erence between the way both of

you think.

Whether you or your adviser turns out to be right in the end is

secondary. What matters more is that you and your adviser have

a fundamental diff erence in thinking about an important issue —

how you manage your assets.

PREPARING TO TALK TO YOUR FINANCIAL ADVISERFinancial advisers cannot make decisions for you. You give them

the facts, they off er advice and you have to decide what to do. It

is a mistake to assume that they can take away the risks and make

predictions. Th at is why it is a good idea to do some preparation

before you meet.

If you only have 10 minutes to spare, here are fi ve questions we

recommend you ask:

1. Do you invest yourself? Tell me about your investing experience.

2. What kind of expertise does your company have to help me?

3. How are you being paid to give me advice?

4. How can I lose money if I follow your investment plan?

5. What problems can I face if I need my money back earlier?

HOW DOES YOUR ADVISER EARN WHEN YOU BUY INVESTMENTS?Your adviser earns from the investments you buy. He could earn

from upfront, one-time-only commissions, or he could earn


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261a recurring fee based on the amount that you have invested

with him.

What? Keep paying your adviser year after year?

If that sounds crazy to you, then you will be surprised to hear that

this is actually becoming a popular way of managing investments.

TABLE 25.1. TYPICAL PAYMENT MODES FOR ADVISERS

Commission

structureUpfront commission Recurring fee

Traditional

commission-based5% None

Recurring fee-based 2% 1%


Example of Traditional Versus Recurring Fee StructureTh e traditional commission-based adviser gets paid a lump sum

when investment purchases are made. Th ese purchases can be

either outright new purchases or switches (where you sell out of one

investment and buy into another one).

Th e recurring fee-based adviser often charges a lower upfront

fee, plus a low, recurring annual fee based on the value of the

investment assets under advisory (AUA). For example, your adviser

may charge you an upfront 2 per cent (as opposed to 5 per cent)

and subsequently on an annual basis, he charges you 1 per cent

based on AUA.

You will see that it will take about three years before you will have

paid a total of 5 per cent (2 + 1 + 1 + 1) in terms of fees. In the

meantime, you can evaluate whether your adviser is doing a good

job or not. Your adviser does well when your investment portfolio

does well. So he has the incentive to do a good job over many years

rather than just during the fi rst year.

If you are planning to pay your adviser annual recurring fees,

do ask about a wrap account. Wrap accounts off er free switching.

When you sell one investment and buy another within a wrap


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262account, it will not cost you any money and your adviser does not

earn from the switching.

Paying for Financial AdviceYou have found your ideal adviser. He is competent, has a team of

experts and he even has a great sense of humour. Would you pay him

a fee for fi nancial advice? NTUC conducted a survey in 2002 and

found that seven out of 10 people were not willing to pay for fi nancial

advice. Are you one of the seven?

Suppose you have $100,000 to invest. Here are two questions you

should ask yourself:

1. Would you value free fi nancial advice?

Imagine going to a dentist who says he will not charge you for

the time and advice he gives you. You will be worried if he

might pull your teeth out to sell you dentures. You see, paying

a fee helps ensure that the fi nancial adviser does his best.

2. Would you be doing the best for yourself?

Suppose you want to learn Chinese. Your colleague off ers to

teach you for free every Saturday afternoon. Good deal? Bad

deal. When things are free, you just will not take things as

seriously. When you pay a fee, you take greater responsibility

for your own aff airs.You will ask better questions. You will

keep better records. You will take greater interest in what is

being said and done. Your fi nancial adviser will serve you

better if he is paid.

Th ere are exceptions, of course, because paying a fee does not

make sense in certain situations. You may know exactly what you

want — for example, a mortgage. Or the amount may be small — you

want to invest $2,000 in a balanced fund. In both situations, a simple

product purchase will do the job. A fee is not paid for any advice, and

the fi nancial adviser earns a commission from the product sold.


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263As a rule of thumb, paying a fee makes sense when the amount

invested or managed is large, such as $100,000; the situation is

complex enough that analysis and advice are needed, such as

creating a comprehensive fi nancial plan; or the objective is a long-

term one that requires regular monitoring and adjustments, such as

managing a portfolio of investments for your retirement.

What is generally true is that many of our fi nancial needs are long

term and they have to be managed over the course of our lives. We

need a structured process to look after these matters. In return for

getting a regular dose of good advice, you should consider paying a

regular fee. Your fi nancial adviser may give you good advice for free

today, but he may not be around too often to help you in future. Be

mindful, though, that paying for advice does not necessarily mean

you will get good advice.

ARE YOU A GOOD CLIENT?A lot of the success of an investor has to come from the investor

himself. Sure, we know that fi nancial advisers have a responsibility to

act in a prudent manner with regard to your money. Th ey have to go

through a fact fi nd with you, ask a zillion questions and then crunch

all sort of numbers. But how prudent are you yourself in making sure

you succeed with your fi nancial objectives?

Let's look at three activities that will help you help yourself — and

better your relationship with your rep.

1. Keep Up-To-Date Records — Do you keep your investment

accounts in a special fi le or do you put them anywhere you can

stuff paper, such as under your car seat or your messy work

table? Do you even know what investments and insurance

policies you own? You’ll be surprised how many people don’t

even know this.

2. Take Detailed Notes — When you communicate with your

adviser on the phone, via email, or in person, take notes. Th is


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264 will give you a hard copy of the experience, and if you are not

so savvy with investments, you will have your notes to refl ect

on and learn. And if there is ever a confl ict between you and

your adviser, these notes will serve as evidence of what

transpired.

3. Track Commissions — Commissions can take a big bite out

of your investment returns, and can be very painful when the

market is going down. So make sure you are being charged

what you are supposed to be charged. Don’t assume that

just because your fi nancial adviser uses a large, fancy computer

programme to generate reports, mistakes can’t happen.

THE BOTTOM LINEOne of our mutual friends who is a very successful adviser was asked

how he became so successful. He replied that 25 per cent of his clients

were, in his words, super-charged investors. Th ey would constantly

hound him for information, question his advice, expect regular

updates on the economy, and quite often, even give him really useful

insights on investments. His super-charged clients keep him on his

toes and as a result, he does know more than other advisers. Are you

a super-charged investor yourself?


1If you had a $100,000 portfolio that fell by 50 per cent to $50,000, your portfolio

would have to go up 100 per cent in order to get back up to $100,000.

Protecting Your Portfolio in

Downturns and Upturns

We have advocated many of our long-held beliefs about how

successful investing should be carried out in this book:

• Place most of your retirement funds into a diversifi ed portfolio.

• Buy and hold because you can’t time the market.

• Get a professional to help you.

If you have done this throughout the years running up to your

retirement, you will have done fi ne.

When the subprime crisis began unravelling, many people found

their portfolios drop by 30-50 per cent in a matter of a few months.

In the fi ve months between October 2007 and March 2008, the

STI fell over 1,000 points. If you were one of the unfortunate ones

whose portfolio fell by 50 per cent or more, here are three points

to consider:

1. Your portfolio will now have to rise by 100 per cent in order for

it to go back to its pre-crisis level.1

2. Where was your fi nancial adviser when all this was happening?

3. What can you do to make sure you don’t get into such a mess

again?

26


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266Let us take the fi rst point. With a 100 per cent climb ahead, you

would be asking when your portfolio would regain its value and

continue its long-term upward trend. We’ve seen that markets do

adjust quickly and with more governments working together to

avert and manage disasters, it might even be faster.

But suppose you don’t have the time because you were planning

on retiring when the crisis hit. Or your children are going to

university next year, and you just lost two years of tuition fees. Th is

would be a very bad situation to be in and not uncommon at all

whenever a crisis hits.

Now what if you do have time to recover because you’re still

young? Well-meaning fi nancial advisers are apt to say that given

time, your portfolio will recover, so don’t sell … hold. Well, you may

be surprised to know that this does not work all the time and when

it does not work, the pain can be excruciating and last a long time.

Look at the STI during these two periods:

Year Level

1996 2400

2006 2400

Th e STI hit 2400 in 1996 on the heels of the Asian fi nancial crisis.

While the STI recovered to pre-crisis levels in 2000, it didn’t go

much higher than the 2400 level. It was only in 2006 that the STI

went appreciably beyond 2400. You see, even when you have time

on your side, you may also have pure bad luck.

Th e next question is how well your fi nancial adviser served

you during this time. Did he contact you when the crisis hit or

did he hide away to avoid your anger? Did he have the ability to

distinguish between safe and unsafe market conditions?2 And

even if he did, would he have asked you to liquidate your positions

when the crisis hit?

2Judging from their huge multi-billion losses, you’ll see that the largest banks in the

world had a tough time fi guring this out too.


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267Probably not. Financial advisers and fi nancial institutions rarely

emphasise selling strategies. Everyone from banks and brokerages

to private bankers and fi nancial advisers all emphasise buying

strategies. And once you have bought, they try their best to

have your funds stay with them since assets under management

(AUM) are a recurring source of income for them. Even when

prospects for an investment have turned very poor, advisers rarely

downgrade its rating from “buy” to “sell”, but instead downgrade

them from “buy” to “neutral”, or from “buy” to “hold”. Tune in to

the business news to listen to analysts and corporate executives,

and try counting the number of buy versus sell recommendations.

Professional advice is often tainted by confl icts of interest and

you have to understand that. In the end, we all need professionals

to do the things we cannot do, but you have to keep both eyes and

ears open. Th e important rule is that you really can’t trust anyone

100 per cent, not even your own spouse or your parents, to monitor

your portfolio the way it should be monitored. It is you who has

that ultimate responsibility.

So the question really is, “Where were you when the market was

falling?” Did you keep up with the news? Did you contact your

fi nancial adviser? Did you speak to your friends in the know about

what was happening? Did you take care of your own fi nancial

well-being?

Finally, what can you do to avoid such situations in future? We

will examine this very question the rest of this chapter.

PROTECTING YOURSELF IN AN UPTURNTh ere’s no typo here. Many people get euphoric and blind when

the market is doing well. Th ey get into riskier instruments, ignore

their fi nancial advisers, give everyone they meet investment tips and

throw their long-term asset allocation down the canal.

When your portfolio is rising in value, there are a few things you

can do to keep it structurally safe.


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2681.Rebalance your portfolio regularly

When your stock allocation rises above the recommended long-

term allocation, rebalance the portfolio. If stocks have outpaced

bonds, it means you should sell stocks and buy bonds to return

your portfolio to its long-term allocation. Buy-low, sell-high

always works. Studies show that rebalancing not only produces

better results than not rebalancing, but also reduces your

portfolio’s risk.

2. Try a short-term momentum strategy

One criticism of rebalancing is that you are selling investments

before they reach their highest point. Here’s an alternative.

Studies have shown that when funds do well in the recent past,

chances are that they will do well in the near future as well.

Th is is a short-term momentum strategy of “buying high” that

appears to be quite opposite to the buy-low sell-high tactic

of rebalancing.

According to a study by Gerald and Marvin Appel, it was

found that funds with above-average performance during a

three-month period have a better chance of returning above-

average profi ts during the subsequent three-month period.3

Th ey showed with the help of ETFs how they were able to

outperform the underlying benchmarks consistently with this

momentum approach. Th is is a strategy we can carry out quite

easily by simply switching into the top-performing funds within a

category every three months. What this would entail for you for

Asia ex-Japan funds, for example, is to access www.fundsingapore.

com every three months to fi nd out which funds outperformed

and to switch into that fund, and to do this every three months.

You should try this only if you are prepared to monitor your

portfolio regularly. We have not back-tested this strategy on our

regional markets although we believe it makes sense because

3“Beating the Market, 3 Months at a Time,” by Gerald and Marvin Appel.


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269when securities are on an uptrend, they tend to remain on that

trend for some time.

3. Redo your risk profi le once a year

Your risk profi le is meant to be a long-term indicator of an

appropriate asset allocation. If you are deemed an aggressive

investor, then your asset allocation should refl ect that view

accordingly with larger amounts of stocks versus bonds in your

retirement portfolio.

You should still do your risk profi le once a year, particularly

when you are at the threshold of the next risk level. For

example, if you are planning on retiring soon and your risk

profi le was done three years ago when you were deemed an

aggressive investor, you should redo your risk profi le right away

and make any necessary adjustments to your asset allocation.

Long-term indicators can change from year to year for short

periods of time. For example, suppose:

• You just won a huge lottery.

• You and your spouse are expecting twins.

• You contract a rare disease and the doctor says you need 12

months to recover.

• Your apartment went en bloc.

• Your daughter won a university scholarship.

• Your retirement portfolio lost 50 per cent this year.

Th ese negative and positive situations are not remote at all. Th ey

happen all the time and they are unpredictable. Do hang on to your

long-term asset allocation, but please do your short-term checks


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270also. Unexpected short-term events can permanently alter your

long-term plans.

PROTECTING YOURSELF IN A DOWNTURNTh e market is falling. If you want to be more active about managing

your portfolio, and not just buy-and-hold, here is a list of strategies

you can consider:

1. Sell your holdings and move to cash

Th is is not our favourite recommendation because it means

incurring selling costs and moving your funds into cash that

earns you less than the infl ation rate.

2. Stay diversifi ed

You should do this without question.

3. Move into more favourable sectors in small steps

Th is requires some monitoring. If the U.S. is faltering and

China is hot, then reallocate fi ve per cent to China or an Asian

investment. If stocks are doing poorly, reallocate fi ve per cent

more to commodities or to bonds. We recommend that you do

such active reallocation in small steps and such that your

portfolio is not completely out of sync with your long-term plan.

4. Buy quality

Buying quality such as blue chip stocks is a defensive move that

works regardless of market conditions. So don’t wait for the

market to be in a downturn before you invest in quality.

5. Buy absolute return investments

Hedge funds are a good choice as they focus on absolute

returns. If you are not an accredited investor, then there are

quite a number of absolute return unit trusts available in

Singapore. While hedge funds can short-sell stocks, use


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271 various derivatives and leverage, unit trusts cannot, but can

use derivatives to generate income and hedge market exposure

in order to generate absolute returns.

6. Invest in commodities

As stocks are falling, commodities have been rising. Not

only is there a low correlation between stocks and

commodities, commodities have provided good protection

against infl ation.

7. Sell derivatives

If you want to protect your Singapore portfolio, for example,

you could short sell STI futures. In the event of a market

downturn, your losses from your actual portfolio can be

compensated by the gains from your short futures position.

8. Invest in the market through ETFs

Th is will save you expenses when you are in a tight spot although

you will have to accept that ETFs are not expected to outperform

their benchmarks.

You see that many of the protective steps you can consider

taking — whether the market is in a downturn or upturn — may

be outside the expertise of your fi nancial adviser, or outside the

scope of products the fi nancial institutions he belongs to off ers.

We’re not suggesting that you have four or fi ve professional

advisers to advise you on your portfolio. After a certain number,

too many cooks will ruin your soup unless perhaps, you have at

least a mega-million dollar portfolio, in which case you may not

even need this book.

Th e Asian fi nancial crisis in 1996 changed a lot of perceptions as

it showed how interlinked the world’s economies are. Th ese days,

we have a globalised fi nancial system that allows billions of dollars

to move from one jurisdiction to another in seconds, hedge fund


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272managers taking a bad situation such as the subprime crisis

to make billions, and the invention of technically challenging

products because of innovations made by fi nancial engineering.

We believe that as you move forward, you really need to pay

attention more actively to the markets, monitor your portfolio

actively and get the best fi nancial advice you can. Yes, we believe

in buy and hold, but please actively monitor your portfolio at the

same time.


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