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Basics of Investment

2005

DraftContents

When to InvestEstablishing Personal Investment Policy Return and RisksHorizon and LiquidityExample - PolicySummaryAppendix

DraftSetting up Priorities

1. Savings for Emergencies

2. Insurance Cover (accidents, medical, life)

3. Investment

DraftTraditional Investment

Cash– Liquid Assets, pay interest– Eg. Short term deposits, Treasury Bills

Bonds– Fixed Income Instrument, pay coupons (or

interest)– Eg. Government Bonds, Corporate Bonds

Stocks– Shares in companies, pay dividends– Eg. Microsoft shares , IBB shares

DraftWhich Ones to Buy ?

Stocks have generally outperformed at some point or another, hence have received quite a lot of attention.

Microsoft Shares? Tech Stocks? Value Shares? Biotech? Growth Stories?

Long term bonds? Munis? Asset Backed?

Lots of Questions – Need Lots of Answers?

DraftAnswer :

Depends on your

Goals

Age

Asset Size and

Risk Tolerance ….

DraftContents

When to InvestEstablishing Personal Investment Policy Return and RisksHorizon and LiquidityExample - PolicySummaryAppendix

DraftSetting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;a. Time Horizonb. Liquidity Requirementc. Laws & Regulationsd. Taxes where applicablee. Unique Needs

Draft1. Return Objective (Goals)

Finding the right Return Objective– Eg. To double your money in 10 years.– Steady return over long periods of time– To get $1,000,000 in 30 years– To get $100,000 in 6 years– etc

DraftData From 1926-2001

Asset Type Average Return per year

Large (Blue Chip) Stocks 10.7%

Small Stocks 12.5%

Long Term Corporate Bonds 5.8%

Long Term Government Bonds 5.3%

US Treasury Bills (Cash) 3.8%

DraftReturn in US Stock Market

Eg. US Stock market investment of US$100 in Dec 1981S&P 500

1981 $100.001982 $114.761983 $134.581984 $136.471985 $172.401986 $197.611987 $201.621988 $226.621989 $288.371990 $269.461991 $340.341992 $355.54

1993 $380.621994 $374.761995 $502.591996 $604.441997 $791.861998 $1,003.041999 $1,198.902000 $1,077.342001 $936.832002 $717.932003 $907.322004 $988.92

DraftInvestment in US Stock Market

US$100 Investment in December 1981 turned to a handsome US$988 in December 2004

0

200

400

600

800

1,000

1,200

1,400

DraftS&P Monthly Returns

Monthly Returns of US Stocks have been Volatile

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Draft

• Source : Stocks, Bonds, Bills and Inflation 2002 Yearbook

DraftSetting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;a. Time Horizonb. Liquidity Requirementc. Laws & Regulationsd. Taxes where applicablee. Unique Needs

Draft2. Risk Tolerance

• Setting Return Objectives needs Risk Parameters

– No pain No gain : No risk No Return

• What Risk to assume??

DraftInvesting in Shares of Companies

Risks in Investing in Shares of Companies– Specific Risk (companies can be unprofitable and at worst

can go bankrupt)– Sector Risk (share price can also fall following the same

companies within the same sector)– Market Risk (share price of a company can also fall with the

rest of the stocks in the same market)

These risks need return compensation. Sometimes you are well compensated, other times you are not.

Solution : DIVERSIFY, across many stocks, many sectors, many markets.

Simpler solution : BUYING INDEX FUND

DraftReturn and Risk

Historical return of various asset classes against the risk (annualized)Sources : Various

0%

5%

10%

0% 5% 10% 15% 20% 25% Risk

Return

US Bonds

US Equity

DraftDiversification : Combining Assets

Benefits of Correlation between asset classes

Stocks and Bonds rises and falls at different times

DraftSetting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;a. Time Horizonb. Liquidity Requirementc. Laws & Regulationsd. Taxes where applicablee. Unique Needs

Drafta. Time Horizon

• Risk and Return objective usually have different parameters depending upon time horizon of the investment

• Age plays an important role for individuals.

• Example Return Objective of Setting a Retirement plan (at the age of 55)– A person who is 25 for instance, will have a different set of

risk tolerance compared to another who is already 48 years old.

DraftPhases of Life

DraftSetting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;a. Time Horizonb. Liquidity Requirementc. Laws & Regulationsd. Taxes where applicablee. Unique Needs

Draftb. Liquidity Requirement

• Again, Risk and Return objective usually have different parameters depending upon Liquidity Requirement from the investment fund

– Example, the need of a regular income as opposed to one lump sum payment

– or the need of a big payment (example a new house) at age of 40. This liquidity requirement has to be incorporated when we set up the portfolio

DraftSetting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;a. Time Horizonb. Liquidity Requirementc. Laws & Regulationsd. Taxes where applicablee. Unique Needs

DraftOther Considerations

• More Diversification– Alternative Asset Classes

• Other Risks– Currency, Country, Counterparties etc

• Regular Investments versus Lump Sum Investment

DraftMore Diversification

Spreading your risk by investing in a variety of assets to protect

your overall investment without sacrificing too much of expected return.

Need to find the optimal diversification mix from a variety of instruments available subject to again your age, asset size, tolerance for risk and investment goals.

DraftVarious Asset Classes and the Risk Profile

DraftCurrency Risks

Studies have shown the following• Expected Returns of Equity Investments are generally

expected to be high. Much higher than the currency risks

• Bond Investment Return on the other hand tends to be more moderate and as such, currency risk may be more pronounced

Currency Management may prove important in a diversified portfolio. More importantly are the goals of the fund

DraftS&P 500 index US$ vs SGD$

• During 1982-2004 SGD$ fell 20% against US$. Investing in US Stocks during the period earned 11% p.a. in US$. In SGD$ term, return is 10% p.a.

DraftContents

When to InvestEstablishing Personal Investment Policy Return and RisksHorizon and LiquidityExample – Mr Ash BurnSummaryAppendix

DraftInvestment Policy Example : Mr Ash Burn

1. Return Objective (Goals) :Wishes to have monthly income of US$5,000 at the age of 56 - for 24 yearsWishes to travel a lot when retired, US$ requirement not a priority

2. Risk ToleranceMedium to High Risk (Age is 24 earning US$2,000/mth 5% increment/year)Don’t really mind currency risk – Wish to have multi currency exposure

Subject to ;

a. Time Horizon - 31 years to go before 1st Paymentb. Liquidity Requirement - No real need of liquidity from this

investment fundc. Laws & Regulations - US law & regulation appliesd. Taxes where applicable - No tax concessions

DraftInvestment Strategy Example : Mr Ash Burn

Based on the policy set in the previous slide example recommendation for Mr Ash Burn is as follows;

Allocation Expected Return Volatility

US Equity Index 20% 9.2% 21.7%

Developed Market Equity Indices (non-US) 30% 6.3% 18.9%

Emerging Market Equity Index Fund 20% 11.1% 27.9%

Private Equity Fund 15% 19.0% 20.0%

Long term Fixed Income Funds 15% 1.2% 6.5%

Total 100% 9.0% 12.0%

DraftInvestment Requirement

Given 9% Annual Return Expectation, Mr Ash Burn will need to come up with either

– a lump sum investment amount of US$ 40,753,or

– an annual investment of US$ 3,615 ($301/mth)

20%

30%

20%

15%

15%

US Equity IndexDeveloped Market Equity Indices (non-US)Emerging Market Equity Index FundPrivate Equity FundLong term Fixed Income Funds

DraftInvestment Requirement

• If Return Expectation is more moderate 6.5%, need;– a lump sum investment amount of US$ 103,896,

or– an annual investment of US$ 7,390 ($616/mth),

Or an even better (less painful alternative)

• $4,885/year (but increasing this payment by 5% per year), hence monthly installment will be $407 on the 1st year, $427 in the 2nd year, and so on and so forth. At 52 for instance, he will be paying $956/mth. Perhaps this will be an easier option as he is assumed to earn more as he grows older

DraftPolicy Review – Mr Ash burn

1 year later, the investment policy is reviewed

Return expectation may change, or his risk appetite may change, or he suddenly decides he wants to incorporate a mansion when he is 60 and is willing to receive less monthly annuities

All of which will require a different investment strategy and hence different monthly installments

DraftContents

When to InvestEstablishing Personal Investment Policy Return and RisksHorizon and LiquidityExample - PolicySummary – 4 Key PointsAppendix

Draft4 Key Points

1. Set up Investment Policy - Return & Risk goes hand in hand

Avoid “get-rich-quick-and-no-risk” schemes

2. Regular Review of Investment Policy At least once a year Adjust Risk Lower Towards Maturity

3. Regular Investments Avoid the need to time market Entry points are averaged over the long run Painful lump sum investment can be avoided

4. Diversified Portfolio Fund Type Investments generally simpler Avoid the pain of being hit by specific risks

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Appendix

DraftMore Classes of Assets

Trade-offs between Return

and Risk

High Returnnormally

associated with High Volatility

DraftRisk versus Return

Yet another chart depicting various assets’ return and

risk characteristics(from the point of view of

US investors)