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KEON CHEE & BEN FOK
HOW TO GROW YOUR INVESTMENT DOLLARS
KEON CHEE & BEN FOK
© 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. Cover images: kavitha/SXC.hu, hele-m/SXC.hu, 2007 Presidential $1 Coin image from the United States Mint Design: Lock Hong Liang Published by Marshall Cavendish Business An imprint of Marshall Cavendish International 1 New Industrial Road, Singapore 536196 All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Request for permission should be addressed to the Publisher, Marshall Cavendish International (Asia) Private Limited, 1 New Industrial Road, Singapore 536196. Tel: (65) 6213 9300, fax: (65) 6285 4871. E-mail: firstname.lastname@example.org. Website: www.marshallcavendish.com/genref The publisher makes no representation or warranties with respect to the contents of this book, and speciﬁcally disclaims any implied warranties or merchantability or ﬁtness for any particular purpose, and shall in no events be liable for any loss of proﬁt or any other commercial damage, including but not limited to special, incidental, consequential, or other damages. Other Marshall Cavendish Oﬃces Marshall Cavendish International. PO Box 65829, London EC1P 1NY, UK • Marshall Cavendish Corporation. 99 White Plains Road, Tarrytown NY 10591-9001, USA • Marshall Cavendish International (Thailand) Co Ltd. 253 Asoke, 12th Flr, Sukhumvit 21 Road, Klongtoey Nua, Wattana, Bangkok 10110, Thailand • Marshall Cavendish (Malaysia) Sdn Bhd, Times Subang, Lot 46, Subang Hi-Tech Industrial Park, Batu Tiga, 40000 Shah Alam, Selangor Darul Ehsan, Malaysia Marshall Cavendish is a trademark of Times Publishing Limited National Library Board Singapore Cataloguing in Publication Data Chee, Keon. Make your money work for you : how to grow your investment dollars / Keon Chee & Ben Fok. – 3rd ed. – Singapore : Marshall Cavendish Business, c2011. p. cm. ISBN : 978-981-4328-61-6 1. Finance, Personal. 2. Finance, Personal – Singapore. 3. Investments. 4. Investments – Singapore. I. Fok, Ben, 1961— II. Title. HG179 332.024 — dc22
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Ben .To Sarah. Sharon. Keon To my wife. and to my children. for the love and laughter. For the encouragement. For making bubbles ﬂoat and the sun shine. Jeryn and Samuel.
Contents Introduction Part 1 : Basic Investment Concepts 1 2 3 4 Why Learn About Investing The Major Types of Investments The Risks and Returns from Investing Managing Crises and Diversification 8 11 20 28 40 Part 2 : Investing In Traditional Assets 5 6 7 8 9 10 Investing in Unit Trusts Selecting and Managing Your Unit Trust Investments Investing in Individual Stocks Selecting and Managing Your Individual Stock Investments Investing in Individual Bonds Selecting and Managing Your Individual Bond Investments 56 67 84 95 110 122 Part 3 : Investing In Alternative Assets 11 12 13 14 15 16 17 18 19 20 Investing in Exchange Traded Funds (ETFs) and Index Funds Investing in Real Estate Socially Responsible Investing Investing in Commodities Investing in Gold Investing in Hedge Funds Investing in Art and Collectibles Understanding Basic Derivatives Understanding Structured Products and Other Derivatives Understanding Currency 132 138 150 161 172 181 191 197 210 220 Part 4 : Special Topics 21 22 23 24 25 26 Investing for Kids Investing During Retirement Protecting Your Wealth with Insurance When Things Go Wrong Getting Financial Advice Protecting Your Portfolio in Downturns and Upturns 231 237 243 249 254 265 .
Introduction We belong to the sandwich generation. The sandwich generation is being chewed on at both ends. This is why for this third edition. we are seeing the price of a higher education rising faster than the rate of inﬂation. We are seeing a rise in derivatives and currency trading by the public. For many people. Our children depend on us. chances are that your neighbour living next door to you will. For our parents. it could make the diﬀerence between a blissful retirement and a painful one. If you don’t. up 35 per cent. That is why learning how to invest is so important. The investment environment has become very diverse in the last few years. 32 per cent for Slovakia. we are possibly looking at hundreds of thousands of dollars in costs for treating major illnesses they run the risk of contracting. you will either have enough money or you will not. Singapore now has the highest concentration of millionaire households in the world. commodity prices far outpacing stocks and bonds. And this is probably the worst situation you can ﬁnd yourself in — when you have to depend on others to support you in your retirement years. In the future. For our children. is expected to generate millionaires at nearly twice the global rate. And Asia-Paciﬁc. People living in Singapore and in Asia overall are getting wealthier and wealthier. lower real returns and a subprime crisis that is taking years to clean up. We are struggling to support ageing parents and pay university tuition fees for our children. hundreds of structured products being made available at any one time and challenging market conditions with inﬂation. It is horrible to retire when you don’t have enough money. Singapore saw the highest growth in millionaire households. followed by 33 per cent for Malaysia. as do our parents. and 31 per cent for China (2010 Global Wealth Report by The Boston Consulting Group). excluding Japan. In the year 2009. and even worse if everyone around you has enough and you can’t even get by. we have added two .
There is nothing like direct experience. vast pockets of paralysing poverty remain. Tommy Koh. revamped one chapter and expanded on previous chapters in the hope of better describing what is out there. investing is your responsibility. There 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. Chief Economist of the Asian Development Bank. Dr. . Once you are armed with the basic knowledge of investing (which we hope you will gain from this book).new chapters. three-quarters of the population (more than 800 million people) survive each day on less than the cost of a Starbucks latte. Finally. In the future. and most importantly. 60 per cent of all Asians still live in poverty. you will either have enough money or you will not. not anyone else’s. estimates that 42 per cent of Chinese live on the equivalent of less than $3 a day. It is neither the government’s responsibility. Second. if you have never invested before. And when you do succeed. along with corruption and the environment. 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. you need to take the plunge yourself. you will probably want to spare a thought for the less fortunate. you need to keep two things in mind. Singapore’s Ambassador. Despite headline hogging news about Asia’s booming economies. nor that of your remisier or ﬁnancial adviser’s. you need to keep abreast of what is happening in the investment markets. All told. knowing what is happening in the markets will become not only less strenuous but also an enjoyable pastime. In India. Ifzal Ali. Only when you handle your own money will you be able to appreciate and understand fully the complexities surrounding the money markets. First. described “social inequity” as one of Asia’s three biggest challenges. To succeed at investing.
retirement is by far the most important one. We will show how investment risks and returns are calculated so you can assess the performance of your investments. Finally. In this section. While there are many reasons for investing. we will look at the main types of investment assets and discuss whether they are appropriate for you. we find out how crises affect investment performance.PART 1 BASIC INVESTMENT CONCEPTS We start with the basic concepts you need to know to understand and appreciate the art of investment. The findings may surprise you. .
The cost of this four-year programme will amount to $200. This story may not reﬂect your situation completely. and consequently. Being strapped for cash when we are past our peak earning years is not going to be fun.000. 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. That is $300. Then.5 per cent. 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). and prudent investing is one of them.01 Why Learn About Investing Congratulations! You have accumulated $1 million in cash and assets. our children may still be ﬁnancially dependent on us. That is a huge sum of money! .000 for 25 years. Brian. Your dad is 82 and has lung cancer. Suppose you are now 40 years old and plan to retire at age 60 and want a monthly income of $5. But here is a reality check. We are marrying later. will be going to the U. Your million-dollar retirement now looks a lot less attractive. Your mum is 78 and healthy. Your son. as may our parents. His expected cost of treatment is $100. by the time we near our retirement. There are ways to get around our various commitments.000. in two years’ time to do a course in computer science.000 to be deducted from your retirement cheque.114. But let us not allow such grim facts to get us down.S.537 between now (at age 40) and retirement (at age 60). WEALTH ACCUMULATION — THE NUMBER ONE REASON WE INVEST To plan successfully for retirement. there is $400. but the underlying facts are real. you would need to accumulate $1. and you are planning to retire next year at age 55.000 tied up in your executive condo.
1 This means that the longer we live. 3rd quarter. It’s not a ﬁgure cast in stone. While we should plan for our ﬁnancial needs based on 80 1 Koh Eng Chuan. However. At higher and higher rates of return. For example. a woman who has reached 65 years of age can reasonably expect to live on till 85 years.TOTAL FUNDS NEEDED TO PROVIDE $5. you would need to set aside even more — $1.034.5% 6.537 $776. “Measuring Old Age Health Expectancy in Singapore”.114.0% 12.0% Source: Authors’ own computations Funds Needed $1. your burden starts to look lighter and lighter.1. the more money we will need during retirement.000 $1.0% 2. 2000. That is the whole idea behind investing — to reach your ﬁnancial objectives with the least amount of eﬀort and time possible.5 million. you halve your burden to $776.12 MAKE YOUR MONEY WORK FOR YOU If you keep your savings under the pillow. If you invest and achieve six per cent returns.500. . in Singapore Department of Statistics newsletter.000 MONTHLY INCOME FOR 25 YEARS Rate of Return 0. the number 80 is somewhat misleading. TABLE 1.034 $474.733 TWO MYTHS ABOUT RETIREMENT Myth 1: I Will Live Till 80 and That’s It We have one of the highest life expectancies in the world at over 80 years.
If you plan to spend less during retirement. Financial assets — such as stocks. Or if you wanted to buy an antique fountain pen or a rare painting. some have given higher returns than others. Historically. Myth 2: I Will Be Spending Less During Retirement After subjecting your mind and body to 40 years of hard labour. Unlike . Choosing the right instruments that provide the best returns can make all the diﬀerence to your retirement. So give yourself more leeway when making your investment plans. the best doctors and the best foods. you probably want the best vacations. For example. jewellery or art — are tangible. you can touch and take physical possession of them. you will end up with less. your ownership is documented by a legal document. One drawback of owning real assets is that they are generally harder to buy and sell. there is a multitude of instruments we can put our money into. Rather than taking physical possession of the asset. Don’t fall into this self-fulﬁlling trap. Real assets — such as real estate. No doubt you could spend less by downgrading your lifestyle. selling a house takes time because it is a big-ticket item and potential buyers need time to evaluate. plan for it and you will end up with more. You can invest in two main investment categories: ﬁnancial assets and real assets. Expect to spend more. you receive a certiﬁcate that acknowledges your claim as a shareholder of the company. So when you invest in a stock. it is best we plan for a few extra years — till age 90 or more.years as a base mark. but this is surely not something you want. 13 Why Learn About Investing CHOOSE YOUR INVESTMENTS WISELY When we invest. bonds and unit trusts — are ﬁnancial claims on assets. you may have to go to a specialised auction house such as Sotheby’s.
instead. RETURNS SCENARIOS Instrument Rate of Return Keep under pillow CPF OA STI S&P 500 0.709 $1 million $5.000 in interest. In Malaysia. after 40 years.0% 2. That is almost $1 million.000. ﬁnancial assets are easy to buy and sell through organised exchanges such as the Singapore Exchange.0% 12. Not bad. it is the EPF or Employees Provident Fund.5% 6. the scope of investment opportunities is too huge to cover in this book. You can retire a millionaire! But if you had annual returns of 12 per cent over the same period. If. .386 to be exact). Based on the history of ﬁnancial markets.14 MAKE YOUR MONEY WORK FOR YOU real assets. you would have accumulated $995.000 $411. In Hong Kong. it is the MPF or Mandatory Provident Fund.709. As you can probably sense. Such plans are commonly found in other countries. we ought to ﬁnd out which of these investment returns are realistic and which are not.745.0% Accumulated $240. Since the Ordinary Account earns 2. our primary focus is on ﬁnancial assets. you invested the $500 per month over the same period while earning 6 per cent interest. For this reason.2. you would have close to $5.9 million ($5. you will have accumulated $411. you will have contributed $240. You would retire a multimillionaire! TABLE 1. That’s nearly $172.882.9 million Source: Authors’ own computation Given the wide disparity of possible results. all three return possibilities can actually be achieved. after 40 years. RETIRING A MILLIONAIRE Consider this: If you contribute $500 per month to your CPF Ordinary Account (CPF OA)2. 2 The Central Provident Fund or CPF is Singapore’s mandatory social security savings plan towards which working Singaporeans have to contribute.5 per cent annual returns.
S&P 500.S. the Singapore Straits Times Index (STI) of common stocks yielded an annual return of about 6 per cent.. or go down a little. which provides the best returns. 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. Risk is the possibility of losing money on our investments. But we have yet to talk about risk. the obvious choice would be the S&P 500.5 per cent. JANUARY 1996 TO DECEMBER 2007 1800 1600 1400 1200 1000 800 600 400 200 0 B A C Jan Ju 96 n No -96 v Ap -96 r-9 Se 7 p Fe -97 b9 Ju 8 l De -98 c M -98 ay O -99 ctM 99 ar Au -00 g0 Jan 0 Ju -01 nNo 01 v Ap -01 rSe 02 pFe 02 b0 Ju 3 lDe 03 c M -03 ay O 04 ct M -04 ar Au -05 g0 Jan 5 Ju -06 nNo 06 vAp 06 rSe 07 p07 (Source: Standard and Poor’s) . Between 1990 and 2005. 15 Why Learn About Investing WHAT ABOUT RISK? If we were given these three investment choices.5 per cent is an almost unchanging rate. but it will never hit negative. which means that we can’t possibly lose money. Our decision making would then be a simple process of choosing the investments with the highest returns. It may move up a little. FIGURE 1.The interest rate for CPF OA is 2. In the U.1. Putting our money into the Ordinary Account can be considered risk-free. The CPF OA rate of 2.
Just to illustrate.16 MAKE YOUR MONEY WORK FOR YOU Look at Figure 1. you will have to tolerate some risk. Investing in the S&P 500 produces winners and losers. What history tells us is that there is a positive relationship between risk and return. 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). a sense of unpredictability. and along with that. which plots daily prices of the S&P 500 for the period January 1996–December 2007. Michael was a very successful investor who made $2 million in the markets .3. let us tell you about someone we know. RELATIVE RISK LEVELS Investment Choice CPF OA STI S&P 500 Index Source: Authors’ own illustration Risk Level Low Medium to High High 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. But we are sure you will agree that if you want to seek out the best returns.1 (page 15). ~Warren Buﬀet in Berkshire Hathaway. Annual Report. and we can assign relative risk levels to the three investment choices as follows: TABLE 1. 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. We can see that looking at returns without considering risk is clearly a major mistake for any investor.
he went to the bank to deposit a cheque. Keeping Too Much Cash According to statistics from the Monetary Authority of Singapore (April 2010 MAS Monthly Statistical Bulletin). Financial advisers recommend putting away six months’ salary in the bank in case of rainy days. avoid the big obvious mistakes by doing your homework.over the last four years. IT sector news was robust and a recovery was expected. Being an IT buﬀ and bullish about the sector. His paper loss was over $1 million. the fund had already lost 50 per cent of its initial value. such as the loss of your job or a major illness. his bad luck. 1. which appeared cheap to Michael. Back home. Michael said no and left. The reason is that if an emergency arises. but lost half of it in only six months. he took four years to earn $2 million in investment returns. these savings can tide you over while you look for another job or settle medical bills. young and old. This works out to $60. 17 Why Learn About Investing Three Mistakes to Avoid When Investing These mistakes are common yet some of them are not so obvious. One. The technology fund was the ﬁrst ever unit trust he owned. In six months. Michael brought out his charts and found that the fund was trading at 50 cents to its initial oﬀer price of $1. Michael blamed the bank. In other words. The manager serving him suggested he invest some money in a technology unit trust. . In January 2001. etc. There are a few lessons to learn from Michael’s experience. There are two we would like to highlight. In the end. Even a successful investor like Michael should have kept this in mind as he went in impulsively. he invested $2 million the next day. over $320 billion now sit in savings accounts and ﬁxed deposits. He admitted only much later that it was his own mistake and he was responsible for it.000 per person. the price of the fund dropped to 25 cents. Second lesson: learn to take responsibility. the IT sector analysis he read.
sometimes even impossible if you are in poor health. Skimping on Life Insurance If you or your spouse dies or suﬀers a major illness. . Imagine getting laid oﬀ when you have medical problems.18 MAKE YOUR MONEY WORK FOR YOU You may not need so much ready cash. Taking Care of Others Before Yourself Many people often go the distance for family members and forget to take care of themselves. We recommend you save three months’ salary. especially if you are still a good way ahead of your retirement age. If you get laid oﬀ. 2. if you have a working spouse. How much insurance do you need? One rule of thumb is to get at least ﬁve times your earnings. Second. it is easy to forget about saving for your own retirement. and anticipating emergencies that occur only infrequently in reality. 3. Having enough life insurance is so essential that you shouldn’t even think about investing unless you are already suﬃciently covered. such coverage is not portable. some of this money can be invested in ﬁnancial assets such as bonds and unit trusts. Getting a new policy would be extremely expensive. plus the total amount of your mortgage. 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. This is a big mistake. since they can be liquidated almost any time. with a little to spare to cover your children’s basic education. you lose the coverage. For example. once you are faced with the monumental task of saving for your child’s university education. with little or no penalty. there should be suﬃcient “back-up” income in the event of an emergency. Keeping too much cash means you are earning less. you have to make sure your dependents will be provided for. First.
What you want to avoid is channelling all your surplus funds into your children’s education. provide for your children. 19 Why Learn About Investing .Saving for retirement should always come ﬁrst. co-payments or otherwise. You and your child can ﬁgure out ways of getting through school when the time comes. only to discover later that you have little left over for yourself. By all means. but do spare a thought for yourself. whether through loans.
both you and your aunt decided to make an investment in FoodMall. realising a 20 per cent return. bonds. But your aunt managed to sell her warrants for $20. There are three main types: 1. 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. Also. In this chapter. Bonds or ﬁxed income securities 3. You now sell your shares for $12. Clearly. .000 — a 100 per cent return. We will be brief in our introduction because we will be discussing each of these investments in greater detail in later chapters.000 worth of FoodMall warrants. Money market investments Each of these is attuned to the three things you need from your investments: growth. while your aunt bought $10. Stocks or equities 2. The type of security we put our money into matters. we will introduce the diﬀerent types of investments that are commonly bought and sold by investors — stocks. derivatives and unit trusts. You invested $10. MAKE YOUR MONEY WORK FOR YOU THE THREE MAIN TYPES OF BASIC INVESTMENTS One of the most important factors in deciding where to put your money is how soon you think you’ll need it back.02 20 The Major Types of Investments Consider this: Two months ago. there is a diﬀerence between common stocks and warrants.000. income or safety. a food wholesaler.000 in its common stocks.
you would own 100 per cent of the company. When a company generates earnings. where “n” is the total number of common stock shares. the ﬁrm is said to be privately held. As owners. you will be entitled to the remaining assets only after all other claims (including those made by holders of preferred stock) have been satisﬁed. Stockholders also have limited liability. If you buy 100 shares of A’s common stock. as a holder of common stock. As a stockholder. since there will be a far bigger buying audience. meaning that they cannot lose more than their investment in the company. the holders of common stock are entitled to elect the directors of the company and to vote on major issues. you also have a residual claim to assets in case the company goes bankrupt and liquidates its assets. In that case. Many companies choose to go public by selling common stock to the general public on a stock exchange. creditors can only claim against the assets of the company. Hence. As a stockholder. Cash dividends are earnings that are distributed to shareholders. you have a residual claim on the company’s earnings and assets. you are entitled to the earnings that remain after all expenses have been paid. you will be the last in line when the company pays out its earnings. and not the assets of individual stockholders.Stocks or Equities If you own common stock of company A. you have an ownership interest in the company. Unlike . 21 The Major Types of Investments Stock Returns The returns from owning stock come from two sources. should the company run into ﬁnancial diﬃculties. This is much like eating the leftovers at a wedding dinner when everyone else has eaten. Such expenses include staﬀ salaries and payments for those who hold ﬁxed income securities (including preferred stockholders). If only a few individuals hold a company’s shares. Companies go public because they can raise additional capital that way. In other words.
These bonds mature in two years and pay 4 per cent interest annually. and they have two main characteristics: 1. stocks do not guarantee the timing or the amount of dividends. will be returned to you when the bond matures in two years. The value of your stock may rise when the earning prospects of the company are favourable. 2. of course. This is the main reason people buy stocks. They have life spans greater than 12 months at the time of issue.22 MAKE YOUR MONEY WORK FOR YOU bonds.000. People are usually afraid of purchasing stocks because they hear about bear markets. They typically promise to make ﬁxed interest payments according to a given schedule. In fact. Let us work with an example. The face value of the bond. or the principal amount of $10. Bonds or Fixed Income Securities Bonds are loans issued by companies and governments to borrow money. The 4 per cent interest equates to $400 a year. Bonds are hence also called ﬁxed income securities. At any time. But this should be a concern only to investors who need their money back within a few years. The other source of returns is capital gains. stocks generally move up and down in value more than any other type of investments in the short term. over the longer term. decreased or taken away altogether. Bonds have their own unique terms.000. you stand a greater risk of losing money if you don’t invest in stocks. your shares may also lose value if the company performs poorly. . corporate scandals and stock market crashes. they can be increased. And. Stock Risk As a group. Suppose you buy bonds with a face value of $10.
Bond Returns The returns from owning a ﬁxed income security come in two forms. Secondly. The price of a bond rises when interest rates fall. pay interest and . Of course. 23 The Major Types of Investments Money Market Securities Money market securities are similar to bonds. They are loans issued by companies and governments to borrow money. Bond Risk Besides interest rate risk. Imagine a see-saw. There are the ﬁxed interest payments and the ﬁnal payment of principal at maturity. and there is thus the possibility of a capital gain from a favourable movement in rates. the risk of default is very real. but for many other issuers. 2. there is the potential for capital gains when you sell a bond before its maturity at a price higher than when you purchased it. ﬁxed deposits. such as private companies. inversely. except that they are short-term investments. bank savings accounts and certiﬁcates of deposit. bonds have default risk. a rise in interest rates will produce a loss. They have two main characteristics: 1. which means the loan must be repaid within a year. This risk is almost non-existent for Singapore government bonds. Money Market Returns Money market investments maintain a stable value. They mature in less than a year from the time they are sold. Some of the most common money market securities include Treasury Bills (issued by the government and considered the safest investments around). Default risk refers to the possibility that the borrower will not make the promised payments.
24 MAKE YOUR MONEY WORK FOR YOU
can be easily converted into cash. Of the three types of investments, money market instruments pay the lowest rate of return. So why bother with them? For the same reason you leave large chunks of your uninvested money in a ﬁxed deposit — safety. When you buy a money market investment, you are pretty sure you will get your money back with some interest. The 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 reﬂect 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 inﬂation. The longer you leave your money in a ﬁxed deposit, the higher the risk of inﬂation eating away the purchasing power of your money. Money market investments are safest when the money is needed in the short term. The very same safe investments become high-risk the longer they stay invested. Stocks are on the opposite track. They 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
Fixed Deposit Stocks
Lower Risk Higher Risk
Higher Risk Lower Risk
Source: Authors’ own illustration
For example, according to a study by U.S. investment management ﬁrm, 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
1926 to 2002, in any one-year period, there is about a 27 per cent chance of losing money. If the holding period is three years, the odds of losing money fall to 14 per cent. And if the holding period is a whole decade, the chances of losing money goes down to just 4 per cent.
25 The Major Types of Investments
Stocks and bonds are ﬁnancial assets. When you invest in a ﬁnancial asset such as a stock in Company X that is currently priced at $10, you receive a contract stating that you have a legal claim on the assets of Company X. If the company does well and its share price rises to $15, you have a direct claim on the company’s assets that is now worth $15, the share price. A derivative is also a financial asset, but it differs from stocks in one fundamental way: the value of the derivative is based on the performance of an underlying financial asset that you do not own.
Options are one of the most common types of derivatives. There are two main types of options — calls and puts. A call option gives the buyer the right to purchase a speciﬁed number of shares, say 100, of a particular stock at a speciﬁed price (called the exercise price) within a speciﬁed time frame. A put option does the reverse — it gives the buyer the right to sell 100 shares at a speciﬁed price within a speciﬁed time frame. A deﬁnite 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
26 MAKE YOUR MONEY WORK FOR YOU
shares at $30 each. For this right, he will charge you a fee of $1,500 and this right lasts three months. In eﬀect, 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. The 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.
Direct investment in stocks, bonds and derivatives is not for everyone. It requires time to research good buys and a fair amount of skill to sieve the duds from the winners. This is not a simple task, given the inﬁnite 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. The 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. There 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.
Some others have a very speciﬁc focus. For example, some funds focus on high-yield bonds, a particular market segment such as biotechnology, or a speciﬁc country such as Thailand. With unit trusts, we can choose funds that match our risk proﬁle. 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 ﬂuctuate 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.
27 The Major Types of Investments
03 The Risks and Returns from Investing
The rewards from investing do not come free. They are accompanied by the four-letter word, risk. Thankfully, history oﬀers 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. That is the good news. The bad news is that greater rewards usually go hand in hand with greater risks. The 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.
When you make an investment, your gain or loss is called the return on your investment. This return has two parts: income and capital gain (or loss). The dividends from shares and interest from bonds you receive constitute the income portion of your returns. The capital gain part of your return comes from the proﬁt you earn when you sell your investment at a price higher than what you paid for your purchase.
you receive cash dividends of $500. On 31 December.25 0.000 on 1 January.000) / 10. XANADU RETURNS OVER 10 YEARS Year Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Return 25% -15% -20% -10% -5% 5% 10% 15% 25% 20% 1 + Total Return 1.1 is a record of the last 10 years: TABLE 3.90 0. your loss is 5 per cent: Total Return (1 year) = (500 – 1. During the year. Table 3. You stay invested for 10 years and re-invest the dividends you receive.10 1.000.000.000 = -5% 29 The Risks and Returns from Investing Measuring Total Returns Over Several Periods Suppose you become completely enamoured of Xanadu. Your Total Return is 25 per cent: Total Return (1 year) = (Income + Capital gain) / Purchase Price = (500 + 2.95 1.80 0.15 1.Measuring Total Returns Over One Period Suppose you buy stock of Xanadu for $10.1. you sell your stock at $12.20 Source: Authors’ own computation .05 1.25 1.000 = 25% If you sell the stock at $9.85 0.000) / 10.
your return on an annual basis is 3.90 x 0.95 x 1.85 x 0. Measuring Annualised Returns How much did your Xanadu stock earn you on an annual basis? The calculation looks complicated.10 x 1.20)1/10 – 1 = 1.8% If the calculation seems complicated initially.15 x 1. What is important is that you understand what the end result means. .85 x 0.80 x 0. but it is not that bad. Unit trust fact sheets and annual reports already calculate this number for you.10 x 1.15 x 1. It means that after staying invested for 10 years and after having reinvested all your dividends.25 x 1.80 x 0. The Annualised Return for Xanadu over a 10 year period is: Annualised Return = (1.25 x 0. (After that.45 at the end of the 10-year period.30 MAKE YOUR MONEY WORK FOR YOU To calculate Total Return for the entire period.95 x (10 years) 1.451/10 – 1 = 3.45 – 1 = 45% Hence. every $1 invested at the beginning would have returned you $1. The Annualised Return is a compounded rate of return over 10 years. simply subtract “1” from the product) The result is this: Total Return (10 years) = (1.20) – 1 = 1.25 x 0. or you would have a Total Return of 45 per cent over 10 years. Here is what the end result means and this is important for you to understand.25 x 1.90 x 0. then multiply all of these together.8 per cent.05 x 1. we ﬁrst add the ﬁgure “1” to each yearly Total Return number. do not worry.05 x 1.
but so have your chances of earning a higher return. it is very useful in explaining diversiﬁable risk. In this case. If eggs were your money and baskets were investment choices. you could deposit money into a ﬁxed deposit account to earn a safe and known amount. The opposite is true as well. you cannot reasonably expect high returns if you are only willing to assume a small amount of risk. the more returns we should expect. this return is ﬁxed. However. risk has eﬀectively been eliminated. and you cannot earn more than this ﬁxed rate. Diversiﬁable (or Non-systematic) Risk 2. but in this instance. then chances are good that your entire investment portfolio will be stable enough to withstand . The more those returns ﬂuctuate. Anything unpleasant that happens to your one and only invested asset would negatively aﬀect your entire investment portfolio. then putting all your eggs (money) in one basket (a single investment choice) is a risky proposition. Non-Diversiﬁable (or Systematic) Risk That is. the greater the risk. Total Risk = Diversiﬁable Risk + Non-Diversiﬁable Risk Diversifiable Risk We wish we could spare you the egg-and-basket routine. But if you were to diversify by placing your money into several investment baskets. At the same time. There is a positive relationship between risk and return — the higher the risk. Supposing then that you want to avoid risk at all cost.RISK A risky investment is one where there is a strong likelihood that actual returns will diﬀer from what was expected. 31 The Risks and Returns from Investing Where Does Risk Come From? Risk consists of two components: 1.
take note. whereas a highly priced collectible such as a 1899 Coca-Cola bottle has high liquidity risk because it can be a challenge to ﬁnd buyers and sellers. (PERC). industry or environment. Business Risk This is the risk of doing business in a particular company.32 MAKE YOUR MONEY WORK FOR YOU an unexpected shock from any one sector. Singapore is still . Despite receiving consistently favourable risk ratings by Political and Economic Risk Consultancy. An investor can control liquidity risk by investing in assets with high liquidity. For example. 2. If you are like many Singaporean investors who invest most of their money domestically. Country Risk Country risk refers to all the negative things that can happen to a country’s economy as a whole. It can be diversiﬁed away. A diversiﬁable risk is easy to identify. An investor can control business risk by investing in other industries. 3. wars and recessions. 3. 1. including political crises. A Treasury Bill has little or no liquidity risk. It can be controlled or reduced. diversiﬁable risk has these three characteristics: 1. In short. Let’s look at a few examples. Ltd. 2. Liquidity Risk A security with poor liquidity means that the security is diﬃcult to buy and sell in the secondary market without incurring price concessions. It is unique to a stock or industry. a semiconductor manufacturing company faces risks inherent in the electronics industry.
Virtually. Poor market sentiment as a result of wars. will be directly related to the overall movements of the general market or economy. When interest rates go up. 2. Even if you hold a well-diversiﬁed portfolio of Singapore stocks. 2. a sudden surge in interest rates will bring down the value of each of the securities in your portfolio. left in the portfolio. There are three systematic risk factors: 1. security prices come down. What is left is the non-diversiﬁable portion called market risk or systematic risk. This is any risk that. It aﬀects all securities. It cannot be controlled or reduced. all securities will be aﬀected. Like non-systematic risk. the diversiﬁable or non-systematic portion). recessions or plain old pessimism are often mirrored by declines in the overall 33 The Risks and Returns from Investing . It cannot be diversiﬁed away. all securities have some systematic risk. Market Risk This is the risk that comes from ﬂuctuations in the overall market as reﬂected by an aggregate stock index such as the STI. and other things being equal. 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 diversiﬁed portfolio and eliminate part of total risk (i. 3. whether bonds or stocks.subject to country risk. Interest Rate Risk Security prices tend to move inversely with movements in interest rates. systematic risk also has three characteristics: 1.e.
Your entire principal sum will be returned to you. interest rates generally rise as well because lenders will demand more for their loss of purchasing power.34 MAKE YOUR MONEY WORK FOR YOU market. what are the chances that you would lose money? Zero. The average return per year is: Average Return = (1 + 1 + 1) /3 = 1% Notice that each year’s return does not deviate from the threeyear average. Let us work out a numerical example. When inﬂation rises. unless POSB defaults. most stocks will be adversely aﬀected. such that what you expect to receive in the future would be worth less today in real terms. let us keep to this familiar deﬁnition. This is the deﬁnition that most of us are familiar with although we will reﬁne the deﬁnition later in this chapter. all securities are aﬀected. Or. If you put your money in the Post Oﬃce Savings Bank (POSB) and you suddenly need to cash out after six months. Hence. If the stock market falls sharply. most stocks will fall in value. All securities will be aﬀected no matter how fundamentally sound the companies are. Inﬂation Risk When inﬂation rises. and each year. Inﬂation also positively aﬀects interest rates. if the interest rate or inﬂation soars. the return is constant at one per cent. Measuring Risk Risk is the chance of losing money when you sell your investment. 3. Inﬂation erodes the purchasing power of your invested dollars. These market movements do occur. It is important to understand that an investor cannot escape nondiversiﬁable risk because the risks of the overall market cannot be avoided. But for now. plus interest. Standard Deviation = 0 . Risk is calculated by a method called standard deviation (SD). Suppose you keep your money in POSB for three years.
) Let us take another example. standard deviation is not as meaningful as when it is compared with those of other investments. and many other situations. inﬂation rising out of control. ever. knowing exactly what you will get. and the third by 15 per cent (35% – 20%). add them up. the second by zero (20% – 20%). and no volatility. standard deviation is an academic deﬁnition that refers to the uncertainty of returns — whether negative or positive. we can conclude that investment ABC is a riskier investment because its returns are far more uncertain than POSB savings’. (To be sure. Risk can arise from POSB folding. 20 per cent and 35 per cent over the last three years. If the standard deviation of POSB returns is zero and investment ABC’s standard deviation is 15 per cent. divide the result by the number of returns minus 1. In reality. we square each of the deviations. Suppose investment ABC had total returns of 5 per cent. you will be able to cash out. and take the square root of the result: (5 – 20)2 (20 – 20)2 (35 – 20)2 Total Standard Deviation = = = = 225 0 225 450 35 The Risks and Returns from Investing = √[450 / (3 – 1)] = 15% Note that by itself. At any time. Standard deviation can be calculated very easily on a spreadsheet or ﬁnancial calculator so this ought to be the ﬁrst and last time you . The Arithmetic Mean is 20 per cent (5 + 20 + 35) / 3. there is no such thing as zero risk. To compute the standard deviation of investment ABC. No surprises. Notice that the ﬁrst return deviates from the mean by -15 per cent (5% – 20%).A zero standard deviation means that there is no risk.
we have Treasury Bills. The following are listed in the order of increasing standard deviation and risk. are inherently more uncertain than the returns from putting your money in POSB. the higher the standard deviation.36 MAKE YOUR MONEY WORK FOR YOU will need to go through a worked-out example. if you are willing to bear a high level of risk. Risk premium is the additional return beyond the risk-free rate that one expects to receive for taking on risk. with Treasury Bills having the lowest of each: • Treasury Bills • Government Bonds • Corporate Bonds • Common Stocks • Derivatives Figure 3. And the more uncertain the returns are.1 puts together our ﬁndings on risk and return. we could create a ranking of their standard deviations. which are virtually risk-free. The return we expect from an investment in a risky asset can thus be expressed as: Expected Return = Risk-free Rate + Risk Premium . The main point is that the returns from an investment such as Xanadu. you may then expect to earn what is called a risk premium. At one extreme. for example. What it shows is that there is a risk-return trade-oﬀ. bonds and derivatives. At the other end of the continuum. The Risk-Return Trade-Off Now if we were to line up some of the most traditional investment choices such as stocks.
Which do you prefer? If you decide by returns alone. Company B generated a tiny 2 per cent standard deviation compared with company A’s 5 per cent. How do you break the tie? . then company B is the clear winner. If. the expected return of common stocks is 8 per cent and the yield oﬀered by Treasury Bills is 2 per cent. If you decide by risk alone.1. Line A is drawn from the risk-free rate to show the risk premium. RISK-RETURN TRADE-OFF 37 R Returns Treasury Bills Government ond Bonds Corporate Bonds Common Stocks Stoc o k Derivatives Risk Premium Line A Risk-free Rate Risk Source: Authors’ own illustration In Figure 3. the risk premium will be 6 per cent: Expected Return 8% = [ Risk-free Rate + Risk Premium ] = 2% + 6% Risk-Adjusted Returns Look at the returns and risk of these two investments in the utility industry (Table 3. Company A generated 10 per cent returns compared with company B’s 6 per cent.1. for example.. then company A is the clear choice.FIGURE 3.2 on page 38).
but also good outcomes such as higher than expected returns. Jensen’s or Information Ratios. risk is deﬁned more broadly as the chance of receiving a return that is diﬀerent from the return we expected to make.2.0 Source: Authors’ own illustration MORE ON RISK Earlier. includes not only bad outcomes. we deﬁned risk as the chance of losing money when you sell your investment. using . These ratios all provide risk-adjusted returns. the risk that you will earn a 10 per cent or zero per cent return is exactly the same.0 6/2 = 3. Company B is considered superior because it oﬀers three units of return for every unit of risk taken. RISK-ADJUSTED RETURNS OF UTILITY COMPANIES A AND B Investment Utility Company A Utility Company B Return 10% 6% Standard Deviation 5% 2% Return/Standard Deviation 10/5 = 2. Thus. Treynor.38 MAKE YOUR MONEY WORK FOR YOU A risk-adjusted measurement takes an investment’s return and divides it by its standard deviation: Risk-adjusted Return = Return / Standard Deviation Investments with higher risk-adjusted returns are generally considered superior to investments with lower risk-adjusted returns because they oﬀer more returns for each unit of risk taken. TABLE 3. You may have come across measurements such as the Sharpe. if the expected return of an investment is 5 per cent. At this point. Risk. in fact. we need to make two reﬁnements to this working deﬁnition. In other words. such as lower than expected returns. In investments.
When you have time on your side. the way you divide your investments depends on your speciﬁc situation and goals. you do not distinguish between downside risk and upside risk. 39 The Risks and Returns from Investing MANAGING INVESTMENT RISK The best way to manage risk is to allow yourself ample time. Finally. when you buy a bond that pays a ﬁxed interest payment every six months and the return of principal at maturity. 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 diﬀer from expected returns. The second reﬁnement to our understanding is that there are investments whose expected return is known ahead of time. Hence. and technology stocks as higher risk). 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. For this reason. For example.standard deviation. Start investing now rather than later. Or they may go for simpler yet commonsensical proxies for risk. They may use a measurement called the semi-variance. For example. (For example. where only returns that fall below the expected return are considered. it makes sense that stocks of technology companies are riskier than those of food companies. you can tell ahead of time what your actual return will be. The risk we have deﬁned so far relates to actual returns being diﬀerent from expected returns. Others prefer to create ranking categories. based on your needs and the type of risk you can take. This exercise will make a big diﬀerence to your investment success. in general. Spend some time thinking about the best way to divide your money. . some investors may not be completely comfortable with standard deviation as a measure of risk. those ranking money market instruments as lower risk.
we learn that historical events do indeed have a signiﬁcant impact on ﬁnancial markets. Uncertainty often clouds judgement.04 40 Managing Crises and Diversification We have a crisis today. MAKE YOUR MONEY WORK FOR YOU TABLE 4. historical evidence suggests that most investors can beneﬁt by staying put. In this chapter. They would buy on ups and sell on downs. the answer is “yes”.50 . some investors are skilled at anticipating market movements. According to a study by asset allocation expert Ibbotson Associates. Terrorists can strike anywhere and at any time. There is uncertainty regarding a sustainable global economic recovery.00 $12. Oil prices are at historical highs.371. While past performance cannot guarantee similar future results. How do you react to these crisis points? Would you sell or stay put? If your answer is “stay put”. But history shows that negative events do not necessarily spell doom for investors. sending even the best of us into panic and gloom. $1 INVESTED IN S&P 500: STAYING PUT OR MINUS BEST 35 MONTHS Value in 1996 Value in 1996 (Minus 35 Best (Stay Put Months) Throughout) $1 invested in 1925 Source: Ibbotson Associates $1. But how many people can do that consistently? The big question for many of us is whether it makes sense to stay invested regardless of market ﬂuctuations. Of course. High inﬂation is causing problems all over the world. you might be doing the right thing.1.
2 per cent after one quarter). the index will fall. then rebound to near pre-crisis levels within three months.371 in 1996. here is more information to consider.6% 21.S. DOW JONES INDEX DURING AND AFTER MAJOR CRISES Event Month/ Year % Change 1 Month Later 3 Months Later 6 Months Later 12 Months Later Exchange closed WWI Bombing at JP Morgan oﬃce 7/14 -10.1 per cent. That’s a compounded annual return of 10.6 per cent. you should be getting “greedy”.2.6 per cent. unless you are conﬁdent of predicting accurately the best and worst months for your investment dollar.They found that a dollar invested in the S&P 500 in 1925 grew to $1. a compounded annual return of only 3.5% 2. industrial stocks) to political.0% 6. including two world wars. Ned Davis Research tracks the reaction of the Dow Jones Industrial Average (an index on major U. TABLE 4. They found that staying put makes sense because each time a crisis hits. because crises provide tremendous opportunities for investing.5% -17. 41 Managing Crises and Diversiﬁcation STAYING PUT IN THE FACE OF CRISES This century has seen many crises and disasters. But when the best 35 months (less than 4 per cent of total time invested) were removed from the analysis.50.9% -9. and from there. What would you do when the next crisis hits? If you are still not convinced about staying put in the market. the 9/11 attacks and the 1997 Asian economic crisis. (The average drop in the market during crises was -6. economic and military crises since World War I in 1914.2% 80. So. the same dollar grew to only $12. the Dow rallied on average 5. stay put.2% 9/20 -5. Crises will continue to take place today and in the future.4% -14.3% . Instead of being fearful during market downturns.2% 10.
42 Event Pearl Harbour bombing Korean War Suez Canal crisis Cuban missle crisis Martin Luther King assassination Kent State shootings Nixon’s resignation USSR in Afghanistan Falkland Islands war U. invades Grenada U.4% -7.S.4% 0.1% 0.2% 22.0% 8.8% -5.3% -9.5% 12.1% 6 Months Later -9.7% 27.3% 2.6% 3.4% 1.1% 3 Months Later -2.3% 12.2% 21.4% 0.7% -17.4% 24.S.9% -13.9% 24.3% 6.6% -2.0% 11.8% -3.2% -1.0% 41.8% 4.7% -8.6% -2.4% 9.0% -9.3% 14.2% 3.9% -4.0% 15.2% 13.3% 10.4% 12/41 6/50 10/56 10/62 -6.3% 1.0% -1.8% -34.4% 26.7% -4.3% 15.9% 14.5% 14.5% -2.8% 9.2% 12 Months Later 5.8% 2.S.5% -12.3% -2.6% 0.8% -4.7% 2.9% 15.2% 36.2% 4.6% 17.5% 6.2% -1.9% 6.4% 24.3% 11.6% 19.1% 11. currency crisis Month/ Year % Change MAKE YOUR MONEY WORK FOR YOU 1 Month Later 3.8% -2.7% -0.4% -4.1% 11.3% 4.1% 4/68 -0.2% -2.3% -0.8% 5/70 8/74 12/79 4/82 10/83 10/83 10/87 12/89 8/90 1/91 8/91 9/92 -6.6% 3.3% 9.4% 25.4% 5.7% .8% 20.5% 3. bombs Libya Financial panic ’87 Invasion of Panama Iraq invades Kuwait Gulf War Gorbachev coup U.5% 30.0% 16.
8% -6.5% 14.0% 10.0% 16.2% 4.5% -17.1% Source: Ned Davis Research Inc.2% NA 15. the exposure to any particular source of risk becomes smaller and smaller.4% 8.7% 6.3% -9.1% 5.9% 9.7% 12. embassies in Africa WTC and Pentagon terrorist attacks Enron testiﬁes before Congress Iraq War Mean 2/93 -0.9% 30.9% 9.5% 4. DIVERSIFICATION: THE RANDOM WAY The easiest way to reduce risk is to diversify.2% 15.7% 1/02 -3.5% 3.4% 5.8% 10/97 -12.6% 9.4% 21.3% 13. Can such a naive strategy work? The answer is “yes”.2% 4/95 1.8% 9/01 -14. Random diversiﬁcation is like investing in stocks selected by darts thrown at an SGX stock report.5% 25.8% 10.1% 8. by applying the Law of Large Numbers.2% 24.2% 3.9% 9/98 0.3% -6. When you randomly diversify.3% 2.0% -11. By randomly adding a large number of securities to a portfolio.7% 3/03 2.S. you care only about selecting as many stocks as possible without caring about criteria such as expected return or risk. .2% 5.5% 25.Event Month/ Year % Change 1 Month Later 3 Months Later 6 Months Later 12 Months Later 43 Managing Crises and Diversiﬁcation World Trade Center bombing Oklahoma City bombing Asian stock market crisis Bombing of U.
shows the standard deviations for equally weighted portfolios.39 Source: Meir Statman.68 20.41 0.93 21.69 19. each containing diﬀerent numbers of randomly selected New York Stock Exchange (NYSE) stocks. STANDARD DEVIATIONS OF RANDOM PORTFOLIOS OF NYSE STOCKS No.3. p.34 19.60 0.39 0.76 0. “How Many Stocks Make a Diversiﬁed Portfolio?”.42 0.16 Ratio of Portfolio SD to Single Stock SD 1. TABLE 4.87 20.21 19.29 19.46 20. Journal of Financial and Quantitative Analysis.98 23.27 19. September 1987.39 0.51 0.36 29.44 0.64 24.39 0.42 19.54 0.3.39 0.42 0.49 0.00 0.24 37.40 0.20 19. of Stocks in Portfolio 1 2 4 6 8 10 20 30 40 50 100 200 300 400 500 1000 Inﬁnity SD of Portfolio Returns 49.39 0.44 MAKE YOUR MONEY WORK FOR YOU Table 4.355 .69 26.
in a 20-stock portfolio. Figure 4. diversiﬁcation’s maximum eﬀect has been realised. With a portfolio of 20 stocks. If you were to select randomly two NYSE stocks and put half your money in each. In a 10-stock portfolio. Standard deviation declines as the number of stocks increases. your standard deviation of return would be about 50 per cent per year. What this means is that if you select a single NYSE stock randomly and put all your money into it. 2. and so on.1 (page 46) illustrates these two points.22 per cent (from 21. Plotted is the standard deviation of the return versus the number of stocks in the 45 Managing Crises and Diversiﬁcation . your annual risk would be about 22 per cent. each stock has a 10 per cent weight. If you sink your money into a 20-stock portfolio. By the time we have 20 randomly chosen stocks. Column 3 measures how risky a portfolio is relative to a onestock portfolio. Stated another way.46 per cent). we see that the standard deviation for a portfolio of one stock is about 50 per cent. Standard deviation declines at a decreasing rate as the number of stocks is increased. and there remains very little incremental beneﬁt to be gained by adding more stocks. a 20-stock portfolio is 56 per cent less risky than a one-stock portfolio. In column 2. Adding 20 more stocks (a 40-stock portfolio) will further reduce standard deviation by only an insigniﬁcant 1. your average annual standard deviation would be about 37 per cent.68 per cent to 20. which is obviously the riskiest portfolio.Column 1 lists the number of stocks in each equally weighted portfolio. and it would only be 44 per cent as risky as a one-stock portfolio. the portfolio’s volatility has declined from 50 per cent per year to about 22 per cent per year. There are two important observations to note: 1. each stock has a 5 per cent weight.
If the returns on two assets tend to move up and .0 30. 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.0 20.0 00 Non-diversiﬁable Risk 1 2 4 6 8 10 20 30 40 50 100 200 300 400 500 1000 Number of Stocks Diversiﬁable Risk Source: Authors’ own illustration DIVERSIFICATION: THE BETTER WAY Harry Markowitz was the ﬁrst person to formally show how portfolio diversiﬁcation works to reduce portfolio risk. The risk that can be diversiﬁed is appropriately called diversiﬁable risk (non-systematic risk). Hence.0 10.0 40. but not all. And the risk that stubbornly remains and cannot be diversiﬁed is called non-diversiﬁable risk (systematic risk). FIGURE 4. PORTFOLIO DIVERSIFICATION 60.0 50.46 MAKE YOUR MONEY WORK FOR YOU Standard Deviation portfolio. spreading an investment across many assets will eliminate some or most of the risk. What is Correlation? Correlation measures the extent to which the returns on two assets move together. Notice that risk reduction from adding securities slows down as we add more and more securities.1.
0 zero correlation Corr = -1. PERFECT POSITIVE CORRELATION (CORR ( = +1. Do note that perfect correlation does not mean that the two assets move by the same amount. we say they are negatively correlated. If asset X has positive returns. The correlation coeﬃcient is used to measure correlation.0 perfect positive correlation Corr = 0.2 shows the returns of two assets with perfect positive correlation. so does asset Y.2. and it ranges between -1. not magnitude. And if asset X has negative returns. If there is no particular relationship between the two assets.down together.0: Corr = +1. 47 Managing Crises and Diversiﬁcation FIGURE 4. If they tend to move in opposite directions.0 perfect negative correlation Perfect Positive Correlation Figure 4.0) ) Asset X Returns Asset Y Time Source: Authors’ own illustration . we say they are uncorrelated. correlation is a measure of direction. we say they are positively correlated. so does asset Y.0 and +1.
FIGURE 4.0) Asset X Returns A tY Asset Time Source: Authors’ own illustration Zero Correlation If we know that the returns of X are positive.48 MAKE YOUR MONEY WORK FOR YOU Perfect Negative Correlation In Figure 4.3. If asset X has positive returns.0) ) Asset X Returns Asset Y Time Source: Authors’ own illustration . FIGURE 4.4. PERFECT NEGATIVE CORRELATION (CORR = -1. the returns of the two assets X and Y move in opposite directions.3. there is zero correlation. ZERO CORRELATION (CORR ( = 0. asset Y will have negative returns. but have no idea what the returns of Y are likely to be.
As a group. And when prospects are poor. 4. risk usually cannot be eliminated. Although risk can be reduced. 49 Managing Crises and Diversiﬁcation DIVERSIFICATION USING STOCKS AND BONDS One of the most eﬀective ways to diversify is to invest in the two main asset classes of stocks and bonds because of their low correlation with one another. securities typically have some positive correlation with each other. your entire portfolio will suﬀer as well. suppose you invest 100 per cent of your money in banking stocks. banking stock returns are highly positively correlated. although portfolio risk cannot be eliminated completely. you should hence ﬁnd securities with the lowest amount of positive correlation as possible. 3. The young . Combining securities with perfect negative correlation can eliminate risk altogether. Combining securities with perfect positive correlation with each other provides no reduction in portfolio risk. How much money should you allocate to each asset group? The ideal asset allocation diﬀers from person to person and is based on the individual investor’s risk tolerance. Good prospects in the industry will see the group rise as a whole. Combining securities with zero correlation with each other does provide signiﬁcant risk reduction. We should avoid securities that are positively correlated as the total risk is then higher. To see how correlation works. In reality. 2. A young executive typically has a higher risk tolerance than a retiree. As an investor.Understanding correlation helps us improve the diversiﬁcation process of reducing portfolio risk: 1.
What returns can I expect from a diversiﬁed portfolio of stocks and bonds? 2. vis-à-vis bonds. The 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. your risk tolerance. Your insurance adviser has one. therefore. Chances are that you are likely to see a diﬀerent version from every company you deal with. In general. the higher will be the proportion of stock in our portfolio. Two questions you could be asking thus far: 1. the higher our risk appetite. The Risk Profile Questionnaire Approach Risk proﬁle questionnaires ask pointed questions to ﬁnd out your risk tolerance. while the retiree may have a less risky allocation of 20 per cent stocks and 80 per cent bonds. How can I create a diversiﬁed 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.50 MAKE YOUR MONEY WORK FOR YOU executive. Your bank oﬃcer has one. may have an asset allocation of 80 per cent stocks and 20 per cent bonds (since stocks are riskier than bonds). . To keep things simple for now. We end this chapter and this section by ﬁnding out how much risk you can take as an investor — that is. FINDING OUT YOUR RISK TOLERANCE Are you a conservative investor or an aggressive investor? The answer to this question determines the amount of risk you can tolerate and hence the type of asset allocation appropriate for you. There is no one single version but many. let us work with just stocks and bonds. The CPF Board has one.
Answer the six questions by circling the choice that best represents your investment situation. 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. The other four questions are more subjective. two objective factors that test your ability to take risk. the more willing you are to take on risk. 2. the higher the amount of risk you can aﬀord to take. Your Appetite for Risk This is the amount of risk you are comfortable with taking. they test your appetite for risk. the higher your score. The possible range of scores is 8 to 24. Your Overall Financial Situation How much money do you already have? The richer you are. They 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. In general. Questions 1 and 2 ask your age and investment time horizon. Sample Risk Profile Below is a sample risk proﬁle. the more comfortable you are with taking risk.Despite the many versions. Add up the points from the six questions to determine your risk tolerance score. and the higher the proportion of stocks your portfolio should contain. Your Ability to Take Risk How old are you? When do you need the money? How long will your assets be invested? The younger you are or the longer your investment time horizon. risk proﬁles all have the same objective — they ask you questions to ﬁnd out the appropriate balance of stocks and bonds for your investment allocation. 51 Managing Crises and Diversiﬁcation . Questions in general ask: 1.
It is OK to see some ﬂuctuation in my returns. (4 points) 40 to 54 years old c. (2 points) 50% in Unit Trust A and 50% in Unit Trust B c. (1 point) I hate losing money and I am willing to accept lower returns. Unit Trust B — Gives an average return of over 10% but portfolio can fall 20% in any one year. (3 points) 30% 3 4 . You accept that your portfolio will ﬂuctuate in value over time.52 MAKE YOUR MONEY WORK FOR YOU RISK TOLERANCE QUESTIONAIRE How old are you? 1 a. (1 point) 100% in Unit Trust A b. how would you invest? Unit Trust A — Gives an average annual return of 5% with minimal downside in any one year. (3 points) 100% in Unit Trust B How do you feel about losing money? a. c. What is the maximum loss you could accept in any one-year period? 5 a. (6 points) Below 40 years old b. but not too much. (3 points) I am willing to take high risk because I believe returns will be higher over the longer term. (6 points) 10 or more years Given two hypothetical unit trusts. (2 points) I do not mind moderate risk. (2 points) 55 years or older When do you plan to use the money you have invested? 2 a. (2 points) Within 3 years b. (2 points) 15% c. a. b. (1 point) 5% b. (4 points) 4 to 9 years c.
(3 points) I would not be overly bothered as it is probably a short-term ﬂuctuation. (1 point) I would be so upset that I would not be able to sleep. This sample risk proﬁle has ﬁve allocations. I might be tempted to sell.4 below for your risk proﬁle and the matching allocation for stocks and bonds. (2 points) I will ﬁnd out what happened from the news or from my contacts. TABLE 4. c.53 Managing Crises and Diversiﬁcation Suppose the market lost over 25% in value in just one day today.4. How will that aﬀect you? 6 a. b. Calculate your total score and record it here: TOTAL SCORE: _______ Then check Table 4. RISK PROFILE AND INVESTMENT ALLOCATION Total Score 8–10 11–13 14–16 17–19 20–24 Risk Proﬁle Conservative Moderately conservative Balanced Moderately aggressive Aggressive % Stocks 20% 40% 60% 80% 100% % Bonds 80% 60% 40% 20% 0% Source: Authors’ own illustration .
you will not ﬁnd two risk proﬁle questionnaires that are exactly alike. When you get older and your circumstances change. Check one: _________ _________ _________ _________ _________ _________ _________ Aggressive Moderately Aggressive Balanced Moderately Conservative Conservative % Stocks % Bonds You realise that risk proﬁle questionnaires and the recommended allocations for equity and bonds are not an exact science. nevertheless. from which the appropriate asset allocation of stocks and bonds can be determined. use the following checklist to record your target investment allocation. As we mentioned. Remember that a particular asset allocation is appropriate only at a certain point in time.54 MAKE YOUR MONEY WORK FOR YOU Your Target Investment Allocation Before moving on. Risk proﬁles. your risk tolerance will change and your asset allocation must evolve along the way. give you a ﬁrst level guide to what your risk tolerance is. .
investing in individual stocks and bonds will be an appropriate next step.PART 2 INVESTING IN TRADITIONAL ASSETS The best way to benefit from this section is to invest in something — if you have not already done so. . 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.000 to invest. when your skills and confidence are better developed and you are ready to do more. Then.000 or $20. Suppose you had $2.
.200 funds available to investors in the Singapore marketplace (www. Fixed Income Funds (or bond funds) — unit trusts consisting of bonds.05 Investing in Unit Trusts Many investors start out with unit trusts. Fixed income funds oﬀer current income and do not ﬂuctuate as widely in value as equity funds do. 2. Investors today have a lot of choices. Fixed income funds are for those with a smaller risk appetite. refer to the unit trust glossary at the end of this chapter. answer the risk proﬁle questionnaire found in Chapter 4. A ﬁxed income fund (as compared with a bond fund) is the more common name for a fund containing mainly bonds.com) — six times more than the number of stocks listed on the SGX. Unit trusts fall into two main categories: 1. There are over 3.fundsingapore. We will use both these terms interchangeably. by now. 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. If you have not. ﬁgured out what sort of investor you are. 1 An equity fund (as compared with a stock fund) is actually the more common name for a fund containing mainly stocks. The next step is to ﬁnd out the type of equity and ﬁxed income funds to invest in. If you need a brief refresher on some of the more popular types of unit trusts found in the Singapore market. Even experienced investors with large portfolios make generous use of unit trusts. You should have. Equity Funds (or stock funds)1 — unit trusts consisting of stocks. They invest in the debt of governments and corporations.
S. That is because the stock market is sensitive to what happens to the economy as a whole. invest in both Singapore and the U.S. in the following proportions: 57 Investing in Unit Trusts TABLE 5. which is a measure of economic output.S. if you split your money 50-50 and say. Global diversiﬁcation then takes each asset class and diversiﬁes it across the globe — into global equities and global ﬁxed income. these four regions represent 75 per cent of world gross domestic product (GDP). The economic output of each is weighted roughly in the percentages given above. the U.1.S. (It is the reason we place our money in diﬀerent asset classes. Now. might fall.FIGURING OUT THE TYPES OF EQUITY FUNDS IN WHICH TO INVEST If you invest all your money in Singapore and the Singapore economy tumbles. The act of diversifying your money into equity funds and ﬁxed income funds is called asset class diversiﬁcation. each representing one of the four major economic regions of the world. namely stocks and bonds. 2 . might rise or when Singapore rises.2 We can easily achieve this by investing in four types of funds. the U. RECOMMENDED ALLOCATION OF EQUITY FUND INVESTMENTS Type of Equity Fund U.. This process is called global diversiﬁcation. Equity Fund European Equity Fund Asia ex-Japan Equity Fund Japan Equity Fund TOTAL Source: Authors’ own recommendations Recommended Allocation 30% 30% 30% 10% 100% According to the IMF World Economic Outlook. then it is likely that when Singapore falls. your entire portfolio will fall. Economies do not rise and fall at the same time.) That is why it makes sense to diversify our investments across countries.
we had Asia broken down into Asia ex-Japan. Even though it is not geographically a region.58 MAKE YOUR MONEY WORK FOR YOU These GDP ﬁgures are not static of course. • Singapore Fixed Income Fund Singapore bonds are typically of the highest quality and have very low risk compared with other types of ﬁxed income funds. unless there is some long-term structural change in the economic outputs of the four regions. Funds invested in Asia fall mainly into two fund categories: Asia ex-Japan and Japan. They also have little exchange rate risk and provide good stability for your ﬁxed income fund portfolio. its economic status qualiﬁes it as such. They go up and down. and Japan. we can simplify the recommended allocation to 30-30-30-10. the reason being that Japan is itself a very large and developed economy — the third largest in the world. Always bear in mind that the allocation to each type of equity and ﬁxed income fund is not an exact science. but in general. ﬁguring out the types of ﬁxed income funds to invest in is a walk in the park. both regions are clumped together because Japan’s ﬁxed income funds are not sold in Singapore. you should be investing in all the major economic regions in the world. In this ﬁxed income fund allocation. whereas all-Asia ﬁxed income funds are. with a few exceptions: • Asian Fixed Income Fund In the equity fund allocation. . in order to create a globally diversiﬁed equity or ﬁxed income portfolio. Japan is set apart from the rest of Asia. FIGURING OUT THE TYPES OF FIXED INCOME FUNDS IN WHICH TO INVEST Now that you have ﬁgured out the types of equity funds in which to invest. Treat what has been discussed as a general guideline. The same principle of diversiﬁcation holds true. Generally.
You must treat the return numbers shown in Table 5. Notice that adding ﬁxed income funds to the equity portfolio also reduces the returns we can expect. It is impossible to use any historical ﬁgures to project the future with 100 per cent accuracy. Starting with a 100 per cent Equity portfolio.2. . As we add ﬁxed income in 20 per cent increments.4 per cent (for a 100 per cent Fixed Income portfolio). (page 60) as mere guideposts to what can be expected of asset allocation in general.1 on page 60. The uppermost 100 per cent equity line is based on the highest amount of risk taken by the Aggressive Investor. Taking a diﬀerent period for study would yield diﬀerent results. returns fall gradually to 5. but the pattern of higher returns from portfolios with higher concentrations of equities can almost always be expected to occur. You can see that returns ﬂuctuate up and down quite a bit. and are very volatile.TABLE 5. which is based on 32 years of data.3. RECOMMENDED ALLOCATION OF FIXED INCOME FUND INVESTMENTS Type of Fixed Income Fund US Fixed Income Fund European Fixed Income Fund Asia Fixed Income Fund Singapore Fixed Income Fund TOTAL Source: Authors’ own recommendations 59 Investing in Unit Trusts Recommended Allocation 30% 30% 30% 10% 100% HOW DO GLOBALLY DIVERSIFIED UNIT TRUST PORTFOLIOS PERFORM? Here is a study that summarises the important points we are making. Look at Figure 5. we can lower risk by adding ﬁxed income funds to our portfolio as seen by an increasingly ﬂatter return line on the graph.
(24 Febuary 2003) .4% 7.000 250. 80% equity 60% bonds.7% 5. (24 February 2003) TABLE 5. 40% equity 100% bonds Source: iFAST Financial Pte Ltd. ANNUALISED RETURNS OF VARIOUS EQUITY-FIXED INCOME COMBINATIONS Equity-Fixed Income Fund Allocation 100–0 80–20 60–40 40–60 20–80 0–100 Annualised Return 9.000 $ 300.000 200. “Rebalancing With Bond Funds”. PORTFOLIO VALUE STARTING WITH $10. 60% equity 80% bonds.4% Source: iFAST Financial Pte Ltd.1. “Rebalancing With Bond Funds”.60 MAKE YOUR MONEY WORK FOR YOU FIGURE 5.000 50.000 100.000 0 1970 1974 1978 1982 1986 1990 1994 1998 2002 Yr 100% equity 40% bonds.7% 6.6% 5.0% 8. 20% equity 20% bonds.3.000 150.
000 $40. if you are a conservative investor (20-80 equityﬁxed income fund allocation).000 and $50. This is because most funds require a minimum investment of $1.1) = $50.4.000.000 $3.2 x 0. RECOMMENDED ALLOCATION FOR A CONSERVATIVE INVESTOR WITH $50.000 TO INVEST Equity Funds US Equity Fund European Equity Fund Asia ex-Japan Equity Fund Japan Equity Fund TOTAL Equity Funds (20%) TOTAL Fixed Income Funds (80%) TOTAL Invested Source: Authors’ own recommendation Recommended Allocation 30% 30% 30% 10% Investment Amount $3.000 $1. Global Balanced Fund 100% The minimum amount needed can be calculated as the minimum investment amount per fund ($1.000 to invest — buy a global balanced fund (also called an Asset Allocation fund).0003 If you have less than $5. For example. These funds invest in both equities and bonds in almost equal proportions.000 / (0. 3 .000 $10.HOW TO BEGIN INVESTING WHEN YOU DO NOT HAVE MUCH MONEY In order to create your portfolio so that it includes all the above recommended fund types.000) divided by 20% (equity fund allocation) x 10% (smallest equity fund allocation) = $1.000. you could organise your portfolio the following way: 61 Investing in Unit Trusts TABLE 5.000 $50.000 $3.000. you will probably need between $10.
Equity Fund European Equity Fund Japan Equity Fund Fixed Income Fund Global Fixed Income Fund Asian Fixed Income Fund Singapore Fixed Income Fund U.S.000 to invest.000 to invest – buy two funds.5. but it is not. buy them in the following order: TABLE 5. you do not have to be precise as .000 to invest — you can begin by buying individual fund types in sequence. For example. if you are a moderately aggressive investor (80-20 equity-bond allocation). You may be thinking that this is tricky to pull oﬀ. You see. So. While you may not be following your recommended investment allocation to a tee. RECOMMENDED SEQUENCE OF BUYING FOR ONE-AT-A-TIME PURCHASES Equity Fund 1 2 3 4 5 Global Equity Fund Asia ex-Japan Equity Fund U. your portfolio can look like this: Global Equity Fund Global Fixed Income Fund 80% 20% If you have more than $10. As you have more and more money available for investment. Do this until you have enough money to take full advantage of the allocation that applies to you. you may buy another fund in another category. if you have more than $10.S. a global equity fund and a global ﬁxed income fund. The following is a suggested buying sequence. Fixed Income Fund Europe Fixed Income Fund Source: Authors’ own recommendations We suggest you start oﬀ with a global fund in order to obtain instant global diversiﬁcation. you should still end up with a reasonably well-balanced portfolio.62 MAKE YOUR MONEY WORK FOR YOU If you have less than $10.
International equity funds are of several types: • Global Equity Funds invest in promising companies anywhere in the world. 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 diﬀerent fund types. so that you will always have some money in categories that are doing well. of which two out of three are equity funds. A stock represents a share of ownership or equity in a company. A 100 per cent domestic portfolio consisting only of investments in Singapore makes your entire portfolio vulnerable to any Singapore market downturn. such as Asia.to how to allocate your money as long as you conform to these guidelines at the start. While the stock market is known for its ups and downs. equities have historically provided higher returns than bonds over a long-term period. The share prices . Your challenge is deciding how to invest money so that it becomes available in the future. International Equity Funds An international portfolio of securities promises less risk and greater diversiﬁcation than one that is purely domestic. 63 Investing in Unit Trusts UNIT TRUST GLOSSARY There are more than 3. Equity Funds (Also Called Stock Funds) An equity fund is a unit trust that invests in stocks (or equities). • Regional Equity Funds invest in the stocks of a single geographic region.200 funds available to investors in the Singapore marketplace. the above guidelines will help you reach your desired investment allocation in a sensible and stress-free way. Europe or Latin America. Following this approach also frees you from the stress of worrying if you are too heavily invested in weak areas. From our experience.
they are cheaper to own as they have lower operating . it is best to consider global and regional funds before singlecountry and emerging market funds. Mexico. If you wish to diversify internationally and seek safety. and they are not for everyone. Investing in a narrow segment is higher risk. As a result. Indonesia and South Africa. Index Funds Index funds are unit trusts that closely track and replicate market indices such as the Straits Times Index. Keep in mind that emerging markets and single-country funds can ﬂuctuate widely because of their narrower focus. the whole portfolio becomes vulnerable. These markets oﬀer the potential for faster economic growth than established markets.S. because if fortunes in that sector fall. Sector Funds Sector funds invest in a speciﬁc industry such as technology or healthcare.64 MAKE YOUR MONEY WORK FOR YOU of these funds typically ﬂuctuate more than the share prices of broadly diversiﬁed global equity funds. but they also present substantial risks. Singapore or the U. • Emerging Market Equity Funds invest in countries that are moving towards an industrialised economy or to a free-market economy. The fund manager does not actively seek the best investments to outperform the market. • Single-Country Equity Funds invest in the stocks of a single foreign country such as China. Examples of such countries are Brazil. These funds are considered riskier than regional funds because of their narrower focus. Sector funds are attractive if you already hold a diversiﬁed portfolio and you want to take on more risk because these funds can sometimes achieve spectacular returns.
which trades like a stock on an exchange. Such securities are bonds backed with a claim on speciﬁc property.S. Many other types of ﬁxed income funds exist. lower-quality corporate bonds. thus experiencing price changes throughout the day as it is bought and sold. Indexing is a passive form of fund management that has been successful in outperforming most of the actively managed mutual funds in the U. We have devoted a chapter to index funds and ETFs. 65 Investing in Unit Trusts Other Types of Funds Money Market Funds Closely related to bonds are very short-term loans (between three and 12 months) known as money market instruments. Here are two: 1. Fixed Income Funds Fixed income funds invest in bonds issued by companies and governments. regionally. commercial paper and corporate bonds maturing within a year are some examples. and are thus of lower risk than unsecured bonds that are not backed by any asset. Like equity funds. there are ﬁxed income funds that invest globally. A close relative of the index fund is the exchange-traded fund (ETF). We do not need to explain these fund types. 2. Singapore government Treasury Bills. High-Yield Fixed Income Funds Such funds seek higher returns by investing in high-yielding.expenses. in emerging markets and in individual countries. Mortgage-Backed Funds These funds seek to maximise income by investing in mortgagebacked securities. One drawback of index funds is that they do not oﬀer any chance of above-market returns. .
where the goal is not to generate maximum income. .66 MAKE YOUR MONEY WORK FOR YOU Money market funds are good for your portfolio because they tend to be used like savings accounts. Balanced Funds (Also Called Asset Allocation Funds) Such funds combine about equal proportions of stocks and bonds in a single fund. thereby eliminating the expenses incurred by registering a feeder fund. oﬀering the growth potential of equities and income from bonds. The beneﬁts 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. balanced funds provide the best of both worlds. but to preserve capital. In this sense. Rules have now been relaxed and fund houses today can bring oﬀshore funds directly into Singapore for sale. Offshore Funds These are funds that are registered outside Singapore in places such as Luxembourg and Dublin. Feeder Funds A feeder fund is a fund that is registered locally and invests in an oﬀshore fund.
2. a fund may be shown as having beaten all its peers during the last one year. Impressive in itself — until one ﬁnds out that the fund lost out in every other measurement over the last 10 years. do your homework ﬁrst. DollarDex and Finatiq. Better still. Banks. the process of ﬁnding good funds must be undertaken with care. make sure you ask why he is positive about any particular fund. SOURCES OF INFORMATION ON FUNDS If you want to select your own funds. You know the type of equity funds and bond funds that will diversify your investment portfolio across the world.06 Selecting and Managing Your Unit Trust Investments You have by now an equity-ﬁxed income fund allocation that matches your risk proﬁle. 3. Third party fund analysis from Lipper. but there are many that are. If you have a ﬁnancial adviser helping you. and the challenge is ﬁnding the ones that are right for you. Financial advisers. That is because fund distributors can typically ﬁnd some performance measure that they can beat. We will show you how you can get a list of good funds later. . such that all funds appear to be “good” funds. Not all funds are good. For example. 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. there are four main sources of information available: 1. Online distributors of unit trusts such as Fundsupermart. and 4.
com • Click on the Basic Search tab • Make the appropriate selections: Universe – select Unit Trust Asset Type – select Equity This produced 1.2. Review Top-Performing Funds Here is how you can generate a list of top-performing equity funds with at least a 5-year record. independent ratings. To narrow our search to the top-performing equity unit trusts over a 5-year period. Use the following criteria as a ﬁrst cut.963 Fund Type Matches that are “Unit Trusts” of type “Equity” (Figure 6.) appears: . as at mid-2010). That is why we can expect them to oﬀer objective. we prefer to consult the ratings provided by Lipper. Click the “15 Matches” icon and the ﬁrst 10 Lipper Leaders (Figure 6.). THIRD PARTY FUND RATINGS As a start. This organisation does not sell unit trusts. make the following selections: • Time Frame – select 5 Year • Total Return – select 5 • Consistent Return – select 5 • Preservation – select 5 • Expense – select 5 This produced 15 Lipper Leader Matches (Figure 6.68 MAKE YOUR MONEY WORK FOR YOU Each of these sources uses similar criteria to evaluate funds. Go to www.fundsingapore.3. 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. So be sure to expect diﬀerent results when you do your own search.1. Keep in mind that the steps outlined below are based on actual screenshots at a certain date.
1.com . Allianz Global Investors KAG mbH Fund Type Matches: 1963 Ctrl=click selects multiple options FIGURE 6.FIGURE 6. SETTING CRITERIA TO FIND TOP PERFORMERS OVER 5 YEARS Select a Time Frame Overall 3Years 5Years 10Years Choose the Lipper Leader Rating from the categories below that match your investment goals.2. SETTING CRITERIA TO FIND ALL EQUITY UNIT TRUSTS 69 Universe Unit Trusts CPF Included All CPF Account type All Select An Asset Type Equity CPF Account type 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. You can make multiple selections. Total Return Consistent Return Preservation Expenses Highest SELECT S ALL SELECT S ALL SELECT S ALL SELECT S ALL 5 5 5 5 Lowest 4 4 4 4 3 3 3 3 2 2 2 2 1 1 1 1 5 4 3 2 1 Historical Performance SGP Lipper Leader Matches 15 Source: www.fundsingapore.
10-year.3. DISPLAYING THE LIST OF TOP PERFORMERS Lipper Leader Ratings — What They Mean Funds are ranked against their Lipper peer group classiﬁcations each month for 3-. without looking at risk and may not be suitable for investors who want to avoid downside risk. For each measure: Rating ‘5’ ‘4’ ‘3’ ‘2’ ‘1’ Position in Peer Group Top 20% of funds Next 20% of funds Middle 20% of funds Next 20% of funds Lowest 20% of funds This 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. 1 adapted from www.com . This measure is for investors who want the best historical return. and overall periods. 5-.70 MAKE YOUR MONEY WORK FOR YOU FIGURE 6.lipperleaders.
do not forget to ask how he generates his list and why he thinks the funds are good. it is very diﬃcult to be nimble. ADDITIONAL TIPS ON IDENTIFYING GOOD FUNDS Here are other suggestions to help you avoid mistakes when making buying decisions. On the other hand. 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. if you prefer to let your ﬁnancial adviser do the selection for you. ﬁnding good funds is really easy. . 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. Treat your list of funds as a source of names for further investigation.• A high rating for Consistent Return identiﬁes a fund that has provided relatively superior consistency and risk-adjusted returns when compared to a group of similar funds. We will teach you how to read some of the performance statistics later in this chapter. 71 Selecting and Managing Your Unit Trust Investments About Your List of Good Funds As you can see. Be careful not to follow recommended funds blindly. • A high rating for Expense identiﬁes a fund that has successfully managed to keep its expenses low relative to its peers. • 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. They argue that when a fund gets that big.
For the investor. which invests 70 per cent in Singapore equities and 30 per cent in Singapore bonds.8 Source: Expense Ratios: Analysis of Trends. What the study found is that smaller funds are a lot more expensive to run than bigger funds: TABLE 6. the salary of research staﬀ. had a fund size of $3. a fund averaged $10 million in size and its expense ratio is 2 per cent.2 >$50 1. Oct 2001.1 billion in July 2010. 5 – Oct 2001 . That means $200. Prudential’s PruLink Singapore Managed Fund. fund managers look long-term and close their funds to further subscription if they feel their fund is too large. it makes sense too for the fund to be big enough because small funds are expensive to run. After all. Mercer conducted a study on CPFIS funds in 2001.1. Should Small Funds be Avoided? Suppose for the last three years. In fact. Do you think that is enough? Experience points to funds getting closed when their size is too small.000 is available to pay for the fund manager’s salary. electricity. But did you know that there are nearly 100 companies on the Singapore Stock Exchange valued at $1 billion or more? That Singtel alone has a value of over $55 billion? Now the Prudential fund does not seem so big after all. Mercer Article No. PCs and other operating expenses. Funds have to be a certain size to be feasible for the fund manager. It is the largest fund invested in Singapore securities. That must seem too big for a Singapore fund.4 $10–50m 2. they will not want a fund so large that they cannot manage it well enough to bring in good results.1% $5–10m 2.72 MAKE YOUR MONEY WORK FOR YOU Let us take Singapore funds for example. BIG FUNDS HAVE SMALLER EXPENSE RATIOS Fund Size Expense Ratio <$5m 3.
15% 0.2.Should Funds with Large Expense Ratios be Avoided? It depends. these funds tend to be more expensive to run because they require heavy resources for research and analysis. In the end.: 73 Selecting and Managing Your Unit Trust Investments TABLE 6. CPF’S EXPENSE RATIO THRESHOLD Equity Risk Higher risk Medium to high risk Low to medium risk Lower risk Source: www. it announced that unit trusts and Investment-Linked Policies (ILPs) cannot accept CPF monies if their expense ratios exceed certain benchmarks.75% 1.2.95% 1. Expense Ratio 1. the CPF Board will not require you to sell or switch your investments although it will likely oﬀer you opportunities to switch from these funds for free within a certain time frame. Just as a Lamborghini takes more fuel to run than a 150cc Vespa scooter. Then there are specialised funds that focus on particular sectors such as technology and healthcare.gov.3 per cent annually. It follows then that given two funds of the same type. expense ratios cannot be higher than those shown in Table 6.sg Type of Unit Trust Equity funds Balanced funds Bond funds Money market funds Max. or to think thrice. It is usually worthwhile to pay more for a fund that gives you superior performance even if they are expensive to own. about funds with larger expense ratios.cpf. From 1 January 2008.65% If you have already invested in funds that exceed these benchmarks. remember that expenses is just one of the factors (although a big factor!) that aﬀect your returns. it makes sense to avoid. some funds are inherently cheaper to run. such as index funds whose expense ratios are as low as 0. So if you come . The CPF Board is so concerned about expense ratios eroding investment returns that at the end of 2006.
74 MAKE YOUR MONEY WORK FOR YOU across a fund that has a high expense ratio. go ahead and take some risk. even speculative. investments. there are those adventurous souls amongst us who would consider taking the plunge each time a new fund or stock is available. Other than a really good reason. Should You Invest in New Funds? The easy answer to this perennial question is. . • Are you going to set aside the time and eﬀort 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. If not. and accept nothing less than a good and convincing reason. do not touch the fund.” Some investors would like to see how funds have performed relative to their peers as well as in good and bad markets. don’t write it oﬀ just yet. Then you can set aside some money or a portion of your portfolio to include riskier. ask yourself the following questions and be comfortable with your answers: • Is your portfolio already diversiﬁed? Do you now want to add risk? If yes. “I won’t invest in a fund that has not been around for at least three years. then you are taking a big risk with your money. you are advised to monitor its performance more regularly than you might an aged fund. • Does the fund manager already have a track record elsewhere? If he is a newly minted MBA or just old enough to shave. If you are one of these risk-loving investors. drop funds that have high expense ratios. Still. Ask yourself or the salesperson why it has higher charges. Remember. your ﬁrst duty is to have a portfolio protected by diversiﬁcation. It may be a specialised fund or it has a superior performance record.
if you are checking a fund every month and you see that it is underperforming for the last four months.com. will underperform its peers periodically. The second thing to do when you monitor your portfolio is to rebalance it. Sell High” principle. 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. you might do it monthly. Reviewing fund performance only takes a few minutes when you use a website like www. even the best ones.000 investment) who is very qualiﬁed and smart to worry about how your money is invested. Suppose you started oﬀ with a 90-10 equity-bond portfolio. For example: . For example. If you really want to get into your investments. To rebalance it back to 90-10. So. fundsingapore. but those who review their investments too often might overreact to short-term market movements.MONITORING FUND PERFORMANCE One of the great things about owning a unit trust is that you are paying someone (about $200 per year for a $10. During the next six months. But as so often happens with good funds. But you still need to check periodically on how the funds you own are doing. 75 Selecting and Managing Your Unit Trust Investments How Often Should You Check? Every six months is usually a good bet. You do not want to ﬁnd out 10 years from now when you need the money that the fund you bought has turned into a pumpkin. WHY REBALANCING MAKES SENSE Rebalancing forces us to put into practice the “Buy Low. the underperformer comes back alive and produces quarter after quarter of dazzling results. you might pull the trigger and sell the fund. and do not leave your funds alone for more than one year. The fact is that every fund. review your funds every six months. if necessary. the portfolio shifts to 70-30 equity-bonds because equity prices have fallen and bond prices have risen.
Rebalancing also forces us to add bonds when interest rates rise (bond prices fall) and sell equities when the stock market goes up. Rebalancing: Points to Consider While the mechanics of rebalancing are straightforward. 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. How Often Should You Rebalance? You may want to set some rules. Whenever equities fell relative to ﬁxed income. These are very wise things to do. this portfolio was actually rebalanced every year. .3 per cent. equities were bought and ﬁxed income was sold. Does Rebalancing Work Over the Long-Term? In the iFAST study we examined in Chapter 5. Well. If the strategy had been buy and hold. • The bond portion had risen sharply and we rebalanced by selling high. the return produced would only have come to 7. • Rebalance right away when interest rates have moved up or down quickly by more than 2 per cent. sometimes the cost or inconvenience of rebalancing may outweigh the beneﬁts.76 MAKE YOUR MONEY WORK FOR YOU • The equity portion had fallen sharply and we rebalanced by buying low. the 100 per cent equity portfolio produced a 9 per cent annualised return over 32 years.
Even if you do not want to rebalance. Perhaps you should wait another six months. 77 Selecting and Managing Your Unit Trust Investments . Fortunately. Change in Risk Profile As your time horizon nears. When you are 10 years away from your objective. you will be removing those positions that can go up even higher. Time and Effort If you have a large number of funds and the amount to rebalance is a mere few hundred dollars. your risk profile is likely to be more aggressive. the answer should be “yes”. switches between funds of the same family are usually cost-free. In any case. your risk profile will change. How much does it cost to switch funds? The transaction costs can be high enough to stop you. you cannot reach that conclusion without going through exactly where your portfolio stands today. it may not be worth the trouble. you may want to try something called a wrap account. your proﬁle will become more conservative and your portfolio will take on more and more ﬁxed income and fewer and fewer equities. Better yet. When you have a wrap account oﬀered by some ﬁnancial advisers. Ask yourself each time when you rebalance — has my risk proﬁle changed? After every few years. you should review your portfolio every six months. Bear in mind that the risk proﬁle you started oﬀ with is not going to be the same proﬁle you end up with eventually. One criticism of rebalancing is that when a fund does well. This may call for an 80-20 equityfixed portfolio. As you get closer and closer to your objective. you can rebalance for free among funds from several fund managers.Transaction Costs This is the most obvious drawback.
If your answer is “no”. But we are investing for future results. Economies go up and . then you believe that any of these three dream performers should be winners again in the future. you will have come out a winner. Unlike reports that measure the reliability of cars. They say that past performance is pretty much worthless when it comes to ﬁguring out the future. then you are saying that these top performers will probably not be able to hold their position in the future.4. The question we need to answer is. “Is past performance indicative of future results?” If your answer is “yes”. not past.78 MAKE YOUR MONEY WORK FOR YOU FIGURE 6. Many experts believe this to be true. DON’T FORGET TO REDO YOUR RISK PROFILE > Aggressive 80% Equity 20% Fixed Income Balanced 60% Equity 40% Fixed Income >Conservative 20% Equity 80% Fixed Income 10 years 5 years 3 years Source: Authors’ own illustration Can You Count on Past Performance? If you had picked any one of the top-performing Lipper Leaders ﬁve years back. investment performance is very diﬃcult to predict. 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.
99% Source: www. • Buy funds with lower expense ratios. In fact. for example.efmoody. If fund A’s expense ratio is 2. To make our choices more bullet-proof.3% 0. we would choose B. but we have to be careful. fund A will cost 1. funds change.8% 47. we rely on the following rules of thumb: • Buy funds with good track records with as long a history as possible.html We believe that while the past is not indicative of the future. underperforming after being a hot fund is common.com/investments/pastperformance. it still does a decent job. you lose out on 15 per cent of returns.7% 51. all else being equal.3. . William Sharpe. If you hold the fund for 10 years.5 per cent and fund B’s is 1 per cent.5% 52. TOP PERFORMERS MAY NOT STAY ON TOP FOR VERY LONG Performance Over 5 Years Top 20% Performers Second 20% Third 20% Fourth 20% Fifth 20% Top 50% Finishers Over Next 5 Years 44. Nobel Prize Laureate in Economics. discussed Barkdale and Green’s ﬁndings: funds that ﬁnished in the top 20 per cent over the past ﬁve years were the least likely to ﬁnish in the top 50 per cent over the next ﬁve years: 79 Selecting and Managing Your Unit Trust Investments TABLE 6. managers and sectors such as technology can blow hot. then cold. in an article on past performance. If fund A is the top performer over the last three years and fund B is a steady performer over the last 10 years.down.5 per cent more to run per year.
investors tend to sell their funds for the wrong reasons. diversify your assets across the diﬀerent asset classes. Sure. then when your $100. But as we will see. 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. but can you . is there really a right time to sell? It is generally accepted that the best time to sell is when you have reached your proﬁt goal. but ﬁnding advice on when to sell a fund can be much harder to come by. More often than not. and stick to a strategy that keeps your retirement goal in perspective. your investments could skyrocket after you sell. you should still weigh your choices. For example. So.000 target is attained. and across diﬀerent fund managers. sell your investments. IS THERE A RIGHT TIME TO SELL? Newspapers and fund distributors have little trouble telling you what funds to buy and when. • Most of all. it might be best to hold oﬀ selling your investments. technology is part of a long-term trend even though it ﬂuctuates during shorterterm cycles.000 in 10 years for your daughter’s education. it is important to examine current trends. You Need the Money Sometimes there will be emergencies in your life when you need money and you have little choice but to sell your investments. rather than past ones. Your Objective is Met If you set out a clear target of accumulating $100. China is a long-term growth opportunity even if it might overheat and have high inﬂation. there are also situations where the fund ought to be sold. Despite the urgency.80 MAKE YOUR MONEY WORK FOR YOU • When it comes to investing. even when it is not proﬁtable. across the globe.
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. If equity funds have gained 8 per cent this year and ﬁxed income funds have lost 6 per cent. allocating your money appropriately in equity funds and ﬁxed income funds is far more important to investment success than chasing after the hottest funds. resulting in a large inﬂux of investor money. you might think ﬁxed income funds do not belong in your portfolio. which leads to liquidity problems. The problem is that with so much more money. his moves are going to be closely watched by the market. Here is an example. Sometimes funds that get big very quickly can be a problem. His success brings a lot of attention.” A good fund underperforming its peer group in any one year is a common thing.stomach the alternative? Suppose you hung on and the market falls sharply and you end up with insuﬃcient money for your objective. because as a major shareholder of the stock. To get around this problem. something is probably wrong. he has to hold more stocks. Suppose fund manager Tommy is great at picking a portfolio of 20 company stocks. One of the worst reasons for selling a fund is when its category is going through a tough time. His job is much tougher now because he is forced to ﬁnd 40 or 50 good stocks. But when a good fund underperforms for two years in a row. 81 Selecting and Managing Your Unit Trust Investments Your Fund is Underperforming If your fund is not doing well. This is the best way to shoot yourself in the foot. ﬁnd out why. Drastic Change in Fund Size Fund size can change dramatically during bull and bear markets. . The best thing to do when you reach your objective is to sell. But as you know from Chapters 1 and 2. he may end up owning a majority of several stocks.
Selling a fund right away because of the fund manager’s departure is generally a mistake. The Fund Manager Leaves A good unit trust is often backed by a solid fund manager. Watch your fund more closely after the change. There is another time when you may want to rebalance. If the fund you hold is run by a star manager and the manager leaves. you may need to rebalance your holdings by selling and buying securities in order to return your portfolio back to its desired allocation. fund management companies tend to adopt a team approach to investing rather than rely on individuals. This makes monitoring manager turnover less meaningful. you may want to reconsider. This does not mean you should blindly ignore a change in manager. (We should mention that in Asia. If its performance lags far behind for a few quarters. a change in fund manager may encourage an investor to hold onto the fund more tightly. This is because the fund managers will have a tough time meeting expenses and investors will be paying high expense ratios. The fund management company surely wouldn’t replace its star performer with a slouch or loser. your current portfolio may no longer be appropriate. YOU NEED TO REBALANCE YOUR PORTFOLIO If you have an asset allocation you want to stick to. and that is when your risk proﬁle changes.) Conversely. a manager’s departure can be a good thing as well. you may want to sell all or part of the fund more quickly than you would in normal conditions. think about selling the fund if the replacement is not known to be a performer. If you are thinking about selling a fund and the primary reason for selling it is not on the list above.82 MAKE YOUR MONEY WORK FOR YOU On the other hand. If your retirement is ﬁve years away and your risk proﬁle has turned conservative. If the fund has been underperforming its peers. it is also diﬃcult for a small fund to survive. Selling a unit trust is not something you do without a great deal .
do it and do not look back. But if you have carefully considered the pros and cons and you still decide to sell it. 83 Selecting and Managing Your Unit Trust Investments .of consideration. Remember that you originally invested in the fund because you were conﬁdent of it — make sure you are clear on your reasons for letting it go.
the eﬀect on the overall portfolio is just minus six per cent (-30% x 20%). This guideline is. If these investments suﬀer a major setback. bonds and other supplementary investments for your retirement. We recommend that up to 20 per cent of your total invested money be invested in individual stocks. bonds. For example. not etched in stone. You begin the process by opening a trading account with one of the 20 or so brokerage companies in Singapore. of course. you are entrusting someone else to make decisions for you and you lose control over what to buy and sell. let us ﬁrst beef up on more details. buying and selling stock is a relatively simple task. INVESTING IN INDIVIDUAL STOCKS AND BONDS Assuming you already have a diversiﬁed unit trust portfolio that you plan to hold for retirement or some other objective. The 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 oﬀer. But before you do. if you have $50. such as a 30 per cent drop. And fortunately.000 or 20 per cent in individual stocks.000 in total to invest. then you could allocate up to 20 per cent of your total invested money in individual stocks. more speculative and other supplementary investments that need not form part of your long-term retirement portfolio. as seen by the millions of stocks that are traded among investors every day. you can allocate up to $10.1 We feel 20 per cent is a safe guideline. Investing in individual stocks requires time and money to manage them eﬀectively. and when. you could build a globally diversiﬁed portfolio consisting of individual stocks. For example. and you can begin submitting orders to buy or sell. 1 .07 Investing in Individual Stocks When you buy a unit trust.
1. Normally perpetual. stocks have always outperformed bonds. . our focus will be on common stock. Some pay dividends. Some have stable prices while others have volatile prices. Of the 500 companies on SGX Mainboard and Catalist. you stand to make money if the company does well. It is possible that you could lose a big chunk of your initial investment. In fact. If you buy a common stock. there are just about ﬁve preferred stock issues traded. Owners of preference stock are also shareholders.COMMON VERSUS PREFERENCE STOCK Most stocks sold in Singapore are common stock. For this reason. 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. 85 Investing in Individual Stocks TABLE 7. preference shareholders beneﬁt from a ﬁxed dividend that does not increase even if the company has a boom year. Less volatile Source: Authors’ own compilation Types of Common Stock Common stock returns come in the form of dividends and capital appreciation — an increase in the share price. For the risk that you take. often by a comfortable margin. But not all stocks are the same. Unlike common shareholders. some do not. over time. MAJOR DIFFERENCES BETWEEN COMMON AND PREFERRED STOCK Common Stock Voting Rights Dividends Maturity Price Movement Always Not ﬁxed or promised Perpetual More volatile Preferred Stock Seldom Fixed. Sometimes the company can terminate the issue or investors can convert to common stock. Can be suspended if company has net loss.
Airline stocks are typically cyclical. but when the economy grows. On the ﬂip side. They do best during expansions.86 MAKE YOUR MONEY WORK FOR YOU One way to diﬀerentiate stocks is to observe how closely a company’s prospects is tied to the economy: FIGURE 7. but do badly during recessions.) moves from bottom to peak during an expansion. People postpone travel when the economy is slow. Cyclical Stocks Cyclical stocks are the most sensitive to business cycles.1. A TYPICAL BUSINESS CYCLE Peak Expansion Recession Bottom Source: Authors’ own illustration As the business cycle (see Figure 7. Food and utility stocks are defensive because people will still eat and turn on the electricity during market downturns. . travellers can suddenly appear in droves at the travel agent’s oﬃce. defensive stocks underperform during expansions — people would not suddenly eat a lot more or keep the lights on all night. diﬀerent industries beneﬁt diﬀerently from the economic changes that accompany the cycle. Defensive Stocks Defensive stocks are the least sensitive to business cycles.1.
Growth Stocks Growth stocks perform better than the industry average. for example. promises of technological breakthroughs. Investors buy growth stocks for their potential price appreciation and not for dividends. 87 Investing in Individual Stocks . Blue-Chip Stocks Blue-chip stocks are solid performers that generate some dividend income. decent growth and. Speculative Stocks Speculative stocks are typically unproven young companies. but puts proﬁts back into the company to ﬁnance new growth. most of all. Value Stocks Value stocks are stocks that are underpriced by the market for reasons that have nothing to do with the business itself. Interest Rate Sensitive Stocks Interest rate sensitive stocks are greatly aﬀected when interest rates change. and they typically pay a lot of bond interest. Value stocks are good investment opportunities that may have been oversold or may be temporarily out of favour. When interest rates rise. but can be winners in the making when there are. Prepare for a rollercoaster ride if you invest in a speculative stock. they also decline in price more signiﬁcantly. They may be erratic. 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. A growth stock usually pays little or no dividends. While the prices of growth stocks usually rise in value more than those of other types of stocks. the cost of servicing its loans rises and this has a downward eﬀect on its stock price. Utility companies have huge ﬁxed costs in plant and equipment. and growth may occur regardless of the business cycle.
many large companies are listed on the Singapore Stock Exchange. If the business grows. The Primary Market — Buying an IPO Going public means that the business sells new stock that previously did not exist. the easiest way to own international stocks is to buy international unit trusts. their prices tend to hold up more when growth stock prices are tumbling. Companies whose stocks fall into this category are typically in stable and mature industries such as utilities and tobacco. 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 proﬁts. This is done in the primary market. the entrepreneur often seeks a second level of funding called venture capital that is provided by wealthy investors and investment companies.88 MAKE YOUR MONEY WORK FOR YOU Income Stocks Income stocks pay a higher-than-average dividend. Many of the world’s largest companies have their headquarters overseas. While income stocks may not have the growth potential of growth stocks when prices are rising. In any case. . While buying shares of foreign companies can pose a challenge for some investors (we will discuss some of these challenges in the next chapter). The road to an Initial Public Oﬀering (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. which is the ﬁrst part of a ﬁnancial market and is part of the process of getting listed on a stock exchange. International Stocks International stocks are stocks of foreign companies. SELLING NEW STOCK THROUGH AN IPO It is the dream of every entrepreneur to take the company he started from private to public ownership.
which we shall call Stock X. the shares trade in the secondary market such as the Singapore Exchange (SGX). 52-wk high 52-wk low Last sale Vol ‘000 Day High Day Low Net P/E M Cap $Mil Company 222 188 * Stock X 210 789 213 210 18. the original issuers receive no additional cash from these secondary market transactions. IPO shares are sold during a subscription period. Once shares start to trade in the secondary market.1 per cent. the share price can rise and fall. the number of shares that should be issued and the price per share. which typically lasts up to a few weeks. The more volatile the stock. and become oversubscribed. the price ranged between $1. The range between the high and low is an indication of the stock’s volatility or price movement.22. 89 Investing in Individual Stocks The Secondary Market — SGX At the end of the IPO subscription period. READING THE STOCK PAGE This is an adaptation of a quotation from a mainboard-listed company. the only formal exchange for stocks in Singapore. or about 18.88 and $2.6 6071 Source: Authors’ own computations The highest and lowest prices for the past 52 rolling weeks are reported daily. Some IPOs are so hot that they can be completely sold out in just a few days. the more you can proﬁt or lose in a relatively short time. to buy all the public shares at a set price and to resell them to the public at a higher price for a proﬁt. depending on investor expectations. For example. These underwriters advise the company on the valuation of the company. At this time. that is. .The management of the IPO goes to an investment banker who agrees to underwrite the stock issue.
6 2. “High” and “low” reports the highest and lowest prices for the previous day.29 cents If you were to buy up all the outstanding shares of the company. The last sale or closing price was $2. The daily diﬀerence is usually small compared with the 52-week spread.com.10 (last sale) is 18. This implies that earnings per share is 11. BUYING AND SELLING SHARES IN THE SECONDARY MARKET Opening an Account There are a few ways to trade shares in the secondary market.poems.071 billion — its market capitalisation. It is calculated as the number of outstanding shares multiplied by the current share price.90 MAKE YOUR MONEY WORK FOR YOU The stock was issued with a par value of 10 cents. It is obtained by dividing the current price per share by the earnings per share.6 means that its current price of $2. The price-earnings ratio (PER) shows the relationship between the stock’s price and the company’s earnings for the previous year.6 = 11. The * on the left of the company name indicates that it is one of the index stocks that make up the STI.10.10 / E = 18.6 times the previous year’s earnings per share.6 E = 2. Volume of 789.sg). Stock X’s P/E of 18.10 / 18. If you know exactly what you want and are more a “do-it-yourself ” investor.000 refers to the number of shares traded the previous day. Commissions for online . you can trade shares through an online brokerage such as Phillip Securities (www. you would have to fork out $6.29 cents (barring any rounding error): P/E = 18.
But your broker tells you that the individual who sold you the BigCo shares failed to deliver the shares to your broker. Trades commonly cost a minimum of $25 for online and $40 for oﬄine. the investor. Brokerage ﬁrms act as intermediaries between you. A margin account allows you to borrow money from the brokerage company to buy more securities. you ﬁrst have to open an account at the Central Depository Pte. CDP provides the clearing and depository function for the Singapore share market — it guarantees and clears all securities traded on SGX. the price of BigCo has doubled and your shares are now worth $40. In order to trade shares. Once you have your CDP account. you call your broker and ask him to sell your shares. Opening a Cash or Margin Account Your broker will need to know if you want a cash account.000 shares of BigCo. you can approach a member stockbroking company to open a sub-account and begin trading. (CDP). This is called leverage and is not for everyone because you can double or triple your proﬁts as well as losses. Now if your BigCo shares were traded through a regulated exchange like SGX. .91 HOW THE CDP WORKS Imagine that you paid $20. Investing in Individual Stocks trades are usually lower than for oﬄine trades done through dealers and remisiers who are representative of the brokerage. One week later. Elated by your windfall. the integrity of your share purchase is guaranteed by CDP.000 through your broker for 1. Ltd. margin account or both. which handles the clearing of trades. and the cost increases based on various contract value sizes. and the CDP.000. Cash accounts require you to pay in full after a purchase is made.
Issuing Buy and Sell Orders When you decide to buy a share. When you “short” a security. It is really important to understand how orders are given and executed.000 worth of securities. suppose you short 1. To see how this works. Short selling is a very aggressive strategy since your upside potential is ﬁxed (the price of the stock cannot go below zero). 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. If you had no existing long position and you expect the market to decline. To you.92 MAKE YOUR MONEY WORK FOR YOU Brokerages in Singapore typically oﬀer a margin equal to 3. instead. If the short sale was for $10 a share and you buy the stock a month later at $7 a share. you will have a loss of $2. and your downside potential is unlimited (the stock can go up and up). Establishing a Long or Short Position When you buy a share. If.000 cash translates into a margin account of $35.000 shares). you make a proﬁt of $3.000 ([$10-$7] x 1. 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. . Hence. bad news is good news.000 ABC shares at $10 a share. you are said to have a long position. ABC is bought back at a higher price of $12 ($2 higher than the short-sale price).000 shares).5 times your cash amount deposited. you may wish to take a short position to proﬁt from the expected decline.000 ([$10-$12] x 1. how exactly do you tell your broker to establish a position? If you are not careful. a deposit of $10.000 to buy up to $35. Your decision to buy means that you hope to proﬁt from an increase in price in the future. you may end up paying more than you expected.
speciﬁes the exact price at which you want an order executed. The 93 Investing in Individual Stocks .00. on the other hand. while a sell stop order is placed below the current market price.20.” you are placing a market order. Stop Orders If you want your order to go through no matter what. A stop order guarantees that your order is ﬁlled by stating the price at which a market order takes eﬀect. For example. For example.000 shares of XYZ.000 shares of XYZ at $10. say you absolutely must own XYZ and it is currently trading at $1. Market orders 2. Limit Orders A limit order. You can see that a limit order may never be executed so long as there are orders ahead of yours in terms of price. a market order at whatever the current price does the job.There are three common types of orders: 1. You can place a stop order to buy XYZ at $1. A market order does not specify a price.” There may be other buy orders in front of yours at more than $10. If they think a stock is really hot and they do not want to miss getting the stock. “Buy 1. you can place a stop order. Some investors feel that market orders are risky because if the market runs up suddenly. Stop orders Market Orders When you phone your broker and say. Limit orders 3. But market orders make sense for other investors. These investors will be serviced ahead of yours because they are all willing to pay more than you are. “Buy 1. A buy stop order is placed above the current market price. they may end up paying much more.00.00.
and at the same time. you want to hang on to the share for extra gains.20 because the closest price at which the stock trades may be $1. Now suppose XYZ has risen to $2. a sell stop order could be placed at $1.20. You want protection against a price decline. The exact price speciﬁed in the stop order is therefore not guaranteed.94 MAKE YOUR MONEY WORK FOR YOU order becomes a market order to buy as soon as the market price reaches $1.80. The order may not be ﬁlled exactly at $1.00. A sell stop can be used to protect a proﬁt. To lock in most of the proﬁt. a market order to sell is triggered. When market price falls to $1.25. .80 or below.
How much money is the company making and how much is it going to make in the future? Earnings are proﬁts and that is what buying a company is about. Both companies made sales of $1.000 but company B earned more as it incurred lower expenses. They may not work all the time. The winning techniques have been tested over and over. 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. but they work often enough. Increasing earnings generally lead to a higher stock price and. Because good stocks tend to stay good. Which company would you buy? . Even if you do not plan to do thorough fundamental analyses yourself. take your time to ﬁnd the right information. in some cases. And when earnings drop. a regular dividend.08 Selecting and Managing Your Individual Stock Investments There really is no secret to picking good stocks. FUNDAMENTAL ANALYSIS So how do the pros sort out the good stocks from the bad? By looking at a business at its most fundamental and ﬁnancial level. it will help you follow stocks more closely if you understand these key terms and ratios. Do your homework. the market may knock the stock price down. This type of analysis examines key ﬁnancial ratios of a company. giving us an idea of the company’s ﬁnancial health and the value of its stock. IT IS ALL ABOUT EARNINGS The bottom line is what investors want to know. Suppose company A and company B are in the same industry.
Earnings Per Share (EPS) One of the challenges of evaluating stocks is making sure we make apple-to-apple comparisons.2.1.000 -600 400 Source: Authors’ own illustration Company B for sure. We calculate EPS by dividing earnings by the number of outstanding shares: EPS = Earnings / Outstanding shares TABLE 8.000 -700 300 Company B 1.Expenses Earnings 1. Yet while earnings are important. EARNINGS OF COMPANIES A AND B Company A Sales . Which family has more earnings to go around? Using raw numbers ignores the fact that two companies have a diﬀerent number of outstanding shares. EPS OF COMPANIES A AND B Company A Earnings Number of Shares EPS 300 10 $30 Company B 400 100 $4 Source: Authors’ own illustration . Suppose Adam’s family earned $300 and Adam is the only child.96 MAKE YOUR MONEY WORK FOR YOU TABLE 8. Let us look at earnings per share (EPS). by themselves they do not tell you anything about the value of the company’s stock. while Betty’s family earned $400 and she’s got nine other siblings. Comparing the earnings of one company with another really does not make any sense. if you think about it.
although it should not be the only one to consider. 97 Selecting and Managing Your Individual Stock Investments Price-Earning Ratio (PER) If there is one number that people look at than more any other. The PER is the most popular tool for analysing a stock. you should note that there are two main types of EPS numbers: 1. which are projections. 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. PER OF COMPANIES A AND B Company A EPS Stock Price PER $30 $300 10 times Company B $4 $80 20 times Source: Authors’ own illustration . if company A has a stock price of $300 and company B’s price is $80. PER = Stock price / EPS For example. Trailing EPS — last year’s actual numbers. it is the Price-Earning Ratio (PER). Forecast EPS — based on future numbers. Before we move on. You calculate PER by taking share price and dividing it by the company’s EPS. but we are close. 2.Now suppose company A has 10 shares outstanding.3. It looks at the relationship between the stock price and the company’s earnings. We still do not know how much we would pay for the stock of company A and B. their PER are 10 times and 20 times respectively: TABLE 8.
98 MAKE YOUR MONEY WORK FOR YOU What does PER tell us? The PER gives us an idea of what the market is willing to pay for the company’s earnings. A high PER can be read as an overpriced stock. Investors can make fortunes by spotting these sleepers before the rest of the market discovers their true worth. we can say that the stock is expensive compared with its peers. a low PER stock may indicate the market’s lack of conﬁdence in the stock. The higher the PER. • 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 cheap compared with its past. we can say that the stock is cheap compared with the entire market. 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. the more the market is willing to pay for the company’s earnings. Its future prospects are dim and the market is depressing its stock price relative to its earnings. On the other hand. Their PERs can be quite high and they can still be considered “cheap” by the market. • 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. Such a stock is called a growth stock. While this may be true. Still. Or it could be a value stock — an underpriced stock that the market has overlooked. 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.
zacks. What is generally more reliable are earning forecasts taken by averaging the estimates of several dozen analysts who follow the stock. 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. A forecast PER on the other hand uses the current stock price divided by the stock’s forecast EPS. what is the forecast price of stock A if its forecast EPS is $1. Given a trailing PER of 15 ($15/$1).com . Forecast price = 15/1 X $1.20 = $18 99 Selecting and Managing Your Individual Stock Investments 1 www. One example is Zacks consensus estimates (called Zacks Rank) for the U. 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.Using the PER to Value Stocks The PERs we see on the stock pages in newspapers are trailing PERs. It uses the current stock price divided by a historical earnings ﬁgure from the company’s latest annual report. Are these consensus estimates reliable? The best stocks picked by Zacks Rank have outperformed the S&P 500 for 15 out of the last 16 years.20? Note that stock A has an historical PER of between 15 and 20 times in the last 10 years.S. Forecast earnings are found in company research reports generated by analysts.1 Forecasting Stock Price with PERs PER is very commonly used by investors to forecast the future price level of stocks and the market.
It consists of a basket of 30 stocks and measures the average price level of the market. The STI is plotted for the period between June 1995 and July 2010. In other words. and assuming the forecast proves accurate. one can expect stock A to increase in price by $3. We have highlighted the most popular — the PER. we are taking calculated risks when we rely on forecast numbers. • That forecast prices are estimated from assumptions about company growth. they will probably bail out of the stock. you would either be very happy or very upset. TRACKING THE MARKET THROUGH INDICES We track the market because it has an overall eﬀect on the performance of individual stocks. • That the forecast EPS of $1.20 is generally reliable. one has to have certain beliefs: • That the stock’s eventual PER will reach a level of 15. the economy and other factors. The Straits Times Index (STI) is the most widely quoted index for the Singapore market. If it does not live up to expectations. In order to make such a conclusion. depending on which period of time you were in the market. If you had invested your money in the Singapore stock market sometime during this period. but for what they hope it will do for them tomorrow. investors buy a stock not for what it can do for them today. This is an established fact. It is thus a good buy because this stock at $15 today is an undervalued stock. . and that these assumptions can be proven wrong in the end. In the end. which is at the low end of the range for the last 10 years.100 MAKE YOUR MONEY WORK FOR YOU Since the current price of stock A is $15. There are countless other ﬁnancial terms and ratios you can learn and use.
THE STI’S BIG JUMPS AND FALLS Period Feb 96–Aug 98 Aug 98–Dec 99 Dec 99–Sep 01 Sep 01–Mar 02 Mar 02–Apr 03 Apr 03–Oct 07 Oct 07–Feb 09 of STI Start STI End No.FIGURE 8.1. . STI PERFORMANCE BETWEEN JULY 1995 AND JULY 2010 4000 3500 3000 2500 2000 1500 1000 500 0 5 6 7 8 9 0 1 2 3 4 5 6 7 8 Ju l-0 9 Ju l-1 0 Ju l-9 Ju l-9 Ju l-9 Ju l-9 Ju l-9 Ju l-0 Ju l-0 Ju l-0 Ju l-0 Ju l-0 Ju l-0 Ju l-0 Ju l-0 Ju l-0 101 (Source: www. you reduce both risk and anxiety. months 2450 800 2500 1250 1800 1200 3850 800 2500 1250 1800 1200 3850 1600 30 months 16 months 21 months 6 months 13 months 54 months 16 months % change -67% 213% -50% 44% -33% 221% -58% Source: Authors’ own compilation That is why the experts harp so much on diversiﬁcation.sgx.com) Look at the self-explanatory volatility shown in Table 8.4 (STI levels are rounded to the nearest 50): TABLE 8.4. By putting your money into several baskets.
The top six weighted companies constitute about 50 per cent of the index. Singtel.2. FIGURE 8. If these top six stocks collectively rise 10 per cent. If you own a unit trust that is broadly invested in Singapore stocks.aberdeen-asia.com . A higher weight therefore means a greater inﬂuence on the index. Jardine Matheson Holdings and OCBC typically occupy the top six positions in terms of weight. the impact on the STI is 5 per cent (50% X 10%). Changes Applied (31/08/99 – 30/06/10) Source: www.7 -50 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Percentage Growth Total Return.3 1 80. Wilmar.102 MAKE YOUR MONEY WORK FOR YOU 175 0 150 125 5 0 100 75 5 50 0 5 25 0 5 -25 Components of the STI What makes the STI go up and down? The answer is this: When its component stocks go up and down. DBS. Using the STI as a Yardstick Stock indices provide a good yardstick against which investors can compare their portfolios. BENCHMARKING A SINGAPORE EQUITY FUND AGAINST THE STI Aberdeen Singapore Equity SGD (MF) Singapore Straits Time TR (IN) 141. you could compare its performance with that of the STI. UOB.
2 103 Selecting and Managing Your Individual Stock Investments International Investing Investors looking for ways to diversify their portfolio have a world of opportunity through international investing. we take each data point and divide it by ﬁrst data point minus 1. if you buy Microsoft (a U. Besides the stock price falling. dividends getting cut and the foreign currency falling in value.S. For example. each U. 2 We rebase in order to compare apples with apples. you will have to contend with: • Confusing accounting rules that may cause earnings to be under. The top chart is the Singapore equity fund also rebased to 100 for comparison. dollar rises against the Singapore dollar (when you sell the stock. • The stock pays dividends. It shows the Aberdeen fund outperforming the STI benchmark over this period. you gain when: • The stock rises in price. • Language barriers or complicated trading rules. stock). . is an excerpt from a factsheet of the Aberdeen Singapore Equity Fund.S.S. To rebase any data series. But there are other risks as well. The bottom line chart is the STI rebased to 100 for the period September 1999 to July 2010. If the ﬁrst 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). dollar converts to more Singapore dollars). • The U.or overstated. • Inadequate disclosure requirements. Buying stocks from an overseas market can earn you returns in three ways.2.Figure 8. a unit trust invested broadly in Singapore stocks. and others.
. But if the US$ falls to S$1.5 on the following page lists some of the most important indices used around the world. Suppose you sell the stock after one year for US$1. • Unit trusts that invest in international markets.600 — a S$200 loss. Table 8.0. • Open an account directly through a foreign brokerage such as Ameritrade and E*Trade.000 when the conversion rate was S$1. If your U. • Some foreign companies list their stocks directly on Singapore exchanges such as Noble Group (Hong Kong) and Total Access (Thailand). MAKE YOUR MONEY WORK FOR YOU How to Invest Internationally There are several ways for you to buy international stocks: • Local brokerages with access to overseas markets — for example.900 — a S$100 proﬁt. Exchange rate risk is a major added risk you need to consider when you invest overseas. you will only receive S$1. investment was purchased at US$1.8 : US$1. you will receive S$1. a breakeven position in terms of price.6.S. Keeping Track of International Markets There are hundreds of indices that measure the broad market or speciﬁc parts of it. If the US$ rises to S$1.104 CURRENCY RISK AND REWARDS Currency movements can accentuate your gains as well as losses. a major currency move when you sell the stock can bring very happy — or unpleasant — results.9. DBS Vickers provides access to Hong Kong and Thailand stocks.000.
funds use the S&P 500 as their benchmark because it is a broader measure of the market. IBM and McDonald’s. Most U. highly liquid stocks. These companies make up 80 per cent of the NYSE’s total value.TABLE 8. The Dow Jones Industrial Average (DJIA) consists of 30 blue-chip stocks such as General Motors. Despite being the most widely quoted stock index in the U. The MSCI Europe consists of over 500 European stocks from 16 developed markets. IMPORTANT INDICES AROUND THE WORLD Country or Region Index 105 Selecting and Managing Your Individual Stock Investments Singapore The Straits Times Index (STI) is the most widely quoted stock index in Singapore with 30 large-cap.5. Source: Authors’ own compilation . U.. U.S. The MSCI Asia ex-Japan index consists of more than 500 stocks in 13 countries. The Standard & Poor’s 500 (S&P 500) consists of 500 large-cap companies quoted on the New York Stock Exchange (NYSE). unit trust fund managers seldom refer to it as their benchmark. Europe Asia Japan World The MSCI World Index consists of more than 1. The Nikkei 225 is based on the 225 common stocks traded on the Tokyo Stock Exchange.S.S.500 stocks in 23 countries globally.S.
but you do not want to make a habit of it. your stock is probably a good sell candidate: The Company is Embroiled in a Scandal This is the most ominous of all warning signs. Sounds familiar? Well. Warning Signs If any of these warning signs appear. The best conditions for an investor to ﬁnd in an overseas economy are that it is growing. In the end. Do not hang around when the ship is sinking. Among factors that make a country’s stock attractive are the stability of the economy. That is because every investor has sold a good investment too soon or failed to get out of a bad one soon enough. FIGURING OUT WHEN TO SELL A STOCK Selling a stock or bond often seems more diﬃcult than buying one. Scandals are long-drawn aﬀairs. there really are not many clear-cut hard and fast rules. Do not wait around expecting to see any silver lining or buying opportunity — sell right away. and when investigations are complete and made known. exchange rate movements and its interest rate environment. focusing on a region’s or a country’s economic environment ﬁrst and then on individual companies.106 MAKE YOUR MONEY WORK FOR YOU PICKING A MARKET Fund managers tend to analyse markets from a top-down perspective. 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. That is why we begin watchfully with “Warning Signs”. It may take many months between the time the scandal is ﬁrst revealed. something is probably very wrong with your stock. You can be patient with a stock that does badly for one . its currency is strengthening and its interest rates are low. it happens to the best of us.
but yet you are hanging on for a miracle. Stock Prices are Soaring and Economic Activity Does Not Seem to be Picking Up Strong economic activity justiﬁes strong stock market performance. Interest Rates are Rising to Historical Highs When interest rates are high. You Made a Mistake You bought a lemon from the start and you know it. High interest rates are one of the worst enemies of any stock investor. sell the stock right away. although. it is probably going to decline as well.year. but you should be impatient if it lags behind two years in a row when the whole industry is doing ﬁne. You are Over-Exposed to One Stock in Your Portfolio We know people who buy nothing but their company stock. companies face the prospect of high borrowing costs and cut back on borrowing and business expansion. 107 Selecting and Managing Your Individual Stock Investments General Market Conditions When economic indicators suggest that the economy is headed towards a recession. Furthermore. If this happens to you. Remember to diversify. Here are some general guidelines for predicting market declines. We say this is suicide. These guidelines are based on economic information that’s available in the newspaper. bond returns increase and become more attractive compared with stocks. the direction of the stock market can never be reliably or consistently predicted. Consumers cut back on spending as it gets too expensive to borrow. 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. . Company stock prices fall as a result. of course. You have a strong sense of regret. then no matter how good your stock is. They say it is plain loyalty and they are conﬁdent their company will prosper.
suppose the economy is coming out of a recession and the stock market has raced ahead in anticipation of increased economic activity. You have started to reject fundamentals. you probably own a good stock.108 MAKE YOUR MONEY WORK FOR YOU If economic activity is not robust. a selection of 5–10 blue-chip. For example. You are making a 30 per cent paper loss. and consumers aren’t going out to spend money. But you have to accept that what you are doing makes little economic sense when the stock is performing really badly. inﬂation from high commodity prices such as oil is pushing up the cost of doing business. Do not hold 20 or more stocks because it becomes exceedingly diﬃcult to follow your investments. “Let us wait until the price rises back to the purchase price. This is not good news for stocks. Your stock is trading at $7 and you bought it for $10. You Hate to Take a Realised Loss This is classic. If you plan to keep stocks for your retirement portfolio. This and other sentimental reasons may be valid reasons to hold and therefore not sell a stock. Still. some of us may stubbornly hang on even when there are obvious reasons for selling. Your good sense shifts to. Just so no stock has . 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.” MANAGING INDIVIDUAL STOCKS IN YOUR PORTFOLIO Individual stocks are ﬂexible. high-quality stocks across several industries should provide a good amount of diversiﬁcation. then it is diﬃcult for any market rally to sustain itself. SOME COMMON MISTAKES FOR NOT SELLING If you are still not convinced that the stock you own should be sold. But you notice consistent poor news — unemployment is high and is expected to increase.
a very heavy impact on the portfolio. 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. 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. You can also trade stocks speculatively. 109 Selecting and Managing Your Individual Stock Investments . each stock should constitute no more than 20 per cent of the total stock portfolio.
or for those who want predictable cash ﬂow. For example. a bond investor can almost be certain that the capital originally invested will be returned. 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 ﬁxed sum of money. There are bonds that MAKE YOUR MONEY WORK FOR YOU . With stocks. but it can happen quite frequently. the loss of money is not only possible. First. • You are retired and you want the certainty of income and your capital protected from ﬂuctuation. and you want the certainty of receiving known and speciﬁc amounts in the future. the principal sum of $100. bonds return a known amount at the end of a stated period. Unless the borrower goes bankrupt.000 yearly. stock returns do better than bonds. These bonds would pay you $4.09 110 Investing in Individual Bonds Just about everyone knows that in the long run. Then why would anyone invest in bonds? Bonds have two main characteristics that stocks simply cannot match. This interest can provide valuable income for retired individuals. you are spoilt for choice because there are as many types of bonds as there are ice-cream ﬂavours.000 worth of bonds that pay eight per cent interest semi-annually and which mature in 10 years’ time. bonds pay interest according to a ﬁxed schedule (typically twice a year). suppose you invested in $100.000 every six months or $8. As an investor. Finally at the end of 10 years. giving you money to live on or to invest elsewhere. such as for your child’s education.000 is returned to you. Secondly.
and subsequently traded in the stock THREE MAIN FEATURES OF A BOND 1. In general. the higher the interest rate to compensate the investor for tying up his money for a longer time. Maturity The maturity indicates when the bond matures. the issuer or borrower makes a ﬁnal payment to the bondholder equal to the bond’s par value. The face value (also called par value) of most bonds is $1. usually in units of $1. Knowing what bonds to invest in and when to do so can make a big diﬀerence to your bottom line. bonds that can be called back by the issuer before maturity and even bonds that convert to stock. an 8 per cent coupon bond with a par value of $1. Face value This is the original value of the bond that will be returned to the investor upon maturity. Corporate Bonds When corporate bonds are issued.pay regular interest.000 pays $80 annually or $40 semi-annually twice a year. 3. At maturity. At the time of issue. they are normally sold at par. For example. the time to maturity is at least one year and can be as long as 30 or more years. . 2. the longer the maturity.000. usually payable in semi-annual instalments.000. bonds that pay no interest. 111 Investing in Individual Bonds BONDS ISSUERS Bonds are issued by corporations and by the government. Coupon The coupon indicates the interest income that the bondholder will receive over the life of the bond.
that is. and more importantly. Here are two examples traded on SGX: TABLE 9.06 or 106 percent of par value.com (29 July 2010) The LTA bond pays 4. The Buy price is the price being oﬀered for the bond.00 1.08%120521 10K JTCn4.2. The highest price submitted was 1. but are available through banks. The Sell price is the price at which a seller wants to sell the bond.600. ﬁnancial advisor companies and Fundsupermart (an online distributor). on the other hand.075 Source: : Extracted from www. or what a buyer is willing to pay. 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.08 percent coupon interest per year.000. .1.).06 1. SGS are not listed on SGX. The Singapore government is the safest of all issuers because it has taxing power. $10. has the highest credit quality assigned by the major rating services (see Table 9. The best (lowest) selling price was 1.112 MAKE YOUR MONEY WORK FOR YOU exchange. that is. $10. matures on 21 May 2012 and has a par value of $10. There are thus no more than a handful of outstanding corporate bonds on SGX.00 or 100 percent of par value.064 Sell 1. Governments are not proﬁt-making enterprises and do not issue stock. Government Bonds Government bonds (called SGS or Singapore Government Securities). the ability to print more money if necessary.826%121024 10K Buy 1.000. Retail interest in corporate bonds is very low in Singapore as investors prefer the stock market.sgx. are issued by MAS. SAMPLE LIST OF BONDS TRADED ON SGX Live Quotes from SGX LTAn4.
Interest rate risk is one of the three major risks bond investors face. If interest rates fall to 3 per cent. new bonds will offer 3 per cent interest. the principal is returned.gov. . This means that an increase in the price of a bond.sgs. More aggressive investors may sometimes trade their bonds before they mature. They expect to receive regular coupon payments during the term. the price of your bond will go down and you will incur a capital loss.2. For example. But you can lose money as well. CREDIT RATING OF SINGAPORE GOVERNMENT BONDS Moody’s S&P Fitch Rating Source: www.000 when interest rates are at 5 per cent. they become increasingly valuable when interest rates fall. suppose you buy a bond for $1. When bonds are issued at a high rate of interest.sg 113 Investing in Individual Bonds Aaa AAA AAA MAKING MONEY WITH BONDS Conservative investors use bonds to provide steady and predictable income.TABLE 9. INVESTING IN BONDS IS NOT RISK-FREE Interest Rate Risk If you sell the bond before maturity when interest rates have gone up. This is because buyers can buy new bonds that oﬀer a higher interest rate and the price of your bond oﬀering a lower interest will have to go down to attract buying interest. And at the end of the term. can produce more proﬁts for the investor than holding the bond to maturity. They buy a bond when it is issued and hold it till maturity. particularly when interest rates fall. The older bond which pays 5 per cent will become more valuable and hence more expensive. or capital appreciation.
the bond could be worth more or less the very next day. At a rate of inﬂation of 2 per cent. Interest Rates in the Economy When a bond is ﬁrst issued. the higher would be the interest rate oﬀered to make up for the risk of tying money up for a longer period. We urge you to devote time and energy to learning the mathematics that drive bond prices and returns. Default Risk This is the risk that the borrower fails to pay you interest and principal. 2. In general. your capital value or the current price of the bond can ﬂuctuate. $100 received in 10 years’ time is worth just $82 today. we have to admit that investing in bonds can be a daunting task for the new investor because of the mathematics. they consider two main factors: 1. While you know how much coupon interest you will get in the future. the coupon rate is typically set to the . When investors want to buy or sell. and many of them seem diﬀerent from those of stocks. Interest rates in the economy. There are all sorts of calculations and terms to master.000 into a bond. the value of those dollars will be eroded by inﬂation.114 MAKE YOUR MONEY WORK FOR YOU Inflation Risk Since the dollar amount you receive on a bond investment is ﬁxed. It will set you apart from most other investors. the longer the term of a bond. bond prices too are driven by supply and demand. Before we go on. Credit rating of the bond issuer. That’s a loss of $18. WHAT IS A BOND WORTH? When you put $1. We will have more on this topic later. Like everything else in life.
Return to buyer Interest (20 x $30) Par value $600 $1. Buyer buys at par Price $1.000 par value on maturity. bond prices go up. making the price of the bond on the day of issue exactly $1.000.000 10 years 6 per cent If Lizzie were to hold the bond to maturity. For example. When interest rates fall.market rate of interest so that the issuer can receive an amount equal to par value. And vice versa. Market interest rates change as time passes by. if the market interest rate is 6 per cent.000. Interest rates and bond prices move in opposite directions like two sides of a see-saw. Ltd. As a result. she would receive 20 payments of $30 each every six months and the return of $1. Lizzie buys a bond at the full price or par value of $1. the issuer sets the coupon rate at 6 per cent.000 Her dollar return is $600 and her yield is 6%. a period of 10 years. issues a new 10-year bond oﬀering six per cent interest semi-annually. bond prices after the day of issue are seldom equal to par value. Seller sells at par Par value Term Coupon Interest 115 Investing in Individual Bonds $1.600 . Let us go through an example: Suppose KayOn Pte.000 $1.000 Holding period 10 years Interest income 20 semi-annual payments of $30 At maturity $1.
Suppose Lizzie sells the bond for $840. Buyer buys at $840 Price $840 Holding period 8 years Interest income 16 semi-annual payments of $30 At maturity $1.000 for a bond paying 6 per cent. The buyer can also expect 16 interest payments of $30 for the remaining eight years of the bond’s life. no buyer will pay you $1.000 Return to buyer Interest (16 x $30) $480 . Seller sells at discount of $840 Market price $840 Interest received $120 (4 payments x $30) $960 Less cost – $1. $1. If new bonds costing $1. To sell her bond. Lizzie would have to oﬀer it at a discounted price that could wipe out the interest she has earned so far.000 $600 $60 / $1.116 MAKE YOUR MONEY WORK FOR YOU Less cost Return Yield to buyer Current yield – $1.000 = 6% Two years later. interest rates have gone up to 8 per cent.000 Loss -$40 The buyer pays $840 and if the bond is held to maturity.000 are paying 8 per cent interest.000 will be repaid. or a capital gain of $160. She would incur a loss of $40.
new bonds selling for $1.Par value Less cost Return Yield to buyer Current yield $1. Seller sells at premium of $1.480 – $1.200. If.000 $1. Lizzie would be able to sell her 6 per cent bond for more than what she paid.000 Proﬁt $320 Buyer buys at $1. in two years’ time. the reverse can also happen.200 .000 $1.200 Interest received $120 (4 payments x $30) $1. the premium (or capital gain) plus interest received of $120 will make her a nice proﬁt of $320.480 – $840 $640 117 Investing in Individual Bonds $60 / $840 = 7.320 Less cost – $1.200 Market price $1.14 per cent Of course.200 Price $1. If she sells the bond for $1. Buyers would be willing to pay more for a bond that pays a higher rate of interest than that prevailing in the economy.000 Return to buyer Interest (16 x $30) Par value Less cost $480 $1.000 oﬀer 4 per cent interest.200 Holding period 8 years Interest income 16 semi-annual payments of $30 At maturity $1.
but it does have a complicated formula. albeit less accurate. formula that helps to explain how YTM uses both capital gains and interest income in its calculation. Current yield remains the same throughout her ownership of the bond. YTM takes into consideration both coupon interest and capital gains/ losses. the investor’s yield changes as well. That is because the market price of the bond has changed. But there is a simpler. For example. YTM is the single most important calculation for a bond. When Lizzie buys the 10-year $1.000 bond paying 6 per cent coupon and holds it to maturity. The investor of the $840 discount bond will earn $160 in capital gains at maturity. Current yield = Coupon interest / Market price = $60 / $1.200 = 5% MORE ON YIELD Yield is what you actually earn. Compared with current yield. .14% There is an even more precise measure of a bond’s value called Yield to Maturity (YTM). she earns $60 a year — an annual current yield of 6 six per cent or the same as the interest rate. When interest rates ﬂuctuate and cause bond prices to move. and this amount is not captured in current yield.118 MAKE YOUR MONEY WORK FOR YOU Return Yield to buyer Current yield $280 $60 / $1. if interest rates had risen to 8 per cent: Current yield = $60 / $840 = 7.000 = 6% An investor who buys the same bond two years later in the secondary market will be looking at a diﬀerent yield.
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. add the annual premium of $20 to the annual coupon of $60 to get $80. The average price is obtained by adding the buying price of $840 and the maturity price of $1. It is best left to a spreadsheet or your ﬁnancial adviser who is handy with a ﬁnancial calculator. Third. The KayOn bond has an annual premium of $20 ($160 / 8 years). These rating services pore through voluminous ﬁnancial statements and study the business prospects of bond issuers to answer the question.7 per cent. divide the annual return of $80 by the average price of the bond. Second.Here it is. ﬁnd out the annual discount or premium over the life of the bond. From doing all this.83 per cent: YTM (approximate) = (160/8) + 60 (840 + 1000) /2 = 8. . which is the annual return from both the capital gain and the income portions. “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. which is slightly oﬀ the actual result of 8. Fortunately. the result is 8. First. rating services such as Moody’s Investors Service (Moody’s) and Standard & Poor’s Corporation (S&P) provide this valuable service.7% You should know the actual YTM value when you invest.000 and dividing the result by 2. 119 Investing in Individual Bonds BOND CREDIT RATINGS As a bond investor. although you need not kill brain cells to calculate it.
120 MAKE YOUR MONEY WORK FOR YOU 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 speciﬁc assets in the event of default. Aa. RATINGS TABLE Moody’s Aaa Aa A Baa S&P AAA AA A BBB Investment-Grade Bonds Highest credit rating. highrisk bonds Extremely speculative Extremely poor investment Bonds in default Source: Authors’ own compilation from Moody’s and S&P . investmentgrade bonds Moody’s Ba B S&P BB B Speculative Bonds Low credit quality. speculativegrade bonds Moody’s Caa Ca C D S&P CCC CC C D Junk Bonds Extremely low credit quality. This gives a secured bond a higher credit rating than an unsecured bond even when issued by the same corporation. maximum safety High credit rating. speculative-grade bonds Very low credit quality. All other grades are considered high-yield or junk. The top four grades (Aaa. investmentgrade bonds Lower-medium quality. TABLE 9. investment-grade bonds Upper-medium quality. A and Baa in the case of Moody’s) are considered investment grades.3.
On the other hand. In the next chapter. the lower a bond’s rating.1. LOW QUALITY SPELLS HIGHER YIELD YIELD AAA AA A BBB BB B CCC CC C D RATING Source: Authors’ own illustration . we will look at strategies for buying and selling. 121 Investing in Individual Bonds FIGURE 9.Ratings Influence Yield As Figure 9. shows. That is why the lowest-rated bonds are often described as high-yield bonds.1. Given the same maturity. the more an issuer must pay. credit ratings inﬂuence the interest rate an issuer must pay to attract investors. and how you can manage your bond investments. the lower the interest it pays. the higher a bond’s rating.
you will have a good idea about whether to pay more or less for such a bond. THE MANY FLAVOURS OF BONDS Bonds have many diﬀerent features. Government Bonds Government bonds (called SGS or Singapore Government Securities) are issued by the Monetary Authority of Singapore (MAS). Knowing about bonds — when to buy them and how to select among a multitude of choices — can reap huge rewards. A $1. There is limited interest from retail investors. If a feature beneﬁts the investor. Corporate Bonds Corporate bonds are issued by corporations. bear in mind whom the feature beneﬁts — the issuer or the investor. government bonds have maturities of between one and 15 years. 4 per cent coupon bond. which make each bond unique. even boring investments.10 Selecting and Managing Your Individual Bond Investments Some investors think that bonds are conservative. As you learn about each feature. its yield should be lower.000. then the bond has lower risk. At the time of issue. Secured Bonds Secured bonds are backed by speciﬁed assets such as mortgages . They are bought and sold mainly by institutions. Think again. and its price should be higher. could rise $149 or fall $180 in response to a 2 per cent change in market interest rates. Here are some of the most common bonds you will ﬁnd. So once you know who beneﬁts from a feature. with 10 years to maturity.
Debentures are issued by high-quality corporations. Callable Bonds Callable bonds give the issuer the right to call back the bond and repay its debt before maturity. if you buy a zero-coupon bond for $900 and you collect $1. Although unsecured bonds sound risky. asset-backed bonds. Floating-Rate Bonds Floating-rate bonds (or ﬂoaters) periodically adjust the coupon interest according to a formula based on current market interest rates. and then sells investors the right to receive the payments that consumers make on those mortgage loans. and they are often more highly rated than secured. Zero-coupon bonds are sold at a discount. When market interest rates are going up. in the hope of paying oﬀ the original loan and reissuing another bond at a lower rate of interest. For this reason. In general. bonds have to be backed by something for investors to be convinced to part with their money. Zero-Coupon Bonds Zero-coupon bonds do not pay coupon interest during the term of the bond. 123 Selecting and Managing Your Individual Bond Investments Unsecured Bonds Unsecured bonds (or debentures) are the most frequently issued type of bond. They are backed by the credit quality of the issuer. the higher the chance the borrower will pay you as promised. Issuers tend to call a bond if interest rates fall. ﬂoaters adjust their coupon interest upwards. In general. the higher the credit quality. . Instead. a mortgage-backed bond bundles mortgages. For example. they generally are not.000 on maturity. you would have earned $100 in interest. callable bonds do not always run their full term. the interest is built up and paid in a lump sum at maturity.and accounts receivables. For example.
If the option to convert is not exercised. 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. High Yield Bonds High yield bonds are lower-grade bonds that pay higher interest rates. Callable bonds are riskier for investors and hence oﬀer a higher rate of return than non-callable bonds. Convertible bonds are less risky for investors and hence oﬀer a lower rate of return than nonconvertible bonds. the convertible remains in existence until the bond’s maturity and you continue to receive interest income. Callable bonds are less attractive for investors because an investor whose bond has been called now faces a lower. High yield bonds are not inferior bonds at all except that they are riskier than investment-grade bonds.124 MAKE YOUR MONEY WORK FOR YOU If you think that is unfair. Hybrids are normally safer than either a bond or a stock. . If interest rates rise and the bond falls in value. they cost more than straight bonds without conversion features. Convertible Bonds Convertible bonds are hybrid investments because they possess some qualities of a bond and some of a stock. This ﬂexibility 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. it is the same idea as you reﬁnancing a mortgage to get a lower interest rate to make lower monthly payments. reinvestment environment. the investor can still beneﬁt if the stock price has risen.
which oﬀer a diversiﬁed portfolio of bonds for as little as $1.000. • A worry-free investment in a bond — Buy bonds and hold them to maturity.CHOOSING THE RIGHT TYPE OF BOND There are so many types of bonds that it can be confusing trying to pick one over another. Purchase individual bonds. Purchase bonds through a unit trust. 2. What is more. Here are some rules of thumb. The prices of short-term bonds are less volatile because they are closer to maturity. • Take advantage of falling interest rates — Choose long-term bonds and zero-coupon bonds. The closer the bonds are to maturity. bond funds come with a fund manager and an investment team — they provide expertise that most individual investors do not have access to. depending on what you want: • Maximum current income — Choose high-yield bonds. 125 Selecting and Managing Your Individual Bond Investments MAKING A BOND INVESTMENT There are two main ways you can have a bond investment: 1. . the less worrisome. • Protection from rising interest rates — Choose high-yield bonds or short-term bonds. Instead of buying individual bonds. This allows investors to diversify risk easily and inexpensively across a broad range of bonds. yields and credit ratings. The typical bond fund has 50 to 100 individual bonds of diﬀerent maturities. many investors ﬁnd it easier to invest in bonds through unit trusts. • Protection from default risk — Choose investment grade bonds.
The impact of a default is greater. you will have to think about what you are going to do with the cash. Source: Authors’ own compilation . Capital Preservation Capital returned is predictable. It is at par at maturity. TABLE 10.1. You are on your own when it comes to managing your bonds. As some bonds mature or are traded away. new bonds take their place. Capital returned is unpredictable — based on the price of underlying bonds (Net Asset Value). Interest Rate Risk Default Risk Default risk is minimised because a fund typically holds 50–100 distinct bonds. Maturity Deﬁnite maturity date. In fact. investment-grade bonds. Less aﬀected by interest rate risk.126 MAKE YOUR MONEY WORK FOR YOU Here are some things to consider when making a decision about whether to invest in individual bonds or in a bond fund. regardless of prevailing interest rates (unless issuer defaults). especially when few distinct bonds are owned. which are aﬀected by prevailing interest rates. Constant exposure to interest rate risk. the risk diminishes as bond reaches maturity. among other things. CHOOSING BETWEEN INDIVIDUAL BONDS AND BOND FUNDS Invest in Individual Bond Invest in Bond Fund Bond funds never mature. Interest income is usually not paid out but reinvested. Income Individual bonds send you interest income on ﬁxed dates. Conservative investors should seek mainly lower-risk. When the bonds are repaid on maturity. Management Unit trusts oﬀer management expertise on an ongoing basis.
Continue this cycle. if interest rates are high. . you will have avoided putting a heavy portion of your money on a single maturity. Buy 10 bonds each with $2. If interest rates are low. As time passes and the ﬁrst bond matures. maturing annually for 10 consecutive years. Buying when interest rates are high gives you two beneﬁts.BOND PICKING STRATEGIES Along with your newfound knowledge of bonds. 127 Selecting and Managing Your Individual Bond Investments Buy Bonds When You Think Interest Rates are High When you buy a bond. Laddering maturities reduces the eﬀect of interest rate risk on bonds. The interest you receive on your bond will be higher. Suppose you have $20. there is probably a good chance that interest rates will fall and the price of your bond will go up.000 to invest in a bond portfolio. They pay more interest because they are riskier than noncallable bonds. invest in another 10-year bond.000 face value. here are some strategies on picking bonds that will help you become a successful bond investor. Laddering Maturities Laddering means staggering the maturities in a bond portfolio. This approach means that you are never concentrated in any one maturity. you should be fussier about what you buy. Here is how it works. you are locking yourself into receiving a ﬁxed amount of interest every year until the bond matures. Second. Look for shortterm bonds that mature in a few years and certainly give long-term bonds a skip. If there is a signiﬁcant change in interest rates. as long as you want to remain in bonds. Beware of Callable Bonds Callable bonds can be called and retired by the issuer before maturity.
This price is always lower than the price of a bond with no callable feature. you will know the rate of return because it can be calculated on the day you buy your bond. it is diﬃcult to achieve a lot of diversiﬁcation. But you have to ask yourself what you will do with the proceeds of your sale. callable bonds ﬁx the price that is paid to you. If you are buying individual bonds worth from about $10.000. but it would not make sense to use the proceeds then to reinvest in another bond that pays only 3 per cent. Such bonds may be low quality and have a high chance of default. For example. You may still hope to buy a bond and sell it for a nice proﬁt when interest rates fall.128 MAKE YOUR MONEY WORK FOR YOU Be careful of callable bonds because bonds are often called when interest rates have fallen. Buy Quality Bonds Be careful about chasing after the highest yielding bonds. While it is alright to allocate a small portion of your money to speculative bonds. Just when you think that lower interest rates point to higher bond prices. Calling a bond allows the issuer to reissue the bonds at a lower interest rate. do not focus only on high yield bonds. you remember that callable bonds have a clause stating the maximum price the issuer will compensate you in the event of a call. This does you no good because you will reinvest your money in a lower interest rate environment.000 to $20. We indicated in the previous two chapters that one of the best reasons to buy a bond . FIGURING OUT WHEN TO SELL A BOND Selling a bond before it matures is a big decision. You should therefore focus on high quality bonds. you can sell the bond and make a proﬁt (if you cash out totally). you bought a bond when interest rates were at 5 per cent. and which have now fallen to 3 per cent. What is more. Buy Bonds That You Expect to Hold till Maturity When you buy a bond and hold it till maturity. Sure.
First. when interest rates fall. 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. Still. this is usually favourable to stocks. there are two situations in which selling makes sense. This is not a bad idea if you are thinking of cashing out. Slipping of credit rating While a drop in rating from AAA to AA is not such a big problem. This defeats the whole purpose of selling. 3. especially when interest rates have risen and bond prices have fallen. It is easy to get the signals wrong. there may be situations where selling makes sense: 1. You need the money We hope you will never ﬁnd yourself in this sort of situation: you have an emergency and your emergency funds are not enough. The worst thing about forced selling is that it may be the wrong time. You may move out of bonds when prices are high and move into stocks as they beneﬁt from falling interest rates. 2. But if it is to buy another bond. a bond falling into the junk or CCC and below category is very risky and has a high chance of default. Falling interest rates Bond prices are rising as a result and you are now tempted to cash in your proﬁts. Nevertheless. But be careful that you have really understood the fundamentals. 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.is when you plan to hold it to maturity. Second. 129 Selecting and Managing Your Individual Bond Investments . then realise that other bonds are also paying lower returns.
preferably of investment grade quality. 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. if you plan to retire in 10 years. . that mature in one to three years. bonds are very ﬂexible investments. then you should go for investment-grade bonds that mature in 10 years. you can consider short-term bonds. If you want protection of capital and high liquidity.130 MAKE YOUR MONEY WORK FOR YOU MANAGING INDIVIDUAL BONDS IN YOUR PORTFOLIO Like stocks. you can consider a bond whose maturity closely matches your time of retirement. If you want to match a bond with your retirement. For example.
. In this section. This is not to say that the traditional products are inadequate. We suggest that you plan your retirement portfolio before putting a single dollar to alternative investments. after setting aside your funds for this most important objective. a capital guaranteed fund is made up of bonds and derivatives. For example. but some of us would like to go a little further. you could add individual stocks and bonds to your portfolio.PART 3 INVESTING IN ALTERNATIVE ASSETS Investing in traditional assets in Part 2 showed you how to build a portfolio of unit trusts for a long-term objective such as retirement. we go beyond traditional investments to include products such as gold and hedge funds. The chapters in this section are shorter than the other sections because they build on what you already know. 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. It also showed you how.
11 Investing in Exchange Traded Funds (ETFs) and Index Funds
An ETF is like a typical unit trust1 but it diﬀers 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 diﬀerent from a portfolio of actively managed unit trust funds in terms of risk, performance and cost? • Can you build a globally diversiﬁed 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.
An ETF trades like a stock on an exchange and so its price ﬂuctuates during trading hours. By owning an ETF, you get the diversiﬁcation
1 What we mean by a typical unit trust here are those unit trusts whose objective is to beat a speciﬁc underlying benchmark.
of an index as well as the ﬂexibility of trading it like a stock. This 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
133 Investing in Exchange Traded Funds (ETFs) and Index Funds
TABLE 11.1. COMPARING ETFS AND UNIT TRUSTS
Objective Passively tracks an index. Will not outperform or underperform the underlying index. Based on what stock brokerages charge, typically measured by bid-oﬀer spread. Typically between 0.75% and 1.5% per annum of amount invested. What you see on the trading screen is your paying or buying price.
Actively attempts to outperform the underlying index. 1.5% to 5% of amount invested. Typically between 1% and 3% per annum of amount invested. Based on forward pricing. Investor will not know price paid or sold at usually till 1–2 days later.
Source: Authors’ own compilation
134 MAKE YOUR MONEY WORK FOR YOU
times 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 diﬀerences between ETFs and unit trusts.
Index 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 ﬁrst launched, there are 2.5 index funds for every ETF. The 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 Eﬃcient 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. That’s when the ﬁrst 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. The stocks of the world’s largest companies are tracked by hundreds of analysts. The amount of information sharing and eﬃciency is very high. There is little that one manager can know that is of material signiﬁcance 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 eﬃciency in the sense that fund managers are able to extract information and
analysis 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.
135 Investing in Exchange Traded Funds (ETFs) and Index Funds
BUILDING A PORTFOLIO OF ETFs AND INDEX FUNDS
There are diﬀerences, of course, between ETFs and index funds. But overall, they are more similar than diﬀerent 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 diversiﬁed 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
US Equity Fund European Equity Fund Asia ex-Japan Equity Fund Japan Equity Fund TOTAL
Source: Authors’ own recommendations
30% 30% 30% 10% 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 U.S. Equity European Equity MSCI World Index Regional Funds MSCI USA Index MSCI Europe Index DBXT MS USA DBXT MS Europe DBXT MS World
136 MAKE YOUR MONEY WORK FOR YOU
Focus Asia ex-Japan Equity Japan Equity
Singapore equity Singapore bonds Hong Kong equity Korea equity China equity India equity Commodities Gold Technology
Index Tracked MSCI AC (All Country) Asia-Paciﬁc Ex-Japan Index Tokyo Stock Price Index (TOPIX) Single-Country Funds Straits Times Index iBoxx ABF Singapore Bond Index Hang Seng Index
MSCI Korea Index Hang Seng China Enterprises Index MSCI India Index Sector Funds RJ/CRB Index Gold Spot Price DJ US Tech Sector Index
Example Fund Lyxor Asia
STI ETF ABF SG Bond Lyxor Hang Seng Lyxor Korea Lyxor China IS MSCI India Lyxor Commodity SPDR Gold Shares IS DJ US Tech
Source: Authors’ own compilation
As indicated by Table 11.3, there’s enough out there for you to create a globally diversiﬁed portfolio as well as have some focused investments in speciﬁc 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 diversiﬁcation. • Portfolio 2 — Put $3,000 each into U.S., Europe and Asia exJapan funds, and $1,000 into a Japan fund. This gives you instant global diversiﬁcation, plus more control over the amount you want in each region.
These investments work in the U. You may be wondering how come you don’t own such funds when the cost of owning them is a lot lower. And if your interest is in the U. market. On the last point. actively managed funds in Singapore and the region do generally beat their regional benchmarks. investors have had with discount brokerages such as Schwab and E*Trade. The bank and ﬁnancial adviser who service and advise you need to earn their keep too. This way you get to have a long-term diversiﬁed portfolio and are still be able to have some fun and take more risk with more focused investments. of course. the question becomes even more important because passive funds in the U. In the end. ETFs and index funds will become more important as the market expands. and the rest into a diversiﬁed portfolio. One reason is that you have may not have been approached too persuasively to buy such funds.S. which is the largest in the world. ETFs do not earn ﬁnancial advisers any money and index funds are less lucrative to sell compared with actively managed funds.S.S. We in this region generally prefer to be helped and advised. you need to appreciate these diﬀerent dynamics between a smaller market such as Singapore. lest you are fuming slightly. Of course the other reason is. There are no straight answers. are the ones that generally do better than active funds.• Portfolio 3 — Put up to $2.S. market. because the degree of self investment there is higher — thanks to the much longer history that U. Our advice is that if you are looking for a fund such as a Japan fund. as we have mentioned. but it is important that you cover these angles when you are buying. and you’ll have increasingly more choices ahead. 137 Investing in Exchange Traded Funds (ETFs) and Index Funds . you must understand that there is a cost to distribution.S. you need to challenge your ﬁnancial adviser by asking whether an active or passive fund is better for you.000 into sector and single-country funds. and the U.
according to the 2010 Merrill Lynch World Wealth Report. “Buy land. as do most Singaporeans. pp 49 The second most attractive reason is that property prices rise over the long term — as long as the underlying economy is growing. First Quarter 2001. Whether you are looking at an investment property in Singapore. MAKE YOUR MONEY WORK FOR YOU FIGURE 12.1 PRIVATE RESIDENTIAL PROPERTY PRICES VERSUS GDP ( (1990 = 100) INDEX 300 0 250 0 200 0 150 0 100 0 50 0 1975 REAL PPI PI REAL GDP 1978 1981 1984 1987 1990 1993 1996 1999 Source: “Residential Property Prices and National Income. the idea of owning another home as an investment might pop into your head. Will Rogers once said. Look at Figure . They ain’t making any more of the stuﬀ. pulling the trigger is something more and more aﬄuent individuals are doing. Australia or Malaysia.” How true especially if you live in Singapore. ” Economic Survey of Singapore. aﬄuent individuals have 18 per cent of their investment portfolios in property. Why is there such an age-old fascination with property? The most obvious reason is that few things in life provide a greater sense of security than having a roof over your head. In fact.12 138 Investing in Real Estate Once you own one home.
com/print/Business/My%2BMoney/Property/Story/ A1Story20100426-212422. and then you can enjoy the rent as proﬁt.12. That’s when the bank will demand that you top up the diﬀerence. As the landlord. This all seems to make a rental property an ideal investment.html 1 . Fortunately.1. Ideally. you are responsible for paying the mortgage. the rent paid to you will cover your monthly expenses of that property. It can get even worse if the property’s valuation falls below your loan amount and you fall into a negative equity position. taxes and cost of maintaining the property. property funds and land banking. it’s you who will get the phone call. You might receive poor rent and have problems servicing your mortgage. Unlike a stock or a bond.gov.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). a rental property requires you to devote time to maintaining your investment. Property costs hundreds of thousands of dollars and may be out of the reach of some investors. Also here: www. buying directly into a physical property isn’t the only way to invest. 139 Investing in Real Estate INVESTING IN A RENTAL PROPERTY You buy a property and rent it out to a tenant. http://app-stg. When the bath tub leaks or the electricity gets cut in the middle of the night. You could also have trouble ﬁnding a tenant or end up with a bad tenant who damages your property. We start by looking at rental properties.asiaone. You can participate in other ways including real estate investment trusts (REITs). You can then sit tight till the mortgage is paid oﬀ and you own the property exclusively.sg/data/article/21/doc/NWS_Property. Alternatively. but landlords will tell you that there are always challenges.pdf. you may sell the property when its price has appreciated signiﬁcantly.mti.
Location. Kebon Kacang. the central business district. Australia Tokyo. We will discuss just two principles that we have found most critical in our own experience. Minato. A home in a remote. Silom Happy Valley. Since most homeowners will buy and sell several times in their lives. Bangsar Bukit Timah. Deep Water Bay. Thailand Hong Kong. TABLE 12. and it’s true: Location really matters. Malaysia Singapore Sydney. Remember that homes are replaceable. the airport and railway stations. Mid-Levels Cilandak. Shibuya A location is considered good when it is close to good schools. Location. Lumpini. Rose Bay. far away location . Shenton Way Chatswood. the beach. Location You’ve probably heard it before. you are likely to have a chance to use these bulletproof principles the next time you buy. Pondok Indah Kenny Hills. A mansion in a poor location is a usually a worse oﬀ investment than a modest apartment in a good location. Japan Source: Authors’ own compilation Good Property Locations Sukhumvit. popular shopping malls. Indonesia Kuala Lumpur. China Jakarta. Ampang. Bondi Roppongi.140 MAKE YOUR MONEY WORK FOR YOU Some Strategies on a Recession-Proof Property Investment Knowing that property prices go hand in hand with economic growth. Orchard Road. your place will sell faster and for a better price than a similar house elsewhere.1 GOOD PROPERTY LOCATIONS City Bangkok. how do you ensure that the price of your investment property does not go south when the economic climate is rough? There are certain strategies you can employ to recessionproof your investment. but land is not. If you’ve got a spot everyone wants.
141 Investing in Real Estate 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. Home prices later recovered and it pained her to think. For instance. 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. you probably have taken on a larger loan than you can manage. This means your holding power is weak. and a sudden drop in home prices could force you to liquidate your investment suddenly at a loss. a group of real estate professionals buys and manages real estate on your behalf.000. It was her sixth property. her matrimonial home. However. The properties . When you invest in a Real Estate Investment Trust (REIT — pronounced “reet”). REITs allow people to invest in real estate without buying property directly. She was left with one property. “if only I could have hung on. you can invest in a piece of commercial real estate to call your own. our friend Dawn bought a semi-detached home in 1997 for $3.has far less potential for attractive price appreciation even when the rest of the economy is doing well.2 million. and servicing your loan takes up most of your monthly income. and a debt of close to $5 million. The semi-detached home was sold for less than $2 million. she found herself in a negative equity position for most of her properties. For as little as $1. The bank was happy to loan her more and more. do not fret. when property prices crashed.” Thus consider your holding power before you invest in property. Every property she had bought till then had produced huge proﬁts. but you do not have $500 million in spare cash. If you have little savings in the bank. and she had to sell ﬁve of her properties at ﬁre-sale prices.
REITs mostly specialise and do not mix and match the types of real estate they own. REITS AND WHERE THEY ARE INVESTED Name of REIT Invests Mainly In AscendasIndT AscendasREIT AscottREIT Cambridge CapitaComm CapitaMall CapitaRChina CDL HTrust First REIT Fortune REIT FrasersCT K-REIT LippoMapletreeIndonesia MapletreeLog Parkway Life Saizen REIT SuntecREIT Source: Authors’ own computations Commercial buildings in India Industrial parks Service apartments in Asia Industrial buildings Commercial buildings Shopping malls Shopping malls in China Hotels Healthcare real estate in Asia Shopping malls in Hong Kong Shopping malls Commercial buildings Shopping malls in Indonesia Commercial buildings Healthcare real estate in Asia-Paciﬁc Residential real estate in Japan Shopping malls . The ﬁrst Singapore REIT is Capital Mall Trust. TABLE 12. and the income is passed on to investors. Over 20 REITs trade on SGX today. For example.142 MAKE YOUR MONEY WORK FOR YOU are then leased and rented out.2. Table 12. industrial buildings or residential apartments). or in speciﬁc property types (such as shopping malls.2 shows a sample of those REITs. which debuted in July 2002. some REITs may focus their investments geographically (such as by country or city).
Management risk Unit trusts invest in companies in which each company has a diﬀerent management team. especially in times when there are many dollars chasing after REITs: 1. 2. The situation becomes worse if the economy is coming out of a low interest rate environment. the income from REITs will become less attractive relative to other investments. With REITs. For example. In fact. But REITs have risks too. Interest rate risk When interest rates rise. government bond yields will rise when interest rates rise. Higher interest rates mean that the cost of borrowing goes up and REITs will suﬀer from larger interest payments on mortgages and bonds. it is just one management team that makes decisions not only on buying and selling. Try selling a house in a hurry and you will ﬁnd that it’s not easy to liquidate. 143 Investing in Real Estate . 2.Why Invest in REITs? Many investors turn to REITs as an alternative to savings and ﬁxed deposit accounts. High dividend yield REITs typically oﬀer two per cent above 10-year government bond yields. Capital values are likely to be vulnerable as well. So if 10-year government bond yields are three per cent. you should take extra precaution. Liquidity REITs are traded on stock exchanges and are liquid compared with buying real estate directly. but also on managing and operating the REIT properties. And why not? REITs oﬀer two attractive beneﬁts: 1. and the upside for interest rates is strong. REITs can be expected to yield ﬁve per cent.
hospitality and healthcare. the capital value of REIT properties decreases over time. In Asia. Managing REITs in Your Portfolio REITs behave like ﬁxed income securities and one can rely on REITs for income. the fund has all the risks associated with sector funds because of its exposure to real estate. S-REITs in Strong Position in Asia The U. However. 4. the capital value of REITs can rise and fall along with cycles in the property market. S-REITs are also well stocked with oﬀshore assets as they have interests in more than 10 countries. thus providing geographical diversiﬁcation. the capital value of your investment can go down.S. If you plan to keep a REIT for retirement. REIT market is the largest in the world with over 50 per cent of total global market value. Remember that an investment in REITs is ﬁrst and . Even if dividend yields remain strong. if a landlord leases industrial land for 30 years at a time. For example.144 MAKE YOUR MONEY WORK FOR YOU 3. the Singapore REIT (S-REIT) market is the second largest after Japan. industrial. The future looks bright as investors are attracted by the number of choices available today. the property is returned to the landlord when the lease runs out. Depreciation Because of depreciation. This is especially true for REITs that invest in industrial property that sits on leasehold and not freehold land. S-REITs are well diversiﬁed with interests in retail. commercial. Industry risk While a REIT may be less risky than an investment in an individual property. Their values will fall in an economic downturn while savings and ﬁxed deposits are virtually immune to economic downturns. do a serious evaluation of the property sector as a whole every three to ﬁve years.
such funds are typically invested broadly across Asia. These funds may invest in one or a combination of the following: 1. (page 142). Europe or globally.2. . Funds that invest in REITs.foremost an investment in real estate. Funds that invest in investment companies (holding companies that buy properties and receive rental income). such funds can make a good addition to your portfolio. property funds are more diversiﬁed in their investments in terms of geography. TABLE 12. As seen in Table 12. And we all know how volatile that is. 2. 145 Investing in Real Estate INVESTING IN PROPERTY FUNDS Compared with REITs. EXAMPLES OF PROPERTY UNIT TRUSTS SOLD IN SINGAPORE Name of Unit Trust Amundi Asian Real Estate Dividend Fund DBS Global Property Securities Fund First State Global Property Investment Henderson Asia-Paciﬁc Property Equities Fund Henderson European Property Securities Henderson Global Property Equity Fund IOF-Asian Property Securities United Global Real Estate Securities Fund Source: Authors’ own compilation Launch Date April 2005 March 2005 February 2005 March 2006 June 1999 March 2005 March 2008 March 2005 If you would like to gain exposure to global and regional property markets without having to buy physical property. Funds that invest in property developers (companies engaged in building and land development activity).3. 3.
Important Considerations • Zoning process • Time horizon • Growth requirements Land Exit Land sold to developers with concept plan already approved by the authorities.2. Important Considerations • Safety of investment • Holding period • Expected Returns Land Value Enhancement Creating value by having the concept plan approved by the authorities. Important Trends to Consider • Population Growth • Economic Growth • Government Policy Land Syndication Dividing the land in smaller units and selling it to investors collectively as co-owners. FIGURE 12.146 MAKE YOUR MONEY WORK FOR YOU INVESTING IN LAND BANKING Land banking is the practice of purchasing raw land with the intent to hold on to it until it is proﬁtable to sell it. THE LAND BANKING PROCESS Land Acquisition Conduct due diligence on the area before acquisition. The 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. Important Considerations • Exit strategy • Transparency • Taxes Source: Authors’ own illustration .
Some of the best known land bankers are people like Donald Trump and the Rockefellers in the US. a national ﬁnancial literacy program launched by the MAS.2 shows an overview of the land banking process.2 The article explains what land banking is. Figure 12. Based on the advertising that you have probably seen. issued a consumer article on land banking in June 2010.sg/publications/quick_tips/Consumer_Portal_Land_ Banking. highlights the key risks and important questions you should consider before deciding whether to invest in land banking. One important diﬀerence 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. The key risks highlighted are: 2 See: www. big plots of land are chopped up into investible pieces for sale to investors like yourselves. Does this mean we should avoid land banking altogether or was the company’s failure a onceoﬀ event? Land banking is not regulated by the Monetary Authority of Singapore (MAS).html . Of course.gov. The goal is to identify such “virgin” parcels well in advance of developers and wait for the value to be realised. this is not always the case. Li-Ka Shing in Hong Kong and the late Ng Teng Fong in Singapore. 147 Investing in Real Estate Look Before You Leap Investors like the concept of land banking as it is a tangible asset as opposed to stocks and bonds. Through land syndication. you might expect that this investment would produce attractive returns with little risk. land banking has been in the Singapore news recently because of the failure of a land banking company to honour its ﬁnancial obligations on a certain project. MoneySENSE. In fact.moneysense.The most desirable parcels of land for land banking are those that lie directly in the growth path of developing cities.
148 MAKE YOUR MONEY WORK FOR YOU • 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. you too can become a successful land banking investor. Land Banking — Not All Bad News Land banking has been available in Singapore for over 15 years and enjoys a good following amongst many investors. 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 . we’d like to leave you with more advice on its risks from our experience with the product. Still. We believe that if you heed more advice than less. if you were to perform an Internet search on “land banking.” you would likely see a fair amount of negative views on the investment. 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. There are many land banking investors who have earned good double-digit returns over the years.
property unit trusts. REITs. Fortunately. • Some land banking ﬁrms may stress that all their projects resulted in proﬁts for their investors. Once you decide that property would be a good addition to your portfolio. you have many choices. • 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. you might like to check on the duration it took for the investors to exit. Investors should check with the land banking ﬁrm on their plans should the proposal fail to get the expected approvals. This is not to be taken lightly as any legal dispute is likely to adhere to the laws and regulations of that country. • Proﬁts are realised when the investors collectively exit from the project upon approval of the development proposal which was oﬀered. make sure that it is no more than 5–10 per cent of your total investment portfolio. a land banking project or other choices you may come across. although it can be fraught with dangers from bubbles to recessions to scams. . • If you do invest in land banking. there is one fact that always works in our favour: as long as the underlying economy is growing (and it usually is). In such cases. 149 Investing in Real Estate CONCLUSION Investing in property is exciting and rewarding. 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. chances are that your property investment will bring you bountiful rewards.record of past performances and its projected returns on land bank investment look promising. You can invest in a rental property.
SRI helps you meet your ﬁnancial goals while ensuring that your investments have a positive impact on people and the planet. because you are looking not only for a proﬁtable investment. epidemics and killer heat waves beyond anything we have ever experienced. For instance. droughts. If the vast majority of the world’s scientists are right. wars are going on across continents. ~An introduction to the Oscar-winning documentary An Inconvenient Truth by Al Gore (www.climatecrisis. Various terms have been used to describe SRI.net) I don’t think any of you would want to retire a multimillionaire on a planet where the air stinks with pollution. or rely on cigarettes and alcohol to make a proﬁt. 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. There is a wide range of attitudes and values out there as SRI investors screen companies and funds to check if they conﬂict.13 Socially Responsible Investing Humanity is sitting on a ticking time bomb. and the poor are not getting by with their most basic food and medical needs. use innocent mice for research. Is there another way? Integrating your personal. or are aligned with their beliefs. social and environmental concerns with your ﬁnancial considerations is called socially responsible investing (SRI). such as Muslims who will not invest in the pork industry and interest-bearing securities. but also for one that meets certain moral criteria and lets you sleep well at night. Some call it Ethical . There are also investors who screen according to their religious beliefs. some will not invest in those that pollute and damage the environment. This is also known as having a “double bottom line”. SRI describes an investment strategy that strives to maximise both ﬁnancial returns and social good. ﬂoods.
Social and Governance (ESG) investing. Another early adopter of SRI was John Wesley (1703–1791). Many believe social investing began with the Quakers (a Christian religious denomination founded in the seventeenth century) in the U. one of the founders of the Methodist Church. According to The Social Investment Forum. A sermon of his.S. the manufacturer of the napalm. that in 1758 took an oﬃcial stand against slavery. This prompted widespread protests across the U. 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. In the late 1970s. Towards the end of the 1970s.Investing and Green Investing while others refer to the concept as Environmental.S. 151 Socially Responsible Investing HOW SRI CAME ABOUT SRI has been around for some time. SRI activism turned its attention to nuclear power and automobile emissions control. is the hotbed of SRI activity today. investors continued the practice by applying similar principles to other companies. against Dow Chemical and other companies proﬁting from the Vietnam War. an international outcry was raised for South Africa to end apartheid. 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. a major national membership association .S. Religious institutions have been at the forefront of social investing ever since. and some investors took their money out of multinational companies that did business there. but nevertheless there are certain shared strategies that form the foundation of SRI. and its beginnings can be attributed to many people and places. entitled The Use of Money. These varying labels make it diﬃcult to frame the market. The U. Although economic sanctions against South Africa ended in 1993. The modern SRI movement probably began during the Vietnam War.
4. Not all SRI investors agree on or have the same priorities. 2.S. For example. are now involved in SRI. Support companies that have a good environmental record. 3. 2. Support companies that demand human rights practices. Support companies that support labour issues. SRI assets increased more than 18 per cent while the broader universe of professionally managed assets increased less than 3 per cent. Reject companies that support the defence industry. WHAT IS YOUR SRI PRIORITY? Before you put any money into SRI. the top ﬁve priorities of SRI investors are that they: 1. SRI is growing at a faster pace than the broader universe of all investment assets under professional management. . Between 2005 and 2007 alone. SRI investors: 1. Support companies with a stance on abortion or birth control. decide what your sociallyoriented priorities are. Support companies with a stance on animal rights. and some issues are more popular than others. Reject companies that support the alcohol industry. 3. 5. On the lower-priority scale. Reject companies that support the gambling industry. Roughly 11 per cent of assets under professional management in the U. Reject companies that support the tobacco industry. 4.152 MAKE YOUR MONEY WORK FOR YOU of social investment practitioners and institutions.
One condition could be that the company is the best in its industry for taking the most steps to cut down on pollution. The only thing you need to do with this style of investing is compile a list of companies you want to avoid. how far along the supply chain would you hold companies accountable? If the company you invest in sells instant noodles to a casino. . As with establishing your social issues. or does the company have to be actively participating in the oﬀending activity for you to screen it out? Or you could take another more moderate approach and include companies under certain conditions. you could end up excluding large segments of the economy. you create a list of companies that you won’t invest in and exclude them from your portfolio. where you end up excluding an ever-growing number of companies from your portfolio. If you expand SRI investing too far. Exclusionary SRI can also become a slippery slope. the standards to which you hold companies are also completely up to you. but they sell alcohol in their cafés and many allow smoking in their rooms. For example. Exclusionary Strategy In an exclusionary strategy. For example. This can be very time consuming and expensive as you have to analyse whole groups of choices to ﬁnd the social duds to avoid. most of which relate to how strict you are about a company’s “purity”. hotel chains are innocent enough. even though it still pollutes.There are several approaches you can take to apply your second bottom line. would you still invest in it. 153 Socially Responsible Investing FINDING SRI OPPORTUNITIES How do you go about ﬁnding appropriate SRI investments after you’ve narrowed down your social priorities? There really are just two main strategies to consider — exclusionary or inclusionary.
the screening process is an honest attempt to ﬁnd the truth and pick the best of the lot. Therefore. through activist investing.154 MAKE YOUR MONEY WORK FOR YOU When it comes down to the bottom line. How do you know if trusting your hard-earned dollars to a treehugger or rainforest conservationist. is a more proactive style. you can use your shareholder rights to vote proxies in line with your goals and attend shareholder meetings to propose appropriate changes. 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 reﬂects your own values. or purposely investing in companies that violate them so you can become a shareholder and vote to change company policy. By investing in companies engaging in undesirable practices. SACRIFICING PERFORMANCE FOR SOCIAL GOOD? As an investor. A good example is green tech companies that are working to provide alternative energy sources. no matter how earnest and well intentioned. Inclusionary Strategy Inclusionary investing. By investing in companies that meet your desired ethical values. also called activist investing. It involves either selectively investing in companies that share your core beliefs. few investors may be willing to throw out traditional investment logic by sacriﬁcing investment opportunities in exchange for the satisfaction of doing the right thing and sleeping well at night. you establish yourself as a shareholder to which the company management must answer. will actually do something positive for your net . It is impossible to have a completely “clean” company in the sense that ﬁnding a company of any size that is 100 per cent in compliance with every social and moral guideline all the time is unrealistic. or ﬁrms that treat their workers well. you are supporting their eﬀorts by increasing their stock price. Nevertheless.
The next question is. Here are some statistics to make you feel more at ease. the Vice Fund was launched in the U. let alone add to your net worth. . Critics take the stance that any approach that reduces the universe of potential investments. SRI advocates argue that screening helps eliminate companies that have risks not generally recognised by traditional ﬁnancial analysis. The DSI is modelled on the S&P 500 and has outperformed that unscreened index on an annualised basis since its inception. No doubt the debate will continue. May/June 2000 issue of the Financial Analysts Journal. The bottom line appears to be that SRI funds do not behave all that diﬀerently from regular funds and that investing in a SRI fund does not negatively aﬀect your returns compared with choosing a conventional index fund. Created in 1990. but not by a statistically signiﬁcant margin. to 1 “Socially Responsible Mutual Funds”. the DSI was the ﬁrst benchmark for equity portfolios subject to multiple social screens. should you focus on SRI and avoid “irresponsible” investments altogether? In 2002. 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. will result in a sacriﬁce in performance.worth? The reality is that there are no guarantees that your money will even come back to you.S. but there are several reasons to be conﬁdent that investing in a socially responsible manner does not equate to giving money away. 155 Socially Responsible Investing INVESTING IN VICE If investing in virtue oﬀers the possibility of superior returns. The record of the Domini 400 Social Index (DSI) is an indication that socially responsible investors do not have to assume a sacriﬁce in performance for sticking to their values.
S. weapons and liquor. and it’s not just ﬂuﬀ and apple pie. gaming. renewable and alternative energies. discounted cash ﬂow and charts? Perhaps.com/id/2123644/ . 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. The fund invests in 2 www. Although there aren’t many SRI funds in Singapore and those available don’t quite span the breadth of SRI. As investors ourselves. you have two main options: (a) invest in unit trusts or (b) pick individual companies yourself. there are more than a handful of attractive choices.slate. a columnist for Newsweek who has been following the vice versus virtue divide. Between 35 and 40 per cent of its portfolio is invested in the U.2 Is it that investing in vice or virtue is a better investing discipline than looking at P/E ratios. The DBS Mendaki Global Fund launched in September 1997 is one of the oldest SRI funds in Singapore. 2. both are eﬀective investing strategies and have handily beaten the S&P 500. and climate protection.156 MAKE YOUR MONEY WORK FOR YOU invest in companies that have signiﬁcant involvement in industries such as tobacco. The DWS Global Climate Change Fund by Deutsche Bank invests mainly in companies that are active in energy-eﬃcient technologies. we can safely say that SRI is a viable investment strategy. INVESTING IN SRI Once you have established your second bottom line or social priority. The folks managing such funds have clearly been good stock pickers. According to Daniel Gross. alone. Investing in unit trusts is a good way to begin as it is not easy to screen companies on your own. Here are three funds you may consider: 1.
157 Socially Responsible Investing POPULAR SRI THEMES Let’s now turn our attention to some of the most popular themes around today that you have probably been hearing about. do look at the individual company investments that SRI unit trusts make. BHP Billiton. The DBS Mendaki Global Fund. Hyﬂux and Keppel Corp among its top holdings (June 2010). water and Islamic ﬁnance. If these companies are already top performers in your books. 3. products and services bring solutions to environmental problems. biofuels. Many of America’s largest companies that had previously been labelled polluters have adopted eco-friendly ways. has Apple Computer. solar energy.listed equities anywhere in the world that harmonise with Islamic philosophy and law. green investing. then you would be satisfying both your social and ﬁnancial bottom lines. and may have billions of dollars at their disposal for socially conscious investments and programmes. Fortis L Green Future invests primarily in the shares of companies whose technologies. Companies have a lot of power in the community and in the economy. but instead promote positive social and environmental change. They control a lot of assets. Hewlett Packard . Even smaller companies with a dozen staﬀ can make signiﬁcant contributions to the community in addition to expanding their corporate bottom lines. such as corporate social responsibility. Corporate Social Responsibility CSR generally applies to company eﬀorts that go beyond what may be required by regulators and involve incurring short-term costs that do not provide immediate ﬁnancial beneﬁt to the company. If you are a more active investor. for example.
The biggest diﬀerence is that green investing focuses on what’s good for the environment. transportation. Islamic ﬁnance is a subset of SRI. or clean technology investing seeks to invest in environmentally friendly technologies and includes six types of industries: energy.” In October 2007. pornography and alcohol businesses. The 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.158 MAKE YOUR MONEY WORK FOR YOU reports on its website that after 20 years. Singapore has its own CSR society called The Singapore Compact. advanced materials. Islamic law also prohibits any participation in weapons. It is a non-proﬁt organisation whose membership includes some of Singapore’s largest companies as well as SMEs (small-medium enterprises). gambling. These principles help to ensure that funds are being channelled into real business activities as opposed to speculative activities. energy eﬃciency and manufacturing. . Green Investing There isn't a huge diﬀerence between SRI and green investing. it congratulated 26 winners of the “Inaugural CSR Recognition Award for Good Corporate Citizens”. Green investing is actually a form of SRI and both terms refer to investment philosophies that are backed by ethical guidelines. water and waste water. pork. Islamic Finance Like green investing. The heart of Islamic ﬁnance lies in two deﬁning principles: The prohibition of riba (interest) and the sharing of proﬁt and loss. Islamic ﬁnance is based on Islamic principles and jurisprudence (or Shariah). Cleantech. it has reached its longterm goal of recycling one billion pounds of computer hardware and supplies in 2007. and agriculture.
And to the south. who are themselves actively growing their expertise and market in Islamic ﬁnance. . Furthermore. which was set up in 2002 to formulate international regulatory and prudential standards for Islamic ﬁnance. 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. Malaysia is one the world’s leaders in Islamic ﬁnance and of Islamic ﬁnance education. business loans and project funding. Get informed — Learn about socially responsible investing. 159 Socially Responsible Investing KEEP A LEVEL HEAD BEFORE YOU INVEST It 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. all the way to PhD qualiﬁcations. Singaporeans have good access to Islamic ﬁnance products and information. these products are increasingly providing both Shariah compliance and good returns. These products cater for housing and consumer ﬁnance. many Islamic ﬁnancial institutions have developed a vast range of products designed to serve the growing market. Yet it is wise to maintain a level head: 1.It used to be that overcoming these prohibitions was very diﬃcult in the conventional ﬁnance system. Singapore is a full member of the Islamic Financial Services Board (IFSB). we have even more positive hope that Islamic ﬁnance will reach mainstream channels. Yet as the Islamic ﬁnance industry progresses. Indonesia has the largest Muslim population in the world. There are over a dozen conferences on Islamic ﬁnance in Singapore every year today. which funds qualify and where you can buy them. Looking at our neighbours.
Go beyond your values — Research the fundamentals and see if you really feel comfortable. Diversify — Think of SRI as a focused investment that. Socially responsible investing suggests that you don’t have to compromise your values to make money. you may be able to put your money into something that both supports your values and lines your pocketbook. together with your other alternative investments. Know your values — Everybody’s values are diﬀerent.160 MAKE YOUR MONEY WORK FOR YOU 2. 3. . Ask tough questions — are some of the green investments out there destroying the environment that they are supposed to protect? 4. Rank your priorities. should occupy no more than 20 per cent of your retirement portfolio. Some may feel strongly about environmental causes while others are more concerned with social programmes. If you approach socially responsible investments like any other investment.
You can see and feel the commodities boom all around — record prices reached on oil. who says that commodity bull cycles have historically lasted between 15 and 23 years. Look at how the prices on this commodities index chart are going through the roof. copper.1. platinum. THE COMMODITIES BULL RUN AS SEEN THROUGH THE THOMSON REUTERS/JEFFERIES CRB INDEX 500 450 400 350 300 250 200 150 100 50 0 1994 1996 1999 2000 2002 2004 2006 2009 2010 Not so according to commodities guru Jim Rogers. a former partner of George Soros. “Is the bull run over?” FIGURE 14.” . rice. the obvious question is.14 Investing in Commodities We are in the midst of the biggest commodities boom in three decades. With such a sharp and swift rise in prices. and predicted that “the current bull market will probably last until 2020.
Tight Supplies There are tight supplies across many commodity markets. There have been no major oil discoveries in the last 40 1 http://www. just as Bill Gates had a vision to put a computer on every desk and in every home.3 billion people to feed. In 2010. a Chinese company. Take oil for example. is the largest microwave oven maker in the world. China’s boom is also a reﬂection of the Asian boom in general. Let us cite three major ones.U. prices have moderated and the U. A lot of the fortunes in Asia have been made in real estate and infrastructure development.csmonitor.S.html .1 It’s not a revolution.162 MAKE YOUR MONEY WORK FOR YOU WHY ARE COMMODITIES BOOMING? Many reasons. That’s only 30 per cent of the population.S. moving up to take second place behind the U. Not only are there 1. Management consulting ﬁrm McKinsey & Company expects 700 million Chinese to have joined the consumer class by 2020. Forbes reported that the number of billionaires in Asia jumped more than 30 per cent in 2007.com/2007/0102/p01s02-woap. 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. Think of the growth ahead. The China Effect The China eﬀect is real. it’s a tidal wave. Global Property Guide reports that real estate price increases in Asia-Paciﬁc should continue to impress in the coming years. Galanz. They are today the biggest users of mobile phones with 400 million subscribers. 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. Forbes reported that a total of 64 people from the China made the list of the world’s richest billionaires. is mired in a housing crisis. while E.
and politically volatile Iran and Iraq are at numbers three and four. combined with tight supplies across many commodity markets. undiﬀerentiated good such as sugar or oil. On the other hand. Well. ﬁve are in the Middle East. In the end. A pound of sugar from anywhere in the world is pretty much the same product. the cuts have also further encouraged currency investors to sell oﬀ dollars in the search for higher yield.S. and a weaker dollar prompts them to seek higher prices. dollar. commodity prices have to go up just to keep relative values the same. They are generally . the U.years according to Jim Rogers. That’s because many non-U. What we need to do is ﬁnd out if commodities make a good addition to a long-term portfolio. enough of these present day trends for now. thus bolstering demand for commodities. In 2006. On the one hand. we have to treat commodities as commodities whether the market is going up or down. So let’s get back to some of the basics behind commodities. Whether a pound of sugar comes from a producer in the Philippines or another producer in Brazil makes no diﬀerence in terms of quality. Of the six top countries in the world with the largest oil reserves. commodity producers still price their exports in dollars. consumed more than twice as much oil as did China. while the reserves in Alaska. regardless of the producer. the cuts make a recession less likely as companies would continue to borrow to fund growth. 163 Investing in Commodities The Falling US$ The falling U. where supply jolts can happen anytime and threaten production. If the dollar is falling. and we know that the gap can only decrease as China becomes wealthier and more industrialised.S. WHAT IS A COMMODITY? A commodity is a basic. The interest rate cuts by the Federal Reserve have also helped push commodity prices higher.S. Mexico and the North Sea continue to decline. has fuelled the big run up in commodity prices.
The most common are petroleum and its byproducts: crude oil. Base metals refer to industrial non-ferrous metals. Commodities are also often used as inputs in the production of other goods or services. excluding precious metals.164 MAKE YOUR MONEY WORK FOR YOU real assets with intrinsic value because they are consumed on a regular basis. For example. which Singapore buys a lot of. aluminium. sand. The reason is that the Mona Lisa is unique and diﬀerentiated from all other paintings. The iPod whose quality and features can be clearly diﬀerentiated from other MP3 products is also not a commodity. heating oil. Note: Ferrous metals contain iron while non-ferrous . Metals • Base Metals • Precious Metals C. lead. Agriculture • Grains • Softs • Livestock Energy encompasses a basketful of products used to provide energy to heat and power homes and businesses. Is a Mona Lisa painting a commodity? Not the original painting by Leonardo da Vinci for sure. brick manufacturing. tin and zinc. is a major component of concrete. propane. natural gas and coal. Today’s Commodity Markets There are around 100 main commodities that are frequently traded and they are generally classiﬁed into three main groups: A. These include copper. nickel. landscaping and land reclamation. glass production. Energy B.
Precious metals are rare and have high economic value. Historically. are softer and have higher melting points than other metals. It also refers to the physical centre where trading takes place. silver. They include gold. Softs is a label for a set of commodities. Grains or cereal crops are mostly grasses cultivated for their edible grains or fruit seeds. have high lustre. the deﬁnition of commodities has expanded to include ﬁnancial products such as foreign currencies and indices. A commodity exchange is an entity. Maize. 165 Investing in Commodities Non-Traditional Commodities More recently. Ferrous metals are usually magnetic and rust. that determines and enforces rules and procedures for trading. sugar. but are now regarded mainly as investment and industrial commodities. THE TRADING OF COMMODITIES The trading of commodities is done mainly at commodity exchanges. they are less reactive than most elements. Livestock refers to animals used for meat production. and includes live cattle. wheat and rice account for 85 per cent of all grain production worldwide. Technological advances have also led to new types of commodities such as carbon credits. New York Mercantile Exchange (NYMEX) —Founded in 1872. Chemically. and coﬀee. pork bellies and lean hogs. platinum and palladium.metals do not. weather and bandwidth. but also including cotton and orange juice. Three of the world’s top exchanges are: 1. These include durum (used to make pasta) and wild rice. precious metals were important as currency. NYMEX is the world’s largest physical commodity futures . usually including cocoa. usually an incorporated nonproﬁt set-up. Other grains that are important in some places have little global production and do not show up on exchanges.
which means that the index does not include rice. Four of the most quoted commodity indices are: 1. nickel. a staple of a large percentage of the world’s population.S. 3. copper. livestock and agriculture. None are based in Asia. including aluminium.S. ﬁnancial derivatives based on U. mortgage-backed certiﬁcates. which trade on the London Metal Exchange (LME). with the exception of three. CBOT trades more than 50 diﬀerent futures and options in agricultural commodities. just as what the S&P 500 or MSCI Singapore indices do for their respective markets. Nineteen commodities are included in the index representing the following commodity sectors: energy. The Dow Jones-UBS Commodity Indexes (DJ UBSCI) is composed of futures contracts on physical commodities. CBOT is the world’s oldest commodity exchange for trading in futures and options. tin. COMMODITY INDICES Commodity indices provide investors with a reliable and publicly available benchmark for investment performance in the commodity markets. 2. zinc and lead. LME is the world’s largest market in cash and futures for non-ferrous metals. The London Metal Exchange (LME) — Founded in 1877. industrial metals. exchanges. The prices quoted for transactions on the exchange are the basis for prices that people pay for physical commodities throughout the world.166 MAKE YOUR MONEY WORK FOR YOU exchange for energy and precious metals. South American Ethanol futures. Chicago Board of Trade (CBOT) — Established in 1848. The represented commodities are traded on U. precious metals. Government bonds and notes. Several unit trusts and ETFs are benchmarked against these indices. . and more recently.
The Reuters/Jeﬀeries CRB Index (TRJ/CRB) was launched in 1957. The index includes commodities that do not appear in other indices such as: rice. . 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. 167 Investing in Commodities BUYING AND SELLING COMMODITIES Spot Trading Buying and selling commodities can be done on the spot through “spot trading” where delivery takes place within a few business days. equally weighted. until 2005. If its weight rises to 30 per cent because crude oil prices have gone up relatively more than other commodities. component weights are assigned and rebalanced monthly. three livestock products and two precious metals. crude oil has a ﬁxed weighting of 23 per cent. 3. More weight is automatically allocated to commodities that have risen in price.2. The Rogers International Commodities Index (RICI) RICI is the most diversiﬁed commodities index available and tracks 35 commodities. eight agricultural products. The goal of the GSCI is to measure commodities in a way that reﬂects their current importance in the global economy. This resulted. With the makeover. This broad range of constituent commodities provides the S&P GSCI with a high level of diversiﬁcation. ﬁve industrial metals. for better or worse. both across sub-sectors and within each subsector. rubber and lumber. the weight is rebalanced back to 23 per cent. The components of this index were. 4. The 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. in orange juice having the same weight as crude oil. For example.
Futures Trading Instead. most commodities are traded on futures exchanges such as NYMEX and CBOT. Here are a sample of commodity contracts. corn is traded in Yen while it is traded in US$ on CBOT. EXAMPLES OF COMMODITY CONTRACTS Commodity Exchange Energy Light Crude Heating Oil Natural Gas Unleaded Gas NYMEX NYMEX NYMEX NYMEX Metals Gold Silver Platinum Copper COMEX COMEX NYMEX LME US$ per troy oz US$ per troy oz US$ per troy oz US$ per tonne US$ per barrel US$ per gallon US$ per mmBtu US$ per gallon Quote . and immediate delivery. few buyers would want to take the risk of accepting whatever the spot price is at the time of purchase. Not all contracts around the world are traded in US$ of course.1. The prices of commodities are eﬃciently and transparently discovered through the participation of thousands of buyers and sellers. where they are traded and how they are quoted. At the Tokyo Grain Exchange. If you consider the fact that commodities are almost always bought in large quantities. TABLE 14. for example. We are only showing you contracts traded on the main exchanges we discussed earlier.168 MAKE YOUR MONEY WORK FOR YOU Spot trading is not the main way in which commodities are bought and sold.
For example. the farmer makes up for that loss with a proﬁt in the futures contract. Or one may hedge to mitigate the risk of a natural position in the commodity. If the wheat crop is signiﬁcantly less due to bad weather. Commodity Index Funds For investors looking to diversify their portfolios without wanting to trade directly. Some funds speciﬁcally track commodity indices: . commodity funds are a good choice. trading directly in commodities has a high level of risk not only because of the volatility of commodity prices.Commodity Exchange Agriculture Quote 169 Investing in Commodities Lean Hogs Pork Bellies Live Cattle Feeder Cattle Corn Soybeans CME CME CME CME CBOT CBOT US cents per lb US cents per lb US cents per lb US cents per lb US cents per bushel US cents per bushel Source: Authors’ own compilation Trading Strategies Those who participate in futures markets usually have two main trading strategies. since the overall supply of the crop is short everywhere that suﬀered the same conditions. a farmer can insure against a poor wheat harvest by purchasing wheat futures contracts. One may speculate by taking a position such as buying a gold futures contract in the hope that gold would rise in price. but also because it requires sophisticated skills and dedicated time to follow a market that’s dominated by large commodity houses and ﬁnancial institutions. For most investors.
tracks the RJ/CRB index. Lion Capital and UOB. Australian company BHP Billiton is one of the world’s largest diversiﬁed producer of diamonds. which is available in Singapore. the investor can buy stocks that are linked directly to commodities such as palm oil. First State. Singaporelisted Wilmar is the world’s largest processor and merchandiser of palm oil. Schroder. coal.170 MAKE YOUR MONEY WORK FOR YOU • The Lyxor ETF Commodities CRB. bus fares. These unit trusts generally invest broadly across the major categories of commodities or they focus on speciﬁc sectors of the commodities market. iron ore and energy. Commodity Stocks Finally. aluminium. petrol and food at food courts. there are about a dozen unit trusts available for retail investors. These unit trusts are managed by fund management companies such as ABN AMRO. energy and agriculture. and also the largest palm biodiesel manufacturer in the world. which is the key indicator of retail inﬂation. Over time. has been rising along with price increases in rice. such as gold. iron ore. and this value does not depend on any nation’s economy or currency. most commodities have held their values against inﬂation very well because anticipated trends in inﬂation are priced into them. This exchange-traded fund began trading on SGX in January 2007. COMMODITIES AS PART OF YOUR LONG-TERM PORTFOLIO There’s no doubt in our minds that an investment in commodities makes sense for our bottom line for several reasons: 1. oil and natural gas. Inﬂation hedge potential — Commodities has recognised value all over the world. The Consumer Price Index in Singapore. Prudential. Commodity Unit Trusts In Singapore. Deutsche Bank. .
international stocks. hold and sit back. Just as up cycles can last 20 years. India and the Middle East.S.Portfolio diversiﬁcation — Commodities have been found to have a low correlation to stocks and bonds. “Commodities as an Asset Class”. commodities should never occupy a large portion of your retirement portfolio. 171 Investing in Commodities 2 The asset compared with commodities were U. study that looked at the correlation between commodities and various asset classes. As these regions grow economically.S. sudden losses. If you cannot stomach huge.2 This means that commodities are a good addition to a portfolio as they reduce overall volatility. U. Participation in global growth — Demand for commodities keeps growing in industrialising and emerging markets such as China. In fact. stocks.S. As an investor in commodities. Our last word of caution is that commodities are subject to long up and down cycles. www.S. so will their demand for commodities sourced from all over the world.investorsolutions. Commodities are highly volatile. government bonds. Two words of caution though. . Treasury bills and small-cap companies. We are no doubt in the midst of a strong up cycle. even more so than stocks. it was found that each asset class had a negative correlation with commodities during the period 1970 to 2003. You have to be more active in your monitoring.2. 3. down cycles have been known to last just as long.com. According to one U. commodities tend to do well when stocks and bonds are down. you cannot just buy. U.
15 172 Investing in Gold Thinking to get at once all the gold the goose could give. Over the years. gold is measured by troy weight and by grams and when it is alloyed with other metals.). with 24 carats being pure gold. It is easily shaped and easily divisible. It does not rust or tarnish. he killed it and opened it only to ﬁnd — nothing. originating in 1919. and in industries. gold is widely used as jewellery and coinage. Gold is beautiful and scarce. – 560 b. Like other precious metals. provides a twice-daily benchmark ﬁgure for the industry. The price of gold is determined on the open market. Gold will always have a value. The purity of a gold bar can also be expressed as a decimal ﬁgure. Why have gold prices suddenly shot up in the last three decades? To answer this and other questions. gold has been recognised and accepted by almost everybody as an ideal medium of exchange and store of value. when included in a portfolio.995. reduces the portfolio’s overall risk. The reasons for investing in gold have remained much the same throughout history.S. Prices rose to over US$900 in April 2008 from average prices of below US$40 in the early 1970s (see Figure 15.c. Besides being a highly reliable store of value. the term carat is used to indicate the amount of gold present.1. Gold is a safe haven in times of economic and ﬁnancial instability. Gold is also an excellent hedge against inﬂation over the long term. such as 0. Gold prices have been on a bull run.). . The Goose with the Golden Eggs MAKE YOUR MONEY WORK FOR YOU Man’s fascination with gold is timeless. dollar. but a procedure known as Gold Fixing in London. It is a proven asset-diversiﬁer that. ~Aesop (620 b. we begin with a short history of gold. And gold is one of the few assets that are negatively correlated with the U. known as the millesimal ﬁneness.c.
This eﬀectively sets a value for the currency. GOLD PRICE SINCE THE EARLY ‘70S 173 GOLD PRICE. $ PER OUNCE (LONDON PM FIX) 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 0 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 10 Source: Global Insight Source: Courtesy of World Gold Council. have described gold as being “common as dust. and its value was used as the standard for many currencies (known as the gold standard) in history. and would buy and sell gold at that price.c.” Gold is mentioned several times in the Old Testament. in our example $1 would be worth 1/100th of . and this gold was important in the establishment of what is probably the world’s earliest coinage in Lydia in 700 b.gold.1. The gold standard is deﬁned as “a commitment by participating countries to ﬁx the prices of their domestic currencies in terms of a speciﬁed amount of gold.org A SHORT HISTORY OF GOLD Egyptian hieroglyphs dating from 2600 b. say $100 an ounce. Exploitation is said to date from the time of Midas.” Money and near-money (bank deposits and notes) were freely converted into gold at a ﬁxed price. www. Gold has thus long been considered one of the most precious metals.FIGURE 15.c. A country under the gold standard would set a price for gold.
Central banks and other ﬁnancial organisations hold approximately one-ﬁfth of the world’s supply of above-ground gold. which is money that is intrinsically useless and is used only as a medium of exchange. also existed. The Bretton Woods System.174 MAKE YOUR MONEY WORK FOR YOU an ounce of gold. The gold standard has not been used in any major economy since that time. In addition.S. Compared with paper money. had a bimetallic system of money. it is still important in the global economy. Other precious metals could be used to set a monetary standard. is on a system of ﬁat money. silver standards were common in the 1800s. for the ﬁrst time in history. including the United States. During most of the 1800s. known as bimetallism. when President Richard Nixon ended the trading of gold at the ﬁxed price of US$35 per ounce. The gold standard eﬀectively came to an end in 1933 when President Theodore Roosevelt outlawed private gold ownership (except for the purposes of jewellery).S. The Bretton Woods System ended on 15 August 1971. enacted in 1946. why is it still important today? The reason is that while gold is no longer in the forefront of everyday transactions. dollar and other major worldwide currencies. formal links between the major world currencies and real commodities were severed. A true gold standard came about in 1900 with the passage of the Gold Standard Act. THE CONTINUING IMPORTANCE OF GOLD Given that gold no longer backs the U. gold has successfully preserved wealth throughout thousands of generations. created a system of ﬁxed exchange rates that allowed governments to sell their gold to the United States treasury at the price of US$35 per ounce. several central banks have focused their eﬀorts on adding to their present gold reserves as their currency reserves soar. A combination of the gold and silver standard. Almost every country. The same cannot be said about paper-denominated currencies because the value of a dollar is constantly being eroded by inﬂation. the U. At that point. And when investors .
especially when inﬂation is rising. WORLD ANNUAL GOLD OUTPUT 2600 2573 2518 2469 2444 2356 METRIC TONS 2500 2400 2300 2252 2200 2100 2000 1995 2000 2005 2006 2007 2008 Source: www. The 1970s testify to this as gold prices largely rose as a result of soaring inﬂation.goldsheetlinks.1. they will start positioning their investments in a hard asset that has traditionally maintained its value.com TABLE 15. WORLD’S TOP FIVE GOLD PRODUCERS Year 1 2 3 4 1995 2000 2005 2006 2007 2008 S Africa S Africa S Africa S Africa China China USA USA Australia USA S Africa USA Australia Australia USA Australia USA S Africa Canada China China China Australia Australia 5 China Canada Peru Peru Indonesia Peru Source: www. 175 Investing in Gold Demand and Supply The supply of gold is fairly constant from year to year although production has been slowing down slightly during the past few years. FIGURE 15.com .2.goldsheetlinks.realise that their money is losing value.
Added to the high cost of mining are the hundreds of millions of dollars and amount of time (three to ﬁve years) it takes to start a new mine. India is the world’s number one importer as its increasingly wealthy middle and upper classes continue to buy and adorn gold. investors in the past who held on to gold were able to protect their wealth successfully. and. Gold certiﬁcates. During such times. with South African mines at the higher end (10. Along with China’s demand.S. Gold bullion bars and coins.000 feet or more) and Canadian mines at the lower end (1.176 MAKE YOUR MONEY WORK FOR YOU One reason for the drop in world output is South Africa’s falling production in the past few years. 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. 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.000 feet or so). whenever there are news events that hint at some type of uncertainty. in some cases. Most of China’s gold output stays in the country where it’s transformed into jewellery and industrial items. Consequently. the falling U. which makes it the largest consumer in the world. 2. dollar. As Table 15. . HOW TO INVEST IN GOLD Investors who wish to invest in gold can do so in ﬁve ways: 1. investors will often buy gold as a safe haven. even use gold to escape from the turmoil. 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.1 shows. The cost to mine gold varies from US$150 to $400 per troy ounce. Middle East tensions and rising inﬂation.
Its true value depends on its gold content and its numismatic value (or collector’s value). up to a maximum of 30 kilobars.15 troy ounces) to the international “London Good Delivery” bar (400 troy ounces). which ranges from one to 1/20 ounce. you can invest in gold certiﬁcates. and 5. The gold is kept in the bank’s vault. especially if you have a large investment. Gold derivatives. Gold coins are legal tender in the country of issuance and their gold content is guaranteed. 4. The bullion coin bears a face value that is largely symbolic. Gold Certificates If you do not want to hold gold physically. and $5 for each certiﬁcate. the bank charges an annual administrative fee of typically $30 per kilobar per annum. Prices for all these investment options are available daily from banks and brokerages. 177 Investing in Gold 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. However.3. An example is the Singapore Lion Gold Bullion Coin. UOB introduced the ﬁrst gold savings account in Singapore . which is currently 7 per cent. Gold Savings Account You can buy and sell gold through a passbook at prevailing market prices. One disadvantage of buying physical is that you’ll have to pay GST. usually of one kilobar each. These certiﬁcates can easily be exchanged for physical gold or cash. There is no GST on certiﬁcates. Gold mining shares. Gold unit trusts and ETFs.
Where these companies make the most is exploration. including Nevada. Funds diversify their holdings among dozens of companies. Russia and Indonesia. based on its management and operating strengths. with a diversiﬁed number of mines in several parts of the world. Gold Unit Trusts and ETFs With gold unit trusts. investors are buying general industry and market risk instead of company-speciﬁc risk. Gold Mining Shares Some investors may be comfortable accessing the gold market by buying stock in gold mining ﬁrms. minus the fund’s expenses. Another way to invest in gold is through the SPDR Gold Shares ETF listed on the Singapore Exchange. and the transaction cost involved is lower than the cost of buying and safekeeping physical gold. The United fund was launched in 1995 and is globally diversiﬁed across the industry. but that is also where one ﬁnds the highest risk.178 MAKE YOUR MONEY WORK FOR YOU in 1981. Denver-based Newmont Mining is one of the world’s largest companies producing eight million ounces annually. but also on the future prospects of the company. 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. which means that it is as good as buying physical gold. The capital appreciation potential of a gold share is dependent not only on the future price of gold. The ETF is benchmarked to spot gold. Gold savings accounts allow those who want to trade frequently to buy and sell in 1g lots. South America. Some of the most established gold mining companies in the world are found on the NYSE. The United Gold and General Fund is one such fund in Singapore. Gold Derivatives Gold futures and options are traded on established exchanges . where your ETF shares can be bought and sold at any time. Australia.
This price ﬂuctuates daily and can be aﬀected by a multitude of factors. dollars and the U.around the world. but also the relative strength of the currency in which it is quoted. gold has an extensive history of maintaining its value. each gold futures contract is for 100 troy ounces of not less than . The strength of the U. dollar has increased 20 per cent by the time you sell it 12 months later. rather than an intrinsic change in gold market fundamentals. A similar contract is available through SGX-DT.995 ﬁneness. the dollar price of gold may increase more in percentage terms than the sterling price. the gold price reﬂects not only the inherent value of gold. Gold prices have historically seen strong ﬂuctuations that saw it hit a 20-year low in 1999. exchange for metals futures and options trading). current demand. At COMEX (New York Commodity Exchange. Still. dollar in the two decades between 1980 and 2000 was an important reason for gold prices not performing well during those years. gold. such as the perceived scarcity of gold. but trading is not very active. against the sterling). For example. for example. and bears a serial number and the identifying stamp of a reﬁner approved and listed by the Exchange. market sentiment and economic factors.S. Second. involve risk.S. like all investments. Therefore. 179 Investing in Gold THE RISK OF GOLD INVESTING As a tangible investment. gold is often held as part of a portfolio because over the long term. your investment would have fallen in value by 20 per cent — regardless of any change in gold market fundamentals. to the extent that the change in price is a reﬂection of dollar weakness (in this case. the price of your gold investment can go down as well as up in value. the leading U.S. like all prices.S. One reason for ﬂuctuating prices is that the value of a bullion coin or a gold unit trust is directly aﬀected by the current spot or market price of bullion. So if you purchase a gold investment in U. It was in part the rapid rise in the dollar .
the diversiﬁcation beneﬁts of gold in a portfolio are backed by strong evidence. a leading authority on asset allocation. Ibbotson determined that of the seven types of assets covered in the study. Ibbotson Associates. Another reason for gold’s poor performance between 1980 and 2000 was the success of the world’s central bankers in ﬁghting inﬂation. can decline in value. you should have adequate cash reserves and disposable income before considering a precious metals investment. however.180 MAKE YOUR MONEY WORK FOR YOU that hurt the dollar gold price. speculating in gold should be avoided at all cost by conservative investors. MANAGING GOLD IN YOUR PORTFOLIO Despite the volatility of gold prices and its sensitivity to fundamental factors. the precious metals asset class is the only one with a negative correlation to other asset classes. In the end. such as stocks and bonds. You should acquire a good understanding of gold products before you invest in them. What this means is that precious metals perform best during the years that traditional asset classes.1 and 15. including gold. Since all investments. gold has produced excellent long-term gains during up cycles. 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. silver and platinum bullion.7 per cent for conservative to aggressive portfolios respectively. covering a 33-year period from February 1971 to December 2004. . Historically. Gold’s role as a hedge against inﬂation is one of the main reasons people buy it. Ibbotson determined that investors can potentially improve their portfolio risk-reward performance by including precious metals with allocations of between 7. had negative returns. it may not be suitable for everyone. performed a study with respect to the portfolio diversiﬁcation beneﬁts of gold.
1 (below). They can reduce overall risk and quite often. and how they can ﬁt into your portfolio. Look at Figure 16. the hedge fund index was not only less volatile. hedge funds can be very good for your portfolio. regardless of market conditions. they can also increase returns. What’s more. but it also provided higher returns. which compares three major indices. In this chapter. While the S&P 500 and Dow Jones World Index went on major roller coaster rides between Dec 1993 and Dec 2000. and as consistently as possible. A All ll rights ight ht reserved d This is the stellar reputation of hedge funds that many of you may have heard about. DOW JONES WORLD INDEX AND CREDIT SUISSE HEDGE FUND INDEX 350% 300% 250% 200% 150% 100% 50% 0% -50% 12/1993 12/1994 12/1995 12/1996 12/1997 12/1998 12/1999 12/2000 12/2001 12/2003 12/2004 12/2005 12/2006 12/2007 12/2008 12/2009 Copyright C ight ht 2010. FIGURE 16. we will help you examine whether hedge funds are right for you. . the Credit Suisse Hedge Fund Index (indicated by the arrow) chugged along very smoothly throughout the 17-year period. Compared with both indexes. 2010 20 10 Credit C di dit t Suisse S i H Hedge d I dg Index d LLC LLC. at lower risk. COMPARING PERFORMANCE OF THE S&P 500.1.16 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.
in theory has no ceiling. and deliver the car to make a $10. Suppose you enter a contract to deliver a Toyota you do not own for $50. prices could go up to $60. What you hope will happen is that Toyota prices will drop and you can buy a Toyota for a lower price of say. It refers to the degree to which the fund is using borrowed money to invest. Leverage Leverage is used to increase risk. When considering if a fund is a hedge fund. However. Short Selling This is an aggressive strategy of sell-high. that is. or $80. sell-high (called a long strategy).000.000.182 MAKE YOUR MONEY WORK FOR YOU WHAT ARE HEDGE FUNDS? To most investors.000 proﬁt. If a fund is leveraged 100 per cent. MAS looks at whether: • Non-traditional investment strategies such as leverage. one can take a long position in Company . Short selling has unlimited risk. Arbitrage Hedge funds use arbitrage to exploit mispricings between related securities. bonds and cash. short selling and arbitrage are used. $40. You see. it means that it has borrowed $1 for every $1 that it actually has. investments other than listed equities. buy-low rather than the traditional strategy used by unit trusts of buy-low. Proﬁts as well as losses are magniﬁed 100 per cent as a result. Here is an example that will help you understand how short selling works. In other words.000 or beyond. or • Investments are in non-mainstream asset classes. hedge funds are shrouded in mystery.000. you are short-selling the Toyota. and that is why short selling is an unlimited risk strategy. price. For example. what happens if the price of the car goes up instead? Technically.
This suggests that hedge funds are not for everyone. you would have.1 lists some of the most popular. should not be placing money in hedge funds.. hedge funds can invest in more complex and more risky investments than a retail fund might. the crabs are going for $80 a kilogramme. In the U. . The variety of hedge fund strategies far exceeds anything oﬀered by traditional unit trusts. Equity and derivatives portfolios with net short. What makes hedge funds diﬀerent is their diversity. made a proﬁt by exploiting a mispricing situation. 183 Investing in Hedge Funds HEDGE FUND STRATEGIES A wide range of investment styles and strategies are available to hedge funds.1. Because of an exemption from the types of regulation that apply to mutual funds. An example would help. or a retiree wishing to protect her income. Suppose Sri Lankan crabs are selling at $50 a kilogramme at the Pasir Panjang Wholesale Centre.A’s convertible bonds and short its stock. POPULAR HEDGE FUND STRATEGIES Strategy Convertible Arbitrage Dedicated Short Bias Objective Exploit price ineﬃciencies between convertible securities and stock. Over at the Telok Blangah wet market. If you are able to buy crabs from Pasir Panjang and sell them at Telok Blangah. TABLE 16.S. These funds employ aggressive strategies and are exempt from many of the rules and regulations governing unit trusts. A retail investor who is just starting out to invest. Table 16. and only a limited number of investors can belong to it. Individuals who buy hedge funds are usually deemed “sophisticated” and they usually have to pay high minimum investment amounts. in essence. “bearish” focus. an investment fund can be exempt from direct regulation if it is open to accredited investors only.
Listed futures strategies often driven by technical or market analysis. Exploiting price ineﬃciencies between related debt securities. Emerging Markets Equity Market-Neutral Event Driven Fixed-Income Arbitrage Global Macro Long-Short Equity Managed Futures Multi Strategy Source: www. Directional macroeconomic strategies. Fund of funds. Directional equity and equity derivative strategies. currency neutral.184 Strategy MAKE YOUR MONEY WORK FOR YOU Objective Equity and ﬁxed-income investments in emerging markets worldwide.com Classifying Hedge Funds Some funds employ only one strategy. Capital guaranteed and protected hedge funds. Single strategy funds. We can hence classify hedge funds in a broader way: 1. it is called a single strategy .hedgeindex. Corporate strategies focused on distressed securities. Single Strategy Funds If a hedge fund adopts one main strategy. Multiple strategies. Oﬀsetting long and short equity positions that are beta-neutral. others are less risky and oﬀer protection for your invested capital. or both. and 3. others may use several. high-yield debt. Some funds are more speculative and comb the world for opportunities. 2. and risk arbitrage. or multi-strategy.
The second diﬀerence is that guaranteed hedge funds tend to make use of leverage. Guaranteed Hedge Funds These funds work like their retail cousins. For one. They 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. 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. The bonds invested in tend to be higher-yielding and are often not of investment-grade quality. The risk for such funds is generally lower than that of single strategy funds. the entire fund loses money. 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. Fund of funds A fund of funds invests in other hedge funds as a means of diversifying strategies and managers. They diﬀer from retail guaranteed funds in two ways. 185 Investing in Hedge Funds . If you invest in one of these funds. Single strategy funds clearly come with higher risk because if the strategy fails. For example. Retail guaranteed funds in comparison would only have the remaining 20 per cent to invest in derivatives.hedge fund. While retail funds may have 90 per cent in bonds. For these funds to succeed. Guaranteed hedge funds have a ﬁxed maturity of typically ﬁve to 10 years. derivatives and other speculative securities to provide the upside kicker in returns. guaranteed hedge funds may have 80 per cent or less because of higher yields. Asking for your money back after two years will cost you in terms of likely capital losses and redemption fees. investors have to pay two layers of fees — one for the individual funds and another for the fund of funds manager. be prepared to stay the course.
Diversiﬁcation At the most basic level. hedge fund managers themselves are usually one of the key investors in the fund. This attracts the best talents. hedge funds can be thought of as just another investment alternative.186 MAKE YOUR MONEY WORK FOR YOU Should You Invest in Hedge Funds? Investors are drawn to hedge funds for many reasons. Source: www. . but are hedge funds right for you? Your decision should take into account these factors: 1. Investors are protected by Singapore regulations. hedge funds can certainly help diversify a portfolio. make money whether the fund goes up or down in price. For investors with the means and appetite. Those who are fearful about hedge funds cite fudged statistics and underhand tactics. on the other hand. These are two very strong incentives for fund managers to perform.com.1 Those strongly in favour of hedge funds often cite statistics that show hedge funds not only reduce portfolio risk. The best talents are drawn to hedge funds The compensation of hedge fund managers is mostly tied to the fund’s performance. Also.hedgeindex. Unit trust managers. as are bond funds and REITs. Investing in Hedge Funds in Singapore Investors can choose between domestic hedge funds and oﬀshore hedge funds. Domestic hedge funds are organised within Singapore. 2. MAS has set guidelines for the minimum subscription amounts for hedge funds: 1 The CSFB/Tremont Hedge Fund Index has a 0.47 correlation with the MSCI World Index. but also increase portfolio returns because of spectacular performance.
000 for the last 12 months or one who owns at least $2 million in net assets. While this does not mean no recourse for the investor should fraud or scandals occur. An accredited investor is deﬁned under the Securities and Futures Act as one earning at least $300. .• Single strategy funds — $100.000. on page 168): 1.2. or a fund whose underlying investors are all “accredited investors”.2 Those 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. Absolute performance Unit trusts are mainly measured on relative performance based on a relevant benchmark such as the S&P 500 index. it does make things a lot more diﬃcult for investors should something go wrong. Oﬀshore hedge funds are structured under foreign law and are available only for accredited investors and not for retail investors. An accredited investor may also be a corporation with net assets exceeding $10 million in value. there are a few important diﬀerences between them and unit trusts that you should be aware of (see summary in Table 16. Hedge-fund ﬁrms were previously exempt from holding a license provided they manage funds on behalf of no more than 30 qualiﬁed investors.000 for each transaction.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 ﬁrms in Singapore that manage more than S$250 million to be licensed. or her aggregate consideration for the acquisition is not less than $200. 187 Investing in Hedge Funds DIFFERENCES BETWEEN HEDGE FUNDS AND UNIT TRUSTS In considering whether hedge funds are right for you. Since such funds are managed outside Singapore. Hedge 2 A “qualiﬁed investor” is an accredited investor. they are regulated under foreign laws.
Performance-based remuneration Hedge fund managers are rewarded with performance-related incentive fees as well as ﬁxed fees.7 billion in 2007. John Paulson. The average compensation for the top 25 fund managers was US$892 million in 2007. 3. even when the relative indices are down. HOW MUCH DO TOP HEDGE FUND MANAGERS MAKE? Hedge fund managers can make a scary amount of money. SUMMARY OF DIFFERENCES BETWEEN HEDGE FUNDS AND UNIT TRUSTS Unit Trust Performance measurement Asset classes permitted Relative Cash. was paid an estimated US$3. Unit trust managers are generally rewarded based on the size of the assets under their management. Hedging risk in a downturn Hedge funds can protect against declining markets by using hedging strategies such as shorting. bonds and stocks Hedge Funds Absolute Unrestricted .2. founder of New York based Paulson & Co. according to Institutional Investor’s Alpha magazine.188 MAKE YOUR MONEY WORK FOR YOU funds on the other hand are expected to deliver absolute returns — they attempt to make proﬁts in diﬀerent market conditions. 2. Unit trusts are not able to protect portfolios eﬀectively against declining markets. TABLE 16. The “poorest” fund manager in the top 50 made US$210 million.
Investors should also be wary of potentially inﬂated returns. According to a study by Burton Malkiel. investing in hedge fund can be tricky and here are a few guidelines you should follow to protect yourself: .Unit Trust Regulations Investment strategy Performance fee Target investors Expenses ratio Leverage Source: Authors' own compilation Hedge Funds Less regulated Unrestricted Very likely Usually monthly High-net-worth Higher Allowed 189 Investing in Hedge Funds Highly regulated Buy and sell only Usually none Retail Lower Prohibited Liquidity (ability to sell easily) Daily BE CAREFUL WHEN YOU INVEST IN HEDGE FUNDS The assets under management of a hedge fund can run into many billions of dollars. When hedge funds fall.S. Take the collapse of the U. The study estimates that fund results are overestimated by an average of 3. Federal Reserve to step in to negotiate a US$3. a Princeton University professor. LTCM made a huge and wrong bet on interest rates in the form of Russian debt and caused the U. This “survivor bias” means that dead funds such as LTCM are not reﬂected in the major indices. they fall hard and often take others along with them. whether they succeed or fail.6 billion bailout plan. Their inﬂuence over the markets and even entire economies. hedge fund Long-Term Capital Management (LTCM) in 1998 for example.74 per cent. and this is usually magniﬁed by leverage.S. can be substantial and there is an ongoing debate about how much they should be regulated or unregulated. hedge fund returns are inﬂated because failed funds that have been liquidated are often not included in key fund indices. For these and other reasons.
make sure the index includes dead funds.000 or more (since one single strategy fund priced at $100. Make sure that hedge funds comprise no more than 20 per cent of your overall portfolio. • Look for funds with at least 10 years of return information. . • Seek a knowledgeable ﬁnancial adviser to give you advice. Do not trust slick brochures that show only recent performance. Ask your adviser how he is compensated by the hedge fund managers he is recommending. If the index includes dead funds. any type of hedge fund will do. MANAGING HEDGE FUNDS IN YOUR PORTFOLIO If you want to invest in a hedge fund for retirement.000 amounts to 20 per cent of a $500.74 per cent (based on Professor Malkiel’s study) from the illustrated returns to compensate for any potential inﬂation of returns. Your due diligence and monitoring must be top-notch. subtract 3. look for lesserrisk fund of funds and capital guaranteed funds. Avoid single strategy funds.190 MAKE YOUR MONEY WORK FOR YOU • Remind yourself that although the rewards can be tremendous. Never place a major portion of your investment funds into hedge funds. If you wish to enhance risk in your overall portfolio. Up to 20 per cent is about right. you take on substantial risk when you invest in hedge funds. • When examining hedge fund returns using an index. We recommend you consider single strategy funds only if your total invested assets equal $500.000 portfolio).
1. It is understandable if you look at the highest prices paid at auctions (see Table 17. is illiquid (not easily convertible to cash) and has high transaction costs. Hello Kitty celebrated its 35th anniversary in 2009 with a limited edition platinum doll that sold for around USD 170. Understanding Basic Derivatives PAINTINGS — GOING. Many collectibles are bought and sold in auctions in which the prices for similar items can vary widely. when a collectible (even for something as seemingly mundane as a toy or a comic book) is highly desirable. the collectibles market is informal. vintage cars or Picasso paintings.17 191 Investing in Art and Collectibles We hear more and more these days about art and collectibles being auctioned for hundreds of thousands of dollars. splurging is not uncommon. Whether you have a passion for Coca Cola bottles. GOING. Ultimately. It is easy to pay too much for a collectible if you do not have the needed experience and knowledge.000 each. you do need specialized knowledge to determine the value of a speciﬁc collectible. or someone discovering that grandma’s stamp collection in the storeroom is worth a fortune. GONE Expensive paintings seem to always take the spotlight when compared with other collectibles. In this chapter. Unlike a stock exchange where thousands of buyers and sellers congregate electronically to provide the latest transacted prices. on page 192): . The ﬁrst issues of Superman and Batman have sold for over USD 1 million each in 2010. we look at the glamorous pursuit of collecting paintings followed by some sensible rules on buying and selling collectibles. There is no updated price list or regulatory authority to ensure that transactions are carried out in an orderly way.
1 LIST OF 10 HIGHEST PRICES PAID AT AUCTIONS1 Painting Artist Year Painted 1948 Year of Sale 2006 2006 2006 Original price (in millions) $140 $137. 1 .9 $101. 1948 Woman III Portrait of Adele BlochBauer I Portrait of Dr.5 $144. 5. is inﬂation-adjusted in US dollars.3 $101.2 $53.8 No.2 $148.5 $78.5 $119.5 1889 1989 $58 plus exchange of works $95. A list in another currency may be in a slightly diﬀerent order due to exchange rate diﬀerences.192 MAKE YOUR MONEY WORK FOR YOU TABLE 17. which is adapted from Wikipedia. This list.2 $106. Paintings are only listed once.9 $106.3 1941 1889 2006 1987 $102.1 $139. consider that just ﬁve years ago.6 million.5 $135 Adjusted price (in millions) $151. Green Leaves and Bust Portrait of Joseph Roulin Dora Maar au Chat Irises Jackson Pollock Willem de 1953 Kooning Gustav Klimt Vincent van Gogh PierreAuguste Renoir Pablo Picasso Pablo Picasso Vincent van Gogh Pablo Picasso Vincent van Gogh 1907 1890 1876 1990 1990 $82.6 Irises by Vincent van Gogh is tenth in the list valued at an astonishing USD 101. To give you an idea how prices have risen the last few years.6 1905 1932 2004 2010 $104. for the highest price sold. Gachet Bal du moulin de la Galette Garçon à la pipe Nude.0 $131.
1 is a list of the highest prices paid for paintings. Although Brosnan’s character does it for the thrill of it. the thief merely cut a padlock on the gate. a ﬁrm that maintains the world’s largest database of stolen and missing art. the painting was already assessed at US$100 million. If a painting like the Mona Lisa were to become available. which very rarely sell them. As such. Most of the world’s most famous paintings are owned by museums. A more recent and embarrassing theft occurred in May 2010 when ﬁve paintings were stolen from the Paris Museum of Modern Art. The guards were alerted only when they noticed the smashed window. While the thief ’s image was captured on CCTV. Long ago in 1962. the museum’s security system had failed terribly as the break-in triggered no alarm. Prices of the top-10 paintings have doubled in the last ﬁve years. STEAL ONE Some art thieves may have been inspired by Pierce Brosnan in the movie The Thomas Crown Aﬀair where he orchestrates an elaborate New York museum heist to steal a Monet painting. art thieves rarely make big money oﬀ . Dressed in black and wearing a mask. most art thefts are performed for monetary gain. Very valuable paintings. 193 Investing in Art and Collectibles IF YOU CANNOT OWN ONE.the “cheapest” painting on the top-10 list was just a little over USD 50 million. Which is the most expensive art theft in history? According to the Art Loss Register. if sold. The stolen pieces included ones by Henri Matisse and Picasso. While this may make art robbery seem like a good career choice for some people. are usually not sold at auctions. Table 17. that may be the 1911 theft of the Mona Lisa. they are quite literally priceless. smashed a window to get inside and then carried oﬀ a stunning haul worth hundreds of millions of euros. It was embarrassing because it was a one-man heist. it would almost certainly sell for much more than any of the paintings listed.
The paintings of Pascal Cucaro. 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.000 while he was at his peak in the 1950s.194 MAKE YOUR MONEY WORK FOR YOU their crimes. her new fame might allow the artist to become more proliﬁc by satisfying the demand while keeping the price at the same level. the publishing of a book. as well as what we might call the close of her artistic production. those same paintings may sell for no more than US$1. and diﬃcult to oﬄoad at their actual value on the open market. In the months immediately following Andy Warhol’s death. 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. General interest caused by an exhibition. ART AND COLLECTIBLES CAN BE RISKY INVESTMENTS Unlike an investment in stocks. Today. Some artists have a huge following only during their lifetimes because of their big personalities. In fact. a colorful San Francisco artist for example. conference. But this posthumous popularity is not always the case. But when an artist dies. a frenzy developed for anything Warhol.artbusiness. or even the production of a major ﬁlm (as in the case of Mexican painter Frida Kahlo and Amedeo Modigliani who was a struggling rival of Picasso). sold for around US$50. That’s because the stolen pieces of art are easily recognisable. 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. the variables that govern price can be very unpredictable and volatile.2 2 www.com . an investment in collectibles cannot be measured by time. One factor that can drive up the value of art is the artist.000. It’s often said that if the artist is alive.
long enough to know about quality. 3. Here are a few sensible strategies to bear in mind when investing: 1. If the piece gets damaged or lost. market trends and pricing practices in the type . phone cards or antiques. Security — Investors are responsible for the safekeeping of the collectible. its value is compromised. she will likely do much better investing in stocks or bonds than buying paintings.What we often do not hear is that collectibles are risky investments and may be diﬃcult and expensive to liquidate. Investing in arts and collectibles is rife with risk and. Their proﬁt potential should be a secondary consideration. If growth is an investor’s sole motivation. Liquidity — Securities can be sold much more easily than art and collectibles because securities are traded more readily on organized networks and exchanges. it is much more diﬃcult to conﬁrm that a fair price is being paid. doesn’t oﬀer the returns aﬀorded in the equities or traditional markets. 2. 195 Investing in Art and Collectibles MAKING SENSIBLE INVESTMENTS IN ART AND COLLECTIBLES Most authorities agree that we should buy art and collectibles primarily because we like them. Here are three other challenges investors may encounter: 1. for most investors. But when buying a piece of art. Buy from reputable dealers — Find a reputable dealer who has been in the business for many years. The 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. Low price transparency — Buying securities usually occur at fair market value in large market places.
4. But collecting for the sake of proﬁt is seldom a productive activity unless you have pockets deep enough to invest in the rarest collectibles. The big ones come too infrequently. 3. Buy quality — Like buying homes in good locations. buying top-quality items while expensive. 2. Limit the amount invested — Avoid putting more than 10 to 15 per cent of an investment portfolio into art and collectibles. Maintain the item — provide appropriate environmental conditions and regular maintenance as well as insure the item adequately.” Happy collecting! . And if you don’t collect all these tiny successes. stamps. the collectibles they acquire may never provide much proﬁt at all or are likely to decrease in value over time. the big ones don’t really mean anything. Happiness is made up of those tiny successes. Collecting things is a very satisfying pastime when you are passionate about the things you collect. “Life is made up of small pleasures. we subscribe to what television producer Norman Lear said. provide price protection even in poorer market times. So for many people. Between ourselves. In the end.196 MAKE YOUR MONEY WORK FOR YOU of art and collectibles to be collected or invested. photos and books. Some cost us a few thousand dollars while most cost just a couple of dollars. we collect coins. The dealer should also provide a written appraisal or certiﬁcate attesting to the quality and authenticity of the item.
The percentage is probably even higher today. Why has there been such an increase in the use of derivatives and structured products by both companies and individuals? You guessed it. You’ve seen the subprime crisis bring about shocking losses for many of the world’s largest banks. then lost half its value in the next 21 months. currency-linked notes and call warrants. Now imagine you are two years from retirement and you have a portfolio of Singapore stocks worth $300. according to a survey by the International Swaps and Derivatives Association (ISDA) in 2003. You saw in Chapter 15 how gold went from US$270 in 2001 to over US$1. chances are that you too own or have owned derivative instruments although you may have done so indirectly. 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 diﬀers.18 197 Understanding Basic Derivatives Over 92 per cent of the world’s largest 500 companies use derivatives to manage their corporate risk. 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. It’s all about risk and return.200 per ounce in 2010. contracts for diﬀerence (CFD). some of which have lost tens of billions of dollars. That’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 ﬂuctuations. Investing in Art and Collectibles WHY DERIVATIVES ARE EVER SO IMPORTANT FOR YOU TO KNOW TODAY The markets are very volatile these days.000 that you . If you’ve ever owned a capital guaranteed product or just a unit trust. These days there are many new products that just a few years ago didn’t exist — such as protected funds.
Like you. We will go over some of the foundation topics on derivatives that we covered in Chapter 2. Like you. He is worried that the price of goats will rise in three months’ time.198 MAKE YOUR MONEY WORK FOR YOU plan to use for travelling and cruises. Let’s suppose that you did. but he doesn’t want to look after a goat for three months. Suppose it is June and you are a goat farmer hoping to sell one of your goats in three months’ time in September. Our advice is that you should leave those daunting details to your ﬁnancial adviser and just focus on how these instruments may be important for your ﬁnancial future.000 years ago in Sumeria. 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. Now suppose there is also a shish kebab maker who wants to buy a goat for a village feast taking place in September. We will not look too much under the hood of these very technically demanding instruments. 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. Volatility can bring about returns that can be very good for your portfolio — or very bad.000 YEARS AGO If you had lived 5. While goats are selling at 100 gold coins today. he is also exposed to price risk. IT ALL STARTED WITH FORWARDS 5. but on the opposite side. In this chapter. and you would be happy with that price. but we will do so at a very conceptual level. you might have had the honour of participating in one of the ﬁrst derivative transactions known to mankind called a forward. . your goat is not quite mature yet. The problem is that you’ll never know for sure which direction the market is headed. Bad economic news and a likely recession then destroy over 50 per cent of your portfolio’s value. which was situated in modern day Iraq and western Iran. he doesn’t mind the price of a goat at 100 gold coins today.
both of you have removed your price risk. I.What you and the shish kebab seller can do is to have a forward agreement with these terms: I. the market price of goats could just as easily have fallen to 50 gold pieces. a special type of goat. In three months’ time. They can be customised since it is usually between one buyer and one seller. By doing so. if the market price of goats rises to 140 gold pieces. The 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. agree to sell one of my goats to shish kebab maker for 100 gold coins in three months’ time. a speciﬁc weight or colour can be speciﬁed. You would. 2. you are obligated by the contract to sell the goat for 100 gold coins. of course. shish kebab maker. 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. 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. Forward contracts have three key features: 1. Both buyer and seller are obligated to buy and sell at the speciﬁed price. agree to buy a goat from goat farmer for 100 gold coins in three months’ time. goat farmer. in which case you would be happy because the shish kebab maker is obligated to buy it from you for 100 gold coins. As you have seen. 199 Understanding Basic Derivatives . But then.
Forward contracts are traded over-the-counter (OTC) rather than on a formal exchange such as SGX. Second. It may arrive with a disease or one leg missing. If the market price of goats rises to 200 gold coins.1. As a result. the goat farmer may decide to scupper the agreement in order to sell it in the marketplace for 200 gold coins. it is hard to guarantee the quality of the goat. there are thousands of buyers and thousands of sellers who converge their interests into one marketplace (see Figure 18. These features of forward contracts do point to some challenges. And third. the trading of futures contracts is diﬀerent from that of forward contracts in the following ways: FIGURE 18. A FUTURES EXCHANGE Thousands of Buyers Clearing House Thousands of Sellers Source: Authors’ own illustration . 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. Because forward contracts are agreements between two parties.200 MAKE YOUR MONEY WORK FOR YOU 3. FUTURES CONTRACTS Futures markets began as a response to some of these challenges experienced with forward contracts. counterparty risk can be high. In a futures market.1).
But this occurred when futures were used for speculating with huge bets on the direction of the market. A corn futures contract would have speciﬁc details of contract size. When used for hedging an existing physical position. Nick Leeson’s trading of Japanese futures made his employer Barings Bank bankrupt in 1995 with losses of US$1. Like a forward contract. they do a wonderful job of reducing. Now suppose you have $300. However. one diﬀerence is that because the contract terms are standardized and the exchange is open to thousands of buyers and sellers. Forward contracts do not have standardised terms and that is why they are diﬃcult to get out of as it requires another buyer or seller who is willing to accept customised terms. delivery times and acceptable moisture quality. risk. China Aviation Oil in 2004 ran up US$550 million in losses from oil futures. If a buyer puts in a buy order and it is accepted. The role of the clearing house is to guarantee the trades that come through. over 95 per cent of all futures contracts are “unravelled” in this manner.000 invested in ten Singapore stocks that you have held for many years. origin of the corn. a clearing house sits between the buyers and the sellers. Second. the clearing house guarantees that the order will be ﬁlled. it is very easy for someone to get out of a position before the contract matures. a futures contract obligates the buyer and seller to buy and sell. not increasing. and you are . It is January.Futures contracts have standardised terms to facilitate trading.4 billion. In fact. Take the case of the shish kebab maker who hedged against price rising in the future by agreeing to a price today. This gets rid of counterparty risk. 201 Understanding Basic Derivatives Futures in Your Portfolio We often hear about the high risk nature of derivatives (especially futures). which is the risk that accepted orders are not ﬁlled for one reason or another.
000 X $10 = $30.) Let us return to our example. With a multiplier of $10 per point. you have greatly reduced or even eliminated the possibility of a loss from a decline in your Singapore portfolio. if the STI index falls 50 points.sgx. you agree to sell a car to John for $20. 2 . You do not wish to liquidate your portfolio but you don’t want to suﬀer losses either should the market decline. the price of one March contract is: Price per contract = 3. the number of futures contracts to sell is: Number of contracts = $300. your proﬁts from your futures position would oﬀset your losses from your actual portfolio. Assuming you don’t already have the car.com and from other exchanges.202 MAKE YOUR MONEY WORK FOR YOU concerned about a market decline over the next two months. What we are focusing on is the important concept that you can hedge (or protect your portfolio) with the use of futures.000 To protect the portfolio against a market decline. you hope to buy a car in a week’s time at a price lower than $20. For example. What you can do is sell2 a number of STI futures contract so that if the market does fall.000 points.000 / $30. and we are not focusing on those details here. the losses from your stock portfolio would be oﬀset by the gains from the futures contracts.000 in order to make a proﬁt. The March STI futures contract is trading at 3.000 = 10 contracts By hedging. If the market indeed falls. For example.000 today to be delivered a week from today. (Note that the operational details of trading futures can be easily obtained from www. your gain from your futures position would be: Selling or shorting is useful when you have a pessimistic view of the market.
For the STI contract. 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. there are details on the STI futures contract that we have intentionally skimmed in order to focus on the concept of hedging. a $10 per point multiplier is used to give the contract a monetary value.” Because the underlying asset is the STI with a points value. We’ve already discussed in Chapter 2 what call and put options are. This is the most important diﬀerence between options and futures/forwards. you have a choice.000 203 Understanding Basic Derivatives However. the gains from the market would be oﬀset by the losses from your futures position. if the goat farmer and shish kebab maker were to agree to an options contract. To review. here are a few things to note: • Futures contracts generally have speciﬁed future expiry dates often going into 12 months or more into the future. That’s because if the market went up instead. If you buy an options contract. . it might look something like this: I. we chose the March contract because it still has two months remaining before expiry. TRADITIONAL OPTIONS CONTRACTS Both forwards and futures obligate the buyer and seller to buy and sell.Gain = 50 points X 10 contracts X $10 per point = $5. shish kebab maker. Finally. • Futures contracts have to be “monetized. you would have also eliminated the possibility of a gain from a price increase. However if you are new to the STI futures contract.
This is called the option premium. It’s that sophisticated. New stock is not issued by the company. If he does not. I must sell. suppose we have the following: Today’s price of XYZ shares Strike price of call option Price of call option Expiration = $10 = $16 = $0. a price has to be paid. but the options have been dormant because of lack of interest. You can see that the option to buy the goat is valuable. 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. the third party delivers the shares to you from its own inventory of shares. To understand what this means. Traditional stock options are popular in the U. Stock options have been created on a few blue-chip companies in the past. and for that. We need to get more speciﬁc about the type of options that we are talking about because there is actually quite a variety of them. If shish kebab maker exercises his right to buy. the calculation of which won its creators the Nobel Prize in Economics.204 MAKE YOUR MONEY WORK FOR YOU I. The options that we discuss here are traditional exchange-traded options.S. They give you the option to buy or sell a number of shares at a speciﬁed price (called the exercise price) within a period of usually three to nine months. This means that if an option to buy is exercised. They are issued by third parties such as a bank.20 = 3 months . and Australia. The 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. rather than by the company itself. In fact. the company whose shares are being bought and sold is usually not at all involved in such transactions. goat farmer. I keep the two gold coins. but they are not popular in Singapore.
you can see that the strike price of $16 is not reasonable. For example. Despite whatever optimism you have about XYZ. a call warrant is what we just described. A put warrant represents a certain amount of equity that can be sold back to the issuer at a speciﬁed price. Warrants issued by companies entitle the holder to buy a speciﬁc number of shares in that company at a speciﬁc price at a speciﬁc time in the future. today’s price.2 One other diﬀerence with traditional options is that traditional warrants are issued by the company itself. When such companyissued warrants are exercised. we now ask what if the expiration is ﬁve years and not three months? Does a strike price of $16 seem more reasonable to you if you had ﬁve years to wait this out? The answer should be yes. it means that you have very gigantic hopes that XYZ would rise at least 60 per cent during the next three months. the exercise price should be closer to. and this is one of the main diﬀerences between traditional options and warrants. It gives its holder the right to purchase a number of shares from the issuer at a speciﬁc price. So. 205 Understanding Basic Derivatives TRADITIONAL WARRANTS Continuing with the last example. Like a call option.Does 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. The exercise price is usually far away from today’s share price at time of issue. on or before a certain date. AsiaWater Tech W110818 2 This is true more so when the company’s share price is considered low. new shares are released. rather than farther away from. on or before a stated date. Warrants are in fact often called “long-dated options” for this reason. There are two diﬀerent types of warrants: call warrants and put warrants. warrants have a lifespan of up to ﬁve years. . At the time of issue.
5 cents or even lower? Then your maximum loss will always be limited to just the initial investment of 3 cents per warrant.5 cents for a total of 7. you have a choice of buying it directly at 6. you’re paying 7. To own Asia Water. For example.5 cents Conversion Ratio = 1 share: 1 warrant Analysing this is not diﬃcult at all. the price of an associated warrant may increase 30 per cent. .5 cents. That is the bottom-line attraction for speculators. The price movement of warrants tends to reﬂect the price changes in the underlying equity — but in an exaggerated fashion. 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. if the price of a share increases 10 per cent.5 cents Underlying Stock Price = 6. if you buy the warrant at 3 cents and Asia Water stock rises to 10 cents in a year. The conversion ratio of 1:1 means that it takes one warrant to purchase one share. Warrants Compared with Options Warrants are similar to long-term options where they oﬀer the opportunity for capital gain.5 cents). which is 1 cent more than buying the stock directly. by buying the warrant and exercising it. 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. And what if the underlying stock price falls to 1.206 MAKE YOUR MONEY WORK FOR YOU is an SGX-listed warrant issued by Asia Water itself. which makes them interesting for speculative investing.5 cents or you can pay 3 cents for the warrant and exercise it by paying another 4. Is this a good deal? First.5 cents per share (10 minus 7.5 cents. For example. you can cash in for a nice proﬁt of 2.
On an exchange. if you arrange a mortgage from a bank to buy a house. which are summarised in Table 18. This does not cause earnings to dilute. Ranges from 1 month to 12 months.But warrants are not exactly like options. When an option is exercised.1 for call warrants and call options. On an exchange. Usually not issued by the company itself. which is why speculators love them. you are gearing up your exposure to the property market. An example of gearing is if you borrow money from the bank and invest the money in the stock market. New shares are issued by the company when warrants are exercised. Usually issued with a 3-5 year life. . Issued by the company itself with a promise to issue new shares if the warrant is exercised. Issuer Dilution Where they are traded Source: Authors’ own compilation The Lure of Warrants Because warrants exaggerate the movements of the underlying equity. This results in earnings dilution for shareholders. A promise is made to deliver existing shares if the option is exercised. there are a few diﬀerences. Similarly. Options Short dated. This feature of warrants is called gearing and this is found commonly in ﬁnancial markets. you are said to be “gearing up” your exposure to stocks. they tend to be more volatile than shares.1. existing shares are delivered. 207 Understanding Basic Derivatives TABLE 18. Warrants thus oﬀer the opportunity for greater price gains than do the associated shares. DIFFERENCES BETWEEN WARRANTS AND OPTIONS Warrants How long they last Long dated.
700 ABC e CW 120328 STI 3. they can plummet just as quickly. In the case of company warrants. share price movements. and have the greatest price increases among securities. structured warrants are issued by third-party ﬁnancial institutions. While warrants can rise spectacularly fast. Warrants are very speculative. in bull markets. as gearing works both ways. Compared with company warrants that are issued by the company itself. (page 209). warrants will easily outperform most shares. They are therefore not appropriate for investors who are interested in income. and magnify.700 ABC e CW 120328 STI is the underlying asset Straits Times Index 3. In bull markets. capital gain plays. Hence. Structured warrants are more ﬂexible as their underlying asset is usually either a stock or an index.700 is the Strike Price* ABC is the name of the issuer .2. Warrant-holders get no dividends or any other type of income.208 MAKE YOUR MONEY WORK FOR YOU The major attraction of warrants is this feature of gearing — they track. instead of shares. This and other diﬀerences are summarised in Table 18. Both types of warrants are listed on an exchange and oﬀer leveraged trading. Here’s an example of how a structured warrant is listed on the stock exchange and what each term means: STI 3. Their values are linked to an underlying asset. Structured Warrants Structured warrants and company warrants have many similar features. to gain from the turbo-charged performance of warrants. The advantages of gearing can also be its greatest danger. the underlying asset is the company’s shares. speculators will often ﬂow into warrants.
Company Warrant Issued by the company itself. ** Warrants with American maturity can be exercised at any time before maturity.E 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. which results in share dilution. Underlying asset Any index or company Shares of the listed shares that are not related company. Maturity period Source: Adapted from http://sg. DIFFERENCES BETWEEN STRUCTURED WARRANTS AND COMPANY WARRANTS Structured Warrants Warrant issuer Issued by third parties such as ﬁnancial institutions. new shares.com .2. likely to be 12 months or shorter. 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. can be as long as 5 years. Short term. 209 Understanding Basic Derivatives TABLE 18.warrants. On exercise Does not result in dilution Company will issue of the underlying shares. Long term. to the ﬁnancial institution.
and hopefully we will help you not only make informed decisions. structured deposits and equity-linked notes — these are just some of the names of securities that you might have heard of in the news. In the end. but also ask the right questions to enhance and protect your bottom line. they can be attached to traditional investment assets such as bonds to become structured products. They can stand on their own as a leveraged investment for speculators. In fact. structured deposits and equity-linked notes. . your conceptual understanding will allow you to diﬀerentiate one product from another. That’s probably because derivatives are such highly ﬂexible instruments. the number of combinations is limitless and like in the previous chapter.19 Understanding Structured Products and Other Derivatives CFDs. • Structured products such as guaranteed funds. and have no doubt been intrigued. They can be added to your portfolio to provide temporary protection from an anticipated market downturn. And as you will see in this 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. confused and enlightened by all at the same time. They can be structured to mimic the behaviour of another asset. we will touch on some of the most popular products in the market: • Contracts for Diﬀerence (CFDs).
Hong Kong and even the U. which means a leverage of ﬁve times — every dollar you put down allows you to hold ﬁve dollars of assets. This lets you multiply your proﬁts if the price moves in your favour. The ﬁrst is the initial margin. and putting down $1. In Singapore. The opposite is true as well. you trade on margin like what you would do with futures contracts.000 position. providing hundreds of CFDs in several markets. A CFD mirrors exactly the performance of the underlying stock where the proﬁt or loss is determined by the diﬀerence between the purchase price and the selling price.000 with a broker such as Phillip Securities1 you are able to hold a $5. If price moves against you. This means that by taking a leveraged CFD position on a stock such as Breadtalk. which is the initial amount required to open the position. but if the balance Phillip Securities is one of the top CFD brokers in Singapore. you might want to think about a CFD. Margin is made up of two parts. Margin trading gives you the ability to purchase. If the price of the stock moves in your favour. your losses are multiplied as a result. Because CFDs are leveraged. A CFD thus allows you to trade on the outcome. A CFD is an over-the-counter (OTC) derivative that represents an agreement between two parties (you and the broker) to exchange at the close of the contract the diﬀerence between the closing and opening prices of the contract. including Singapore.S. You would not have voting rights or ownership entitlements such as warrant issues and rights issues. the initial margin level is typically 20 per cent.CONTRACTS FOR DIFFERENCE (CFDS) If you love BreadTalk and can’t seem to get enough of their buns and pastries. Malaysia. A CFD allows you to take a leveraged position on a security such as equities or indices. or performance. 1 211 Understanding Structured Products and Other Derivatives . a stock without putting up the full principal value. or gain an exposure to. no additional margin will be required. CFDs are a very simple type of derivative that oﬀers all the beneﬁts of trading shares without actually having to own them. of Breadtalk and other securities without owning the stock or security.
you can lose more than what you put down. CFDs can be risky and speculative.30%) Financing (5 days) Proﬁt ($) Proﬁt (%) Source: Authors’ own illustration $10.00 (GST excluded) $10.50 / $10.142.50 ($52. Or if it goes against you. This principle is no diﬀerent from buying a home with a loan. Let’s look at a simpliﬁed example in Table 19. and you should know what you’re doing.1% ($2. let’s assume it is also 20 per cent). you put down a deposit (for example.00 $5.1.500 $157.212 MAKE YOUR MONEY WORK FOR YOU goes below a maintenance margin (for simplicity. SAMPLE CFD POSITION IN XYZ STOCK Opening Position: Price of XYZ Number of shares Value of shares Margin Required (20%) Commission (0.000 $50.000 $150. then you will get a margin call to top up so your balance returns to at least the 20 per cent level. If the property market goes up in your favour.150) .150 (margin plus commission) Closing Position (5 days later) Price of XYZ Number of shares Value of shares Commission (0.50 5. 20 per cent) and you borrow the rest (80 per cent). When you buy a home.50 $50.000 $52. your proﬁts are multiplied a few times relative to your initial deposit.1 of a long trade in which you open a CFD position in XYZ stock which is trading TABLE 19.00 $2.30%) Total Value of Transaction $10.142.500 minus commissions and ﬁnance charges) 21.000 $10.
you can compensate for the losses from your actual shares by the proﬁt made with the short CFD position.at $10. To simplify the example. you close out your position for a proﬁt of $2. Long CFD positions are required to pay ﬁnancing since you are eﬀectively borrowing 80 per cent of the total position like in a home mortgage.1 per cent return on the initial investment.00 per share.000 for a $50.000 position. • You can hedge — Suppose you own actual shares of XYZ that you don’t want to sell because your grandmother gave them to you. If. Bear in mind again that as proﬁts are magniﬁed. we assume this is $50 for ﬁve days. in fact. Five days later. 213 Understanding Structured Products and Other Derivatives CFDs in Your Portfolio There are two main ways you can use CFDs: • You can speculate — if you are convinced about the direction of a stock’s price.50. you could speculate by longing (you are bullish) or shorting (you are bearish) the CFD. imagine a 50 per cent drop as a result of the leverage feature. Even if you expect its value to decrease from a market downturn. If you can’t even stomach a 10 per cent drop in your favourite stock. . given a ﬁve per cent move in XYZ’s stock price. The above example shows a 21.50 after subtracting commissions and other expenses. the stock goes down from $10 to $9. You put down an initial margin of $10. so too will your losses be. Since CFDs are margined instruments. any positions held overnight are subject to ﬁnancing. if the price goes in the opposite direction instead. CFDs are bad for your nerves if you are a risk-averse investor. when XYZ has gone up to $10. This is to take into account that your broker is actually lending money to a client or borrowing money from him. you can maintain your ﬁlial duty by opening up a short position using a CFD on the individual share.142.
1 per cent: Return =13. If the technology index does really well and your stock options go up 30 per cent. Your return is zero per cent. Still. if the technology index does poorly.6 per cent of your investment money.1% Congratulations! You have just created your own technology capital guaranteed fund.000.6% x 30% = 4. you are comforted by the fact that you did not lose any money. The Appeal of Guaranteed Funds A basic structured product such as a guaranteed fund has a very simple structure: Capital Guaranteed Fund = Bonds + Higher-risk Investments . STRUCTURED PRODUCTS Suppose you have $1. and we will look at three — capital guaranteed funds. you earn a return of 4.000 to invest. You invest the entire $136 on stock options that are tied to the performance of a technology index.000. you now venture to take a huge risk with the remaining $136 or 13. You buy a high-quality AAArated zero-coupon bond for $864. Structured products are very popular with retail investors. a type of structured product. Since your capital has been “guaranteed”. In three years.214 MAKE YOUR MONEY WORK FOR YOU CFDs 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. structured deposits and equitylinked notes. Because of leverage. your returns can swing very wildly. you walk away with $1. The bond matures in three years’ time whereupon you will receive $1.
billions of dollars have been invested in capital guaranteed funds. In other words. structured products express an investment strategy. A guaranteed fund. is an investment strategy that provides the investor with protection from a downturn. Structured products can be used as an alternative to direct investment. the STI was in a slump. It fell from 2500 in December 1999 to lower than 1300 points 21 months later in September 2001. yet gives the potential of proﬁts should the market go up. They were the rage when the ﬁrst funds appeared at the end of 2000. A good deﬁnition comes from Michael Fraikin. for example. As such. In Singapore. there is hope of an upturn. This is appealing to not only a risk-averse investor. 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 ﬁve years’ time. Hungry investors seized what was a great investment. Would you ever buy a capital guaranteed fund? It is understandable if your answer is “no” since theoretically you can just do this yourself. who deﬁned a structured product as “a systematic way of investing rather than one that centres on the use of derivatives”. Now imagine if you had to pay a commission to someone to create the above structure. the cost and transaction volume requirements of many derivatives are beyond most individual investors. but also one who has the view that while the market could weaken. At the time. . Director of the Global Structured Products Group at INVESCO. However. as a way to reduce portfolio risk. structured products were created to meet speciﬁc needs that cannot be met from traditional ﬁnancial instruments. 215 Understanding Structured Products and Other Derivatives Defining Structured Products The term “structured products” in the market is somewhat unclear and frequently refers to the packaging of derivative products with traditional ones. or to exploit a current market trend.You can create a similar structure on your own.
the appeal of structured deposits lies with depositors. FIGURE 19. It is easy to see why when we look at how low ﬁxed deposit and savings rates have fallen over the years (see Figure 19.46 per cent. What is diﬀerent is that structured deposits were sold as alternatives to ﬁxed deposits. Take structured deposits for example. Billions of dollars too have poured into structured deposits. While capital guaranteed funds appeal more to investors.1.14 per cent.1). This is a very depressing rate for depositors. Around mid-2010. At the start of 2002. BANK FIXED DEPOSIT AND SAVINGS RATE (1995 TO 2010) 6 5 4 Percent (%) 3 2 1 0 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 Bank 12 Month Fixed Deposit Rate Bank Savings Rate .216 MAKE YOUR MONEY WORK FOR YOU Structured Deposits The most serious risk associated with many structured products is that many investors buy them when they don’t quite understand their risk-return characteristics. the rate was 0. 12-month ﬁxed deposit rates were around 2. They 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.
If you are thinking that this is a great deal. the lower the returns. regular payouts) Whatever the amount or the regularity. Chances are that if the income portion is guaranteed. if you are getting a lot of “returns” upfront.What many structured deposits oﬀer are high early payouts. Please ask the salesperson about the capital gains portion. the higher the returns. • The capital is usually protected Capital protection is a little diﬀerent from capital guarantee. Second. Here are a few characteristics about structured deposits that you should know about: • There is often a high early payout (the earliest versions oﬀered lower. so are thousands of depositors. you could even suﬀer capital losses. it does so by oﬀering lower returns. If an investment makes guarantees. A capital guarantee is a guarantee that you will get your capital 217 Understanding Structured Products and Other Derivatives REMINDER — TWO BASIC TRUTHS ABOUT INVESTING First. a structured deposit may oﬀer 8 per cent returns in eight months. . For example.000 invested. do not be too happy yet. the capital gains portion is not. remember that this is just the income portion. And the higher the risk. the most sacred investment truth of all — the lower the risk. And very often. returns consist of two components: Return = Income + Capital Gains So. for example 8 per cent or $80 for every $1. That is just the income portion of your returns.
the bank takes on the risk. MAS has issued a notice that “Unlike traditional deposits. the bank will pay you your money.”2 Equity-Linked Notes An equity-linked note (ELN) is a structured product. If they are both guaranteed. if the capital portion is guaranteed.sg. If the bank buys a bond and the issuer defaults. It starts with a debt instrument. The worst that can happen is when you get a high early payout and get locked in for 10 years. There have been plenty of complaints by investors about structured deposits and how they were being sold. It is diﬀerent from a bond. • Long lock-in period Some funds lock you in for up to 10 years and there is a penalty for early withdrawal. But when they learned that they needed cash and wanted to liquidate. structured deposits have an investment element and returns may vary. .gov. So while capital protection is still low risk to you (the bonds purchased are usually good quality). the income portion is probably not.218 MAKE YOUR MONEY WORK FOR YOU 2 back. They are not. 7 October 2004. you can't then expect the returns to be great. There were also complaints that banks were selling structured deposits as if they were simple deposit products. Some investors complained that they were lured by the high early payouts. And then at the end of the period. The next time you read a product brochure and you are confused. the bank passes the risk to you if the issuer defaults. If the income portion is guaranteed. www. With protection. usually a bond. they got upset by the penalties for early withdrawal.mas. Or. you ﬁnd out that you would not be getting any extra returns because the options and other higher risk investments failed to perform. MAS Guidelines on Structured Deposits. which is unlikely. With the guarantee. it is not risk-free. the capital portion is probably not guaranteed. think about it this way.
however, in that the ﬁnal 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 diﬀerent from being capital-guaranteed. A common feature is that the ﬁnal 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 diﬀerent from that of a capital-guaranteed fund.
219 Understanding Structured Products and Other Derivatives
MANAGING STRUCTURED PRODUCTS IN YOUR PORTFOLIO
Structured products may be suitable for you if you have suﬃcient cash elsewhere so that the possibility of an early withdrawal is remote. If you want to enhance returns on your ﬁxed 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.
20 Understanding Currency
Currency movements seem to be favouring Singaporeans these days. The US$ is weak. The 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
USD / SGD
1.9 1.8 Exchange rate 1.7 1.6 1.5 1.4 4 1.3 1.2 Jan 94 Jan 97 Jan 00 Jan 03 Jan 05 Jan 09 Jul 95 Jul 98 Jul 01 Jul 04 Jul 07 Jul 10
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 INVESTING
Investing in currencies is becoming quite popular these days. Everyone from housewives to doctors seem to have a view of where
the 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 ﬁt into your supplementary bucket. Each country has its own currency. Singapore’s oﬃcial currency is the Singapore dollar. Switzerland’s oﬃcial currency is the Swiss franc, and Japan’s oﬃcial 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.
221 Understanding Currency
CHANGING ON THE SPOT
We 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$10,000 exchanged to spend on luxurious spa treatments, the money changer would quote you a “spot exchange rate”, so called because the exchange is made on the spot for immediate delivery. The price you pay to buy US$ 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? The 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.
222 MAKE YOUR MONEY WORK FOR YOU
Of 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$10,000. You may be asking whether or not it is possible to “ﬁx” the rate you pay one year ahead of time? By doing so, you will know ahead of time what rate you will pay exactly, thus removing the uncertainty of rates moving against you.
Fixing Rates Ahead of Time
There are a few common ways to ﬁx rates ahead of time. One way is to open a 12-month foreign currency time deposit by accepting the spot exchange rate that the bank is oﬀering today. Of course, you would opt for this only when you are comfortable with today’s exchange rate and you don’t mind locking this in today. So if the US$/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$10,000 plus interest. If you did not ﬁx the rate, then you would face the risk of the US$/ 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 oﬀer time deposits based on maturities of between one week and 12 months. If you need a more ﬂexible time frame, you may consider a customised contract called a forward contract where you and the bank can agree to a schedule of ﬁxed 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 oﬀering. For example, if you have a recently deceased wealthy relative from Australia who left you A$5 million and her will instructs that A$500,000 be transferred to you every six months for a total of 10 payments, then this might be a good situation in which to approach the bank to structure a forward contract to lock in a series of 10 exchange rates.
What we just discussed is called hedging your currency risk, where you manage your risk by locking in an exchange rate today to buy or sell a currency in the future.
223 Understanding Currency
WHAT AFFECTS EXCHANGE RATES?
The most fundamental factor that aﬀects exchange rates is demand for the currency. If the demand for a currency is high, then the currency tends to be strong. So when you are trying to ﬁgure out whether the US$ is going to strengthen in the next 12 months, you need to ﬁnd 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. This 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 inﬂuence on currencies. A rise in the price of oil will positively aﬀect the currency of an oil-exporting
suppose your bank oﬀers 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 trading line. Such accounts are called leveraged accounts because you are able to trade using “borrowed” money. If you obtain a trading line with a leverage of 10 times. To see how this works. 10 or more times what you deposit.000 and a leverage of 10 times. High global demand for non-oil commodities such as iron ore and wheat has also beneﬁted major commodity exporters such as Australia.000. This makes sense as a rising stock market is an indication that the country’s economic prospects are positive. On . but also to grant you a trading line that is ﬁve.S. For example. suppose you have a trading account with an initial deposit of US$50. 4.224 MAKE YOUR MONEY WORK FOR YOU country such as Saudi Arabia and Canada. then you may wish to open a currency trading account. This means that you will receive a US$500.000 to start). and negatively aﬀect oil-importing countries such as the U. then your losses and gains can be magniﬁed 10 times. 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. The risk of leveraged accounts is that they magnify your gains as well as your losses by the amount of leverage. Stock market performance — The overall direction in stock prices has an impact on currencies as money ﬂows into countries with rising stock markets. SPECULATING IN FOREIGN CURRENCY If instead you want to speculate and take on risk because you have a certain view about where a currency is headed. and hence the greater the demand for the country’s assets and currency.
000 Your loss is US$45.000 and sell YEN for settlement on 19 April (1 month forward). you commit to buy US$ 500.45 Sell JPY50. you have the view that US$ will weaken against the Japanese Yen.000. Exchange Rate JPY 95 / US$1 Buy US$526.79 Sell JPY50. fewer JPY are now needed to buy US$1. Outcome 2: US$ Weakens — You make a proﬁt On 1 July .79 (US$526. your loss would be 10 times less or 9.315.545. This represents a return of 53 per cent on your initial deposit of .000).454.000.45).000 225 Understanding Currency Two possible outcomes can happen: Outcome 1: US$ Strengthens — You lose money On 1 July. You decide to buy Yen against US$500.55 (US$500. Had your account not been leveraged. more JPY are now needed to buy US$1.000.000 Your gain is US$26.315.000. US$1 now buys more JPY or said another way.79 minus US$500. US$1 now buys fewer JPY or put another way.000 minus US$454. This represents a loss of 91 per cent on your initial deposit of US$50.315. the US$ strengthens to JPY 110.1 June. On 19 March.000 based on a rate of JPY 100 = US$1 to be settled one month later on 1 July.545. Exchange Rate JPY 110 / US$1 Buy US$454. Exchange Rate JPY 100 / US$1 Buy JPY 50.1 per cent.000 Sell US$500. the US$ weakens to JPY 95.
Your potential losses and proﬁts in foreign currency trading can be substantial because of the volatility of exchange rates and the leverage oﬀered on trading accounts. From what she described. the HK$ becomes costlier to buy. a case in point being the foreign currency trading losses of SembCorp of US$248 million. Had your account not been leveraged. You’re ﬁne with this arrangement except that you get a very low return on your savings account. Not only were there exchange losses but also. which came about from just one individual. you have to accept whatever the exchange rate is at the time you travel and the risk each time is that if the S$ falls in value. you visit the money changer to get HK$ for whatever the spot HK$/S$ rate is. whether the stock market is headed up or down. So. These funds are managed by currency specialists who follow the market very closely with research and analysis.226 MAKE YOUR MONEY WORK FOR YOU US$50. The actual dates on which you travel are not known ahead of time and you’ve travelled on short notice a few times.000.000 in your savings account for this purpose. . fell more than 15 per cent when the news broke.3 per cent. and each time you go. its mother SembMarine shares. you’ve travelled to Hong Kong several times a year to shop. CURRENCY UNIT TRUSTS If you still want to take on risk and beneﬁt from currency movements. the losses can be extreme. Also. you can consider unit trusts that take positions on currencies. And in certain cases. your proﬁt would be 10 times less or 5. DUAL CURRENCY INVESTMENTS Suppose for the last few years. The relationship manager (RM) at the bank calls you one day about a dual currency investment (DCI). separate from your other monies. They 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. You’ve set aside S$50. currency funds are able to generate positive returns.
S$ SCENARIOS Scenario 1 Rate on maturity date S$ weakens to 0.000. On maturity.200 / 0.20.the DCI seems to ﬁt your needs. which is far higher than what you are getting from your savings account. You then select a suitable maturity date. and one that you are comfortable with if you had to exchange S$ for HK$.20. say you invest S$50.000 at a strike price of HK$/S$ = 0. On maturity. you choose one month.000 (S$50. you would get an attractive S$200 worth of interest.8 per cent. The interest earned based on a S$50. First of all. If the S$ strengthens as in Scenario 2.15 Principal & interest to be paid in HK$ HK$251.8% X 1/12 = S$200 You next invest by choosing two currencies.000 investment would be: S$50. depending on which is the weaker currency when measured against a pre-determined exchange rate (called the strike price).200 Scenario 2 S$ strengthens to 0. Note that this strike price is a value that you agree with the bank. and the other as the alternate currency (the HK$). S$). one as the base currency (in this case. if the S$ weakens against the HK$ as in Scenario 1. you get paid in either the base or alternate currency. ranging from a few weeks to up to six months. suppose the S$ weakens or strengthens as follows: 227 Understanding Currency TABLE 20. based on an exchange rate of 0.25 Payout currency Principal + interest received Principal & interest to be paid in S$ S$50. To see how this works.000 X 4.1.20) Source: Authors’ own illustration In sum. which was an exchange rate you were . which is far more than you would have achieved leaving it in your savings account. it provides an attractive return of 4. you get HK$251.
And if you want to take advantage of the fact that the HK$ is now cheaper. only if you choose to convert the HK$ back to S$. a huge diﬀerence of HK$62. the rest of the deal is not attractive. Note that if you had not gone into the investment. converting the HK$ back to S$ is not a consideration for you.750 rather than HK$251.000. since you do plan to have HK$ anyway.228 MAKE YOUR MONEY WORK FOR YOU comfortable with at the start. and wish to earn an attractive return on your principal. But again. you don’t get all the proﬁts except a higher-than-market yield. calling them attractive investments that are without much bite.750. you could buy more at S$0. But if you are a maturing and increasingly sophisticated investor. While the high interest rate is attractive. If your foreign currency goes down (the HK$ weakens as in Scenario 2). not inside Singapore. you must take all the losses — but of course. With Scenario 2. FINAL WORD As you have seen from the examples above. you could have exchanged your S$ at a more attractive rate of 0.200. currency investing can be mind-boggling.000 x 0. you can actually lose quite a lot of money if you decide to convert the HK$ back to S$: HK$251. But if the S$ weakens (the HK$ strengthens as in Scenario 1). So the bottom line is that if you are planning to speculate because you have a view on a pair of currencies. then DCI may be suitable for you. The reason you may not see .650 This translates to a loss of S$12. understanding currency products is a must. 4.15 = S$ 37.350 or nearly 25 per cent. you would have obtained HK$313. you would get limited proﬁts with unlimited losses.15. Having a globally diversiﬁed portfolio means that most of your money is invested outside.8 per cent in our example. Based on an amount of S$50.15. But if you are comfortable holding money in either currency. Some ﬁnancial commentators have written against DCI.
Singaporeans are becoming more interested in direct investments in other countries and alternative investments such as real estate and wine. you will need to deal with foreign currencies. Having a good understanding of what makes foreign currencies move is absolutely necessary. 229 Understanding Currency . if you are a unit trust investor.this is that. As you make more of such investments. the currency translations and movements are hidden away from you for convenience.
from basic investment concepts to investing in traditional and alternative products. during retirement. we turn our attention to special topics such as investing for kids. we discuss what we can do to protect our portfolios more actively whether the market is in an upturn or downturn. . In the final chapter. your rights as an investor. and whether or not you should get professional financial advice. In this last section.PART 4 SPECIAL TOPICS We have covered a fair bit of ground in the first three parts.
who will win? Your kids. you have probably already tried to get a sense of how much it will cost to send them to university. by the time our children are ready for university. What you want to avoid is ﬁnd yourself broke after having taken care of all your children’s educational needs. So when putting together a strategy for your child’s education. Your child’s education comes second. When you are faced with the monumental task of saving for your child’s university education. or yourself? Most of the time. thereby placing yourself in a position of dependency. Many people often go the distance for family members and forget to take care of themselves. whether this be through loans. Saving for retirement always comes ﬁrst. co-payment or some other means. Investing GOLDEN RULE OF INVESTING FOR KIDS Back to the question above — in the tussle for your money. it is usually about the time we retire. Unfortunately. consider these three steps: . You and your child can ﬁgure out ways of getting him through school when the time comes. There will be a tussle for money — should you provide for your kids ﬁrst 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 ﬁnancially responsible so that we won’t have to support them in our old age. That is a big mistake.21 231 Investing for Kids If you have young children like we do. you will give in to your kids and that will mean less for your retirement. it is easy to forget about saving for your own retirement.
000. Remember: Do not give them everything. the cheapest overseas location popular with students. we get depressed.000. 3. Going to Canada. Every month. How much does a basic four-year science degree cost all-in? Based on our compilation. 1 Basic cost information was taken from the 13 April 2010 Straits Times article “Fee hike unlikely to deter foreign students. and no more. If you have two or more children. you will be doing them a favour. As far we can see. Tertiary expenses include tuition.1 the cost of a four-year science degree from a Singapore university was S$140. The rest of your savings should go into your retirement account.000 dollars in the 2010 academic year. it will cost the equivalent of half a three-room HDB ﬂat to educate one child in Singapore today. would cost $185. the cost of educating your child in Singapore starting in 2020 is $250. it will require putting aside more money than you could possibly aﬀord.” and then projections were made. and one entire four-room ﬂat if your child furthers his/her studies overseas. To send your children overseas. 2. set aside the minimum needed for education funding and no more. . books. 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. travel and accommodation. Set a goal to save for up to two years of university expenses. If we project an education inﬂation rate of six per cent. Make them work for part of it.232 MAKE YOUR MONEY WORK FOR YOU 1. By teaching them ﬁnancial responsibility. you’ll have to be a millionaire probably a few times over.
1 COST OF FOUR-YEAR SCIENCE DEGREE Country 2010 2020 Singapore Canada Britain Australia USA $140. But you can at least use the ﬁgures in Table 21.000. 2.00 $220.00 $185. 233 Investing for Kids TABLE 21. Table 21.00 $230. (page 234) shows a framework for managing your asset allocation as time moves forward.000.It’s not possible to project what it will cost exactly.00 $320.000. Note: Figures are rounded to nearest ﬁve thousand and includes cost of living expenses. the nearer your child is to university. .000. invest your money aggressively with as much stock funds as your risk tolerance allows.00 Source: Authors’ own compilation. Investing for pre-teens If your child is under 13. Investing for teenagers By this time.000.2. and it is hoped this will stir you into action.000.00 $410.000.1 to obtain an idea of what your children’s education would cost. the less risk you can aﬀord to take. you would have begun to switch gradually out of stocks and into bonds.000. 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. Let us assume traditional investments such as unit trusts and bonds are used in the following examples: 1.000.00 $250. Investing for University How you invest depends on when the money is needed.00 $570.00 $330.000. Assuming the university going age is 18.00 $400.
however. The scheme only covers full-time courses oﬀered locally. SOME OTHER MATTERS TO CONSIDER Here are some other options and matters to consider: Borrow From Your CPF (Ordinary Account) Your child can borrow against your CPF. but start to be drawn down as short-term bonds and cash increase as time passes. ASSET ALLOCATION IN RELATION TO CHILD'S AGE CHILD'S <9 AGE Stock funds % Bond funds % Short-term bonds % Cash % TOTAL 100 100 100 100 100 100 80 20 9 80 20 10 70 30 11 70 30 12 60 40 13 50 40 10 14 40 30 20 10 100 15 30 20 30 20 100 16 20 10 50 20 100 17 10 18 0 70 20 100 70 30 100 Source: Authors’ own calculations Table 21. plus interest. the CPF Board will actually take action to recover the money borrowed. There are many conditions to satisfy. • We suggest short-term individual bonds that are held to maturity. and pay it back as soon as he starts working. or get ﬁnancial advice. Holding bonds to maturity oﬀer a known yield and certain cash when the money is needed. • Bond funds ﬁll the diﬀerence initially. so please do your homework.2. What if your child decides not to pay up? Well. . shows: • The exposure to stock funds gets lower and lower as time passes.2.234 MAKE YOUR MONEY WORK FOR YOU TABLE 21.
if they have been exposed to the mechanics of saving. but very soon. parents used to be able to rely on their children to support them in their old age. It took Sarah some time to get used to the new habit. Ken would put in $2. the better oﬀ everyone will be. Ken deposited twice what Sarah managed to save each day. Things have changed. So if Sarah saved $1. Youngsters We have a friend Ken. If your son . Think how absolutely thrilling it is for children to be able to watch their money grow! Teenagers Most teenagers. We ﬁgure that the more ﬁnancially literate our children are. she was ﬁlling the piggy bank happily. When the piggy bank was full. we will still be supporting our kids. Ken opened a POSB account. you may not even have money to cover the ﬁrst year of your child's education. who bought his eight-year-old daughter Sarah a piggy bank. Real estate is too risky for such a near-term objective. But as a savings tool. Because we marry later and have children later. Ken told Sarah that her university tuition cost is going to be shared 50-50. This was an important lesson. so she should start saving up part of her allowance. jiggling it ever so often to hear if it was full. it is entirely possible that by the time we retire. will sooner or later show an interest in investing. 235 Investing for Kids Teaching Your Kids about Investing In the old days. If you take a large loan and the market collapses. it just does not generate suﬃcient returns.Investments to Avoid Cash value life insurance serves a great purpose in providing protection for the whole of your life. Sarah learned that money that is wisely put away can grow. To give Sarah the incentive to save. With the interest from POSB.
Better still. is best learnt while young. but regular discussions will show the next generation that ﬁnancial planning is fun and should be part of everyday life. 15 or 30. try signing up for a joint beneﬁciary account with one of the online fund distributors and buy a unit trust or two. like any other skill. they would have learned one of the most important rules in investing: that even the best investments may hit a snag. You don’t need a huge portfolio. Do not discourage him. let him choose which fund to buy and ask him why.000 in the bank. ONE LAST THOUGHT Whether your child is ﬁve. . You will soon see them going to the newspapers for the latest prices.236 MAKE YOUR MONEY WORK FOR YOU has $2. Investment. always discuss family investments in their presence. Even if the chosen fund bombed out.
1. The fact is that while retirees need income and safety from their investments. how will you have enough to last you through your retirement years? . How is one to achieve growth. Take a look at Table 22. we know that inﬂation has frequently been higher than ﬁxed deposit rates. based on an inﬂation rate of 2 per cent. It is a balancing act. in order to meet their near-term and long-term needs.22 Investing During Retirement Contrary to what many people think. they will have started to adjust their portfolios along the way by switching to bonds and withdrawing from riskier instruments. If you are not growing your money during retirement. What is really important now is to ﬁnd ways to satisfy their need for both income and growth. Looking at history. (page 238) which shows how much living costs can increase over a long retirement. without taking too much risk? There 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 inﬂation? HOW INFLATION CAN CREATE AN UNHAPPY RETIREMENT When I hear retirees talk about how their portfolios consist mainly of ﬁxed deposits. we cringe. which is essential to meet rising future income needs. Why? Because we know inﬂation will cause them to end up with less money to spend. As they move towards retirement. retirees need not make major changes to the way they invest. they also need growth.
719 32. is getting ready to retire and he estimates that his living expenses in his ﬁrst year of retirement will be $40.000 33.624 82.996 99.835 67.204 36.812 36.326 97. (page 239) which shows the number of years money will last at a given rate of return.227 39.402 60. Let us consider Table 22.000 22.998 44.994 66.876 131.380 26. He could withdraw 12 per cent or $36. HOW LONG WILL YOUR MONEY LAST? This is the big question. you can withdraw $30.482 70.842 126. That is $500 more per month. and a withdrawal rate.000 40.293 44.454 90. If you have $300. your money will last 13 years.341 72.248 144.211 104.000 88.218 65.760 60.000 66.1.297 49.330 94.682 119.245 73.000 77.122 44.000 in your retirement fund.950 40.991 176.2 shows that if your retirement dollars can earn 5 per cent a year and you withdraw 10 per cent of your money each year.157 98.578 59.376 53.140 80. it can quickly add up over a long retirement. Daniel will need $59. By age 80.241 88.000.669 118.917 29. While inﬂation in Singapore has been low.2. aged 59.000 per year for 13 years. Keeping most of your money in a ﬁxed deposit is not a good long-term retirement plan.436 108.000 per year for 13 years. Now suppose your buddy Joe invests his money at 8 per cent.643 Source: Authors’ own computations Let us go through an example. LIVING EXPENSES DURING RETIREMENT ADJUSTED FOR INFLATION Age Annual Living Expenses Adjusted for 2% Inﬂation 60 65 70 75 80 85 90 95 100 20.000 50.082 24.438 a year or 50 per cent more than he started out with.238 MAKE YOUR MONEY WORK FOR YOU TABLE 22.438 74.520 107.795 139.030 54.563 80.322 110.752 89.993 132.570 48.286 85.909 159.161 30.016 114. .997 79.163 55. Table 22. Suppose Daniel.568 59.992 154.
When you add riskier investments such as equities to your bond portfolio. . but it is true. By adding equities to your portfolio. Together. The reason is that equity and bond prices do not move together. you can reduce your portfolio’s overall risk. or about 20 per cent. A sudden rise in interest rates near the time you need the money can ruin your retirement party. Lower overall portfolio risk This sounds weird. they usually lead to a reduction of overall portfolio risk. The volatility of equities balances out the volatility of bonds. HOW LONG WILL YOUR MONEY LAST? Rate of Capital Withdrawal (% per year) 6 5% 6 7 8 9 10 11 12 Source: Authors' own computations 239 Investing During Retirement 7 24 32 8 19 22 30 9 15 17 20 27 10 13 14 16 19 25 11 11 12 14 15 18 24 12 10 11 12 13 15 17 22 13 9 10 10 11 12 14 16 20 14 8 9 9 10 11 12 13 15 15 8 8 8 9 10 10 11 13 16 7 7 8 8 9 9 10 11 35 SHOULD YOUR PORTFOLIO HAVE ZERO EQUITIES? Bonds are less risky than stocks. they are not totally immune to volatility.2.TABLE 22. you obtain: 1. But that does not mean the retiree should invest 100 per cent in bonds. While bonds are less volatile. studies show that retirees should have a healthy amount of stocks in their portfolios. In fact.
You obviously would not know how many years of life you have after 60. Higher overall portfolio returns Equities will oﬀer you the growth to counter inﬂation as well as increase your income for a nice. So if you plan to retire at 60. First. BEGIN YOUR RETIREMENT PLAN TODAY Now that you have some idea about what it means to retire.1. what lump sum will you have at retirement? Let us suppose you expect to have one million dollars. you will have 30 years of retirement. let us formulate a plan of action. . long retirement.000 annually. Second. HOW EQUITIES AND BONDS TOGETHER REDUCE PORTFOLIO RISK Equities Bonds Portfolio becomes less volatile Source: Authors’ own illustration 2.240 MAKE YOUR MONEY WORK FOR YOU FIGURE 22. begin by stating your number of retirement years. To be safe. expect to live till 90. This amount invested at 6 per cent will last 30 years if you withdraw 7 per cent or $70.
Consider Getting Professional Advice If choosing investments that strike the right balance between growth and protection seems too daunting for you at this time. save and invest like crazy. you could beneﬁt from the advice of a ﬁnancial adviser. We have seen more than a few of our middle-age friends get hoodwinked by these schemes. Even when you are anxious. don’t further endanger your future. Avoid “Get Rich” Traps The newspapers and internet are ﬁlled with get-rich.Third. unexpected expenses and your children’s education got in the way of a regular savings plan. None of us wants a scaled-down lifestyle during retirement. 241 Investing During Retirement IF YOU HAVE NOT INVESTED MUCH — HOW TO CATCH UP You had wanted to start investing for retirement years ago. With only 10 to 15 years till retirement. Or maybe you are counting on your CPF money. you cannot aﬀord to wait any longer. and help determine the most appropriate asset allocation to meet your retirement goals. low-risk schemes. you need to choose investments that will provide growth potential as well as security. do not dispose of your common sense. But monthly bills. A ﬁnancial adviser can help you choose funds. A balanced portfolio of 40 per cent in equities and 60 per cent in bonds would be a good start. But you now know that your CPF funds are not going to be enough to support you comfortably through 30 years of retirement. stocks and bonds. . Stash the money aside today so that you can live it up during your retirement. If you are now in your 40s or 50s and have yet to start building a retirement nest egg. If you are on a late start.
It can be fun especially when you have a job you enjoy. If cutting your expenses is not ﬁnding you enough money. consider getting them to take a loan instead. The income from a second job for a few years could get you back on track. It is one of the most ﬁnancially draining things to own. Make a commitment to live more frugally. You do not have to go hungry. while you have a short time to prepare for retirement. consider selling your car.242 MAKE YOUR MONEY WORK FOR YOU Finding the Money Finding the money to invest is a big challenge because you do not have the luxury of time. If one of your challenges is funding your children’s university. They will have a long time to pay it oﬀ . but you can go to fewer expensive restaurants. You could also consider a second job. consider postponing your retirement by ﬁve years. Working past your 65th birthday is nothing to dread when you need money. And ﬁnally. . go for cheaper holidays and look out for bargains when you shop. you would have to cut back on your current spending to ﬁnd money to invest. Most likely.
1. health and wealth UL N IO AT IN VE ST IN G NG VI SA S IN SU RA NC E . it’s necessary to your ﬁnancial plan. health and life.23 243 Protecting Your Wealth with Insurance You might be asking why we are talking about insurance in an investment book. but certain things absolutely need to be properly insured. This is where protection is needed. These include your life. Well the reason is simple. you probably already have a fair amount of insurance to protect your home. car and home as indicated by the bottom layer of the pyramid shown below (see Figure 23. Protecting Your Wealth with Insurance FIGURE 23. income. investing and planning for the future won’t mean much if an unforeseen event such as an accident or business failure leaves you ﬁnancially devastated. health. You have worked hard to build wealth and put your ﬁnances in order. You understand that while insurance may seem like an added expense in your budget. Saving. and you don’t want to leave your ﬁnancial security to chance. Like most people.) We will assume that you have already taken proper care of those basic insurance needs. You can insure almost anything under the sun.1 INSURANCE: THE FOUNDATION OF FINANCIAL SECURITY EC SP Higher possibility of loss Principal not guaranteed Diversify your Investments Principal is safe Save 6 months’ salary for emergencies Foundation of your Financial Security Protect your life.
244 MAKE YOUR MONEY WORK FOR YOU
The type of insurance we are discussing in this chapter deals with protecting wealth that you already have acquired. That’s right. We are assuming that you are aﬄuent with a fair amount of wealth accumulated or you are steadily on the way to becoming ﬁnancially comfortable. In fact, even if you are still busy building wealth for your ﬁnancial 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. Aﬄuent 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. The reasons for protection usually range from wanting to pass on as much wealth as they can to their families to funding a charity. They want to meet these goals without causing a huge drain in their wealth or aﬀecting their ability to continue their present lifestyles. For these reasons, aﬄuent individuals like Sally should consider life insurance; a vital component of their long-term planning.
INTRODUCING UNIVERSAL LIFE
These days, aﬄuent 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 diﬀerences. Universal life insurance is a form of “interest sensitive” type of WL that oﬀers a death beneﬁt, and because of its ﬂexible premium feature, it provides the opportunity to build cash values that the policy holder can borrow from or withdraw. The policy cash values earn interest at a declared rate, which may change over time. Most
UL plans guarantee a minimum interest crediting rate. Within certain limits the policy holder can choose the amount, method and timing of the premium, payments. There are three areas where UL diﬀers from WL. Firstly, UL insurance oﬀers a more transparent fee structure. That 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. Thirdly, UL policies have sums assured typically in the millions of dollars. For families of the aﬄuent, the only thing more challenging than attaining wealth is protecting it, keeping it for a lifetime and for the next generation. This 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 beneﬁt is usually guaranteed. It also serves as form of diversiﬁcation to other investment assets. This means that despite the occasional declines in the stock and bond market the value held in a UL policy may remain unaﬀected.
245 Protecting Your Wealth with Insurance
TABLE 23.1. SOME DIFFERENCES BETWEEN TERM, WHOLE LIFE AND UNIVERSAL LIFE INSURANCE
Term Insurance Duration Premium Cash Value Fixed such as 10 or 20 years. Usually ﬁxed. None. Whole Life Permanent, all of life. Guaranteed ﬁxed. Projected cash value. For those who are conservative savers and want protection all of life. Universal Life Permanent, all of life. Flexible. Guarantee minimum interest crediting rate. For those who want a large amount of protection and access to cash values that grow at competitive interest rates.
Suitable For those who for Whom seek pure protection for a ﬁxed period and because it’s aﬀordable.
246 MAKE YOUR MONEY WORK FOR YOU
Let’s now turn to two situations in which aﬄuent 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) Cash Accounts receivables Commercial property TOTAL ASSETS 5 10 25 40 TOTAL LIABILITIES 25 NET ASSETS 15 LIABILITIES (in Millions) Accounts payable Property loan 5 20
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 ﬁnancials, 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. The
company’s creditors and customers lost conﬁdence in the company. Suppliers demanded to be paid. The 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 ﬁre-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-eﬀective ways of funding such plans. Yet business owners often shy away from insurance. When Kim ﬁrst took out a loan to buy the commercial property, her ﬁnancial 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 ﬁnancial 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 ﬁnding and training a replacement. John Leaves a Legacy to His Favorite Charity Aﬄuent people are some of the most generous givers to charitable causes. To them, giving back can be one of the most fulﬁlling experiences of their lives, but they want to do so without wrecking their retirement plans. This is where life insurance can help.
247 Protecting Your Wealth with Insurance
248 MAKE YOUR MONEY WORK FOR YOU
Suppose 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 beneﬁciary of his policy. The price of a $1 million UL policy for a 40-year-old male nonsmoker 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.
UL policies have a place in your portfolio even when you are aﬄuent. 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 ﬁnd with your ﬁnancial adviser to examine your ﬁnancial 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 oﬀshore 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 oﬀshore, 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 ﬂexibility of UL policies to make adjustments as your circumstances change.
the price of the unit trust falls 30 per cent. You think the relationship manager pressured you into buying. There are countless opportunities to pick up investment tips. This is a common story — investors losing money from investments that have gone sour. a relationship manager tried to interest you in an Asian unit trust. In this chapter. 1 Visit MoneySENSE at www. web tools and other seminars. Despite being new to investing. You’re very upset. What can you do when things go wrong? While there will always be cases of unscrupulous salespersons who take advantage of unwary consumers. we will discuss your rights as an investor and what you can do when things go wrong. the fact is that many of us are capable of making appropriate investment decisions. newspaper articles. One month later.gov. ﬁnancial advisers. You can learn more from consumer guides. including the many educational programmes and seminars sponsored by the government as well as investment companies.24 When Things Go Wrong You went to the bank to deposit money into your savings account. You feel you should not have bought the unit trust. TV programmes. insurance companies and stock brokerages — are fair and even-handed in their dealings with the investing public.mas. Constant scrutiny by the media and regulatory watchdogs such as MAS have contributed to this practice of fair dealing.1 Fortunately for consumers. You decided to invest the money that was meant for your savings account.sg . most ﬁnancial services companies — banks. While there. you were won over by the relationship manager’s convincing presentation.
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. whether you own 1. Looking at the glossy pages in an annual report or the numbers in the ﬁnancial statement seldom gives a clear understanding of the management’s style and objectives. The Right to Information One of your most important rights is that the management keeps you informed about the progress of. You should understand that disclosure aims to put you on equal footing with every other investor. especially minority ones. and that even the most transparent disclosure provides no guarantee against loss. Every investor should attempt to attend annual meetings as they give a clearer insight into how the aﬀairs of companies are conducted. 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. You own part of the company and the company’s management board is answerable to you.250 MAKE YOUR MONEY WORK FOR YOU YOUR RIGHTS AS A SHAREHOLDER As a shareholder. . Of course. you have certain rights. The Proxy Statement The 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.000 shares or 10. the law has to strike a balance. and the material developments that aﬀect the company as it is required by law to do. If you are investing a large sum of money in a company.000 shares. The Annual General Meeting (AGM) The annual general meeting (AGM) is an important occasion for shareholders. to meet and ask questions. big or small.
For example. you can vote against re-electing the present management. As a shareholder. your best option. Hence. which may include issues such as approval for ﬁnancial statements. it is not uncommon for a law-abiding. you should contact MAS or the police. or the way an account was handled. If the investment was related to securities. declaration of dividends. It is generally diﬃcult for individual shareholders to get rid of the existing management unless it has openly performed ﬂagrant acts such as fraud. Errors that occur are simply errors . is to walk away by selling your shares. if you feel a company’s management is doing a poor job. but mediocre management to continue running a public company for a number of years. A proxy also provides for a negative vote. The ﬁrst consists of outright criminal activity such as stealing and cheating of money through some sort of scam or phony transaction. you may be surprised to receive a conﬁrmation via e-mail about a stock you have sold. Or you may be surprised at the price at which your unit trust was sold when you had told your ﬁnancial adviser to transact at a distinctly higher price. although you never gave such an order. Most ﬁnancial advisers and institutions are honest and fair in their dealings with investors. particularly if ownership of the company’s shares is fragmented. So unless you own a substantial amount of shares (5 per cent or more).There is usually a section on the voting of resolutions. The second and more common category of problems encountered by individual investors has to do with the execution of a trade. 251 When Things Go Wrong WHEN SOMETHING GOES WRONG Most problems investors face fall into one of two categories. a proxy statement is a ballot sent to a company’s shareholders whereby the company requests that shareholders vote in favour of its oﬃcers and directors continuing in their positions. proposals for additions to the board of directors and remuneration for auditors. In essence.
. please see “Getting it Right: How to Resolve a Problem with your Financial Institution”. Where to Turn for Help Should you still feel that you have been unfairly treated. Consumers pay a 2 For a more detailed explanation on dispute resolution. 2. capital market disputes and all other disputes (including third party claims and market conduct claims): up to S$50.252 MAKE YOUR MONEY WORK FOR YOU and there is rarely an intention to cheat. consumers can go to FIDReC in the following situations: 1. Such errors are generally corrected as soon as they are brought to the attention of the company representative who sold you the investment. you can consider a dispute resolution scheme.gov. (FIDReC) is an independent institution specialising in the resolution of disputes between ﬁnancial institutions and consumers.000. FIDReC’s services are available to all consumers who are individuals or sole-proprietors. You can submit an oﬃcial letter of complaint to the ﬁnancial institution.000. If this does not resolve your problem. FIDReC provides an aﬀordable and accessible one-stop avenue for consumers to resolve their disputes with ﬁnancial institutions without having to go to court.2 The Financial Industry Disputes Resolution Centre Ltd. 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 ﬁnancial sector of Singapore. For disputes between banks and consumers. At present. which is a costlier and more timeconsuming option. a MoneySENSE Consumer Guide at www.mas.sg. For claims between insured consumers and insurance companies: up to S$100. there are several ways to seek redress. For example.
3 253 When Things Go Wrong 3 For more information. In general. Not every complaint is heard by the committee. These organisations handle disputes across all types of products and services. If you do not accept the panel’s ruling. and not just those on ﬁnancial matters. The panel will give you access to a pool of industry experts and professionals. the matter is referred to SGX. 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. www. If the complaint is serious and it contravenes the bye-laws of SGX.gov.sg.com. The panel has the authority to order the ﬁnancial institution to do certain things. www. You may even go one step further by seeking the help of a panel of mediators appointed by FIDReC. the committee will seek a cordial settlement with the broking house concerned.org. such as perform their contractual obligations or make monetary awards.sias. taking legal action should be the last resort as it is usually time-consuming and costly. sg. If you have a problem with your remisier. please visit these websites: www. and the ﬁnancial institution pays S$500. but not on you.sg.ﬁdrec. If the complaint is justiﬁed.mas. you can choose to pursue legal action or approach the Consumers Association of Singapore (CASE). www.org. the Singapore Mediation Centre (SMC) or the Small Claims Tribunal (SCT).nominal administrative fee of S$50 when their cases proceed for adjudication.sg .case.com. sgx. As with FIDReC. and www. legal action is avoided. Its rulings are binding on the ﬁnancial institution.
oﬀering a very nice return of 25 per cent annually over ﬁve years. FIGURE 25.25 Getting Financial Advice Are you a DIY (do-it-yourself ) investor? Or do you prefer to work with a ﬁnancial adviser and let him help with the analysis? As it turns out. market between 1995 and 2000. investors felt that ﬁnancial advisers were unlikely to be able to add further value. according to a survey. from 500 to 1500 points. your answer could very well depend on market conditions. your answer would have been “no”. the S&P 500 tripled in value.1. S&P 500 BETWEEN 1985 AND 2010 2000 1500 1000 500 0 1985 1990 1995 2000 2005 2010 Source: Standard & Poor’s As the market rose. That is because during that time. In such an euphoric environment.S. If you were invested in the U. people started to liken the market to a moneymaking machine. .
when the S&P fell 50 per cent. Have you a game plan when that happens? 2. Every six months. or at some ﬁxed interval. This is time that is taken away from your family. Time Investing on your own takes time. How much time are you willing to spend constructing and monitoring your portfolio. 2. answer these two questions: 1. who shared the Nobel Prize in Economics with Vernon L. Discipline Financial advisers use a structured process to manage your investments. 255 Getting Financial Advice DO YOU NEED A FINANCIAL ADVISER? Before deciding whether you need a ﬁnancial adviser.By 2003. Working with a ﬁnancial adviser oﬀers three important beneﬁts: 1. your adviser will meet you to update you on your portfolio and the . or suggest that you could use some help. Daniel Kahneman. Some of the smartest people around have ﬁnancial advisers. admits that he gets advice from his ﬁnancial adviser. Smith in 2002. your work and hobbies. as well as following the market and reading up on new products? If these questions make you feel uneasy. A second survey done by the same company then found that over 90 per cent expressed interest in working with a ﬁnancial adviser. a ﬁnancial adviser can be a great ally. many investors lost large fortunes. Are you worried about how to handle market volatility? Markets will sometimes go crazy.
But the fact is that ﬁnancial advisers have made the commitment to attain a level of expertise that most investors are not willing to make. ARE ALL CERTIFICATIONS CREATED EQUAL? If you have trouble sifting through the alphabet soup to tell the diﬀerence between a CFA. Financial advisers go through rigorous exams to get licensed. 3. Some ﬁnancial advisers even take professional exams to get more expertise. products and solutions to help you. We have spent chapters of this book saying you can. ChFC and CFPCM. Certiﬁed Financial Planner (CFPCM) A CFPCM holder has overall expertise in personal ﬁnancial planning in these areas — risk management. Below is a list of ﬁve popular designations and what each one does: Chartered Financial Analyst (CFA) This is the Rolls-Royce designation for investment professionals. This is not to say that investors are not capable of attaining this expertise. CFAs tend to work with institutions rather than directly with individuals. Expertise Financial advisers have the expertise that most investors may not have to do an eﬀective job. A CFA holder is a specialist and he has to demonstrate competence by passing exams on accounting. If your adviser is worth his salt. here is some help. tax. . economics. they have the latest knowledge of the markets.256 MAKE YOUR MONEY WORK FOR YOU market. he will also consistently nag you to invest smartly to keep you on track. insurance. money management and security analysis. As a result.
257 Getting Financial Advice How Meaningful are These Letters? Certiﬁcations are a mark of professionalism. The ChFC holder has also not demonstrated specialist knowledge in any one area.estate planning. WHERE DO FINANCIAL ADVISERS COME FROM? There are some 13. Unlike a CFA holder. Certiﬁcations are conferred on individuals with a certain number of years of relevant work experience. This ensures that the ChFC or CFP sitting across the table is not fresh out of school. Chartered Life Underwriter (CLU) This designation is for a specialist in insurance. Chartered Financial Consultant (ChFC) The ChFC is similar to the CFPCM. While certiﬁcations are not everything. The two exams deal with planning for business owners and wealth management. Their title does not indicate training in other areas of ﬁnancial planning. you should give credit to an adviser who has any of these designations.000 ﬁnancial advisers in Singapore and they come from two main sources: . Many of these certiﬁcations require many hours of study to meet high standards. He conforms to a strict code of ethics to provide advice for your beneﬁt rather than his own. a CFPCM holder has not obtained the knowledge to be a specialist in any one area. Certiﬁed Public Accountant (CPA) CPAs are specialists in tax and accounting. A professional has gone the distance to acquire expertise. investments and retirement planning. Where they diﬀer is that the ChFC requires the candidate to pass two more exams compared with the six the CFPCM candidate has to take.
showed that investors are generally starved of good advice and that a mere 26. you can buy many investment products directly on your own. an untied FA will have access to many of the fund management houses in Singapore.000 tied advisers in Singapore. One study by CEG Worldwide in 2003 by Russ Alan Prince. If you are looking for an investment product. The remaining three-quarters regard . there is also Great Eastern and NTUC Income. This is the bottom line — products do not make the valued adviser. So if you are looking for an investment product. ongoing debate that is not about to cease.000 advisers in total. good advice does. a renowned researcher on the wealthy in the U. Financial advisers who are not tied to a speciﬁc company and its products These untied ﬁnancial advisers can advise and sell you products from several product manufacturers. Products are always available. There are about 12. Tied advisers usually come from four large companies — besides Prudential and AIA. 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.. Does this mean that you should only go with untied ﬁnancial advisers who can oﬀer you products from many companies rather than a tied ﬁnancial adviser who can oﬀer products from only his company? This is a huge. Financial advisers who are “tied” to a speciﬁc company and its products Tied advisers such as those from Prudential and AIA can only sell ﬁnancial products created or distributed by their companies. but not good advice.S.258 MAKE YOUR MONEY WORK FOR YOU 1.7 per cent of investors surveyed were very satisﬁed with their current advisers. If you take the trouble. your AIA adviser can sell you only products that AIA distributes. There are around 30 untied companies in Singapore with about 1. 2.
259 Getting Financial Advice FINDING A GOOD ADVISER Just what should you look for in a good adviser? Here are three “must-have” factors to look out for. you might want to drop the fellow. Just as your doctor would not know what is wrong with you unless you tell him.their advisers as “fair” or “poor” and are willing to work with someone else. When we present lectures to ﬁnancial advisers on investing. Registered financial advisers have a fiduciary responsibility to provide financial advice that is in your best interest. 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 ﬁnancial advising company. Comfort Zone If you come across an adviser who annoys you no matter how clever he is. It would be silly of you to take this lightly. you need a basic level of comfort and rapport to get anything done. we convey this important message — it is not worth the money to work with a client that you do not like. your ﬁnancial planner will not know how best to help you if you do not tell him your ﬁnancial goals. The questions help you and your adviser learn about your ﬁnancial objectives and risk proﬁle — two critical components to ﬁnding suitable investment products for your portfolio. or do not get along with. While you and your adviser need not be soul mates. . 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.
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. Whether you or your adviser turns out to be right in the end is secondary. PREPARING TO TALK TO YOUR FINANCIAL ADVISER Financial advisers cannot make decisions for you. That is why it is a good idea to do some preparation before you meet. It is a mistake to assume that they can take away the risks and make predictions.260 MAKE YOUR MONEY WORK FOR YOU Making Sense Do you generally agree with how your adviser thinks? Or are you always arguing with the recommendations your adviser makes? The fact is that if you are always in disagreement with him. one-time-only commissions. Do you invest yourself? Tell me about your investing experience. He could earn from upfront. or he could earn . How can I lose money if I follow your investment plan? 5. 2. How are you being paid to give me advice? 4. here are ﬁve questions we recommend you ask: 1. What kind of expertise does your company have to help me? 3. What matters more is that you and your adviser have a fundamental diﬀerence in thinking about an important issue — how you manage your assets. If you only have 10 minutes to spare. there is probably some fundamental diﬀerence between the way both of you think. they oﬀer advice and you have to decide what to do. You give them the facts.
These purchases can be either outright new purchases or switches (where you sell out of one investment and buy into another one). then you will be surprised to hear that this is actually becoming a popular way of managing investments. your adviser may charge you an upfront 2 per cent (as opposed to 5 per cent) and subsequently on an annual basis. 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. TYPICAL PAYMENT MODES FOR ADVISERS Commission Upfront commission Recurring fee structure Traditional commission-based Recurring fee-based 5% 2% None 1% Source: Authors’ own illustration Example of Traditional Versus Recurring Fee Structure The traditional commission-based adviser gets paid a lump sum when investment purchases are made. he charges you 1 per cent based on AUA. Your adviser does well when your investment portfolio does well. In the meantime. do ask about a wrap account. What? Keep paying your adviser year after year? If that sounds crazy to you. 261 Getting Financial Advice TABLE 25. If you are planning to pay your adviser annual recurring fees.1. you can evaluate whether your adviser is doing a good job or not. recurring annual fee based on the value of the investment assets under advisory (AUA). Wrap accounts oﬀer free switching. So he has the incentive to do a good job over many years rather than just during the ﬁrst year. When you sell one investment and buy another within a wrap . plus a low. For example. The recurring fee-based adviser often charges a lower upfront fee.a recurring fee based on the amount that you have invested with him.
There are exceptions. Good deal? Bad deal. a simple product purchase will do the job. of course. You will keep better records. a mortgage. . You may know exactly what you want — for example. When you pay a fee. You see.262 MAKE YOUR MONEY WORK FOR YOU account. 2. has a team of experts and he even has a great sense of humour. Or the amount may be small — you want to invest $2. In both situations. paying a fee helps ensure that the ﬁnancial adviser does his best. Would you pay him a fee for ﬁnancial advice? NTUC conducted a survey in 2002 and found that seven out of 10 people were not willing to pay for ﬁnancial advice. You will be worried if he might pull your teeth out to sell you dentures. you just will not take things as seriously. He is competent. Would you value free ﬁnancial advice? Imagine going to a dentist who says he will not charge you for the time and advice he gives you. Your colleague oﬀers to teach you for free every Saturday afternoon. Paying for Financial Advice You have found your ideal adviser. because paying a fee does not make sense in certain situations. and the ﬁnancial adviser earns a commission from the product sold.000 to invest. You will take greater interest in what is being said and done. When things are free.You will ask better questions. Here are two questions you should ask yourself: 1. Would you be doing the best for yourself? Suppose you want to learn Chinese.000 in a balanced fund. Are you one of the seven? Suppose you have $100. Your ﬁnancial adviser will serve you better if he is paid. you take greater responsibility for your own aﬀairs. A fee is not paid for any advice. it will not cost you any money and your adviser does not earn from the switching.
000. Take Detailed Notes — When you communicate with your adviser on the phone. such as $100. They have to go through a fact ﬁnd with you. This . Your ﬁnancial adviser may give you good advice for free today.As a rule of thumb. such as creating a comprehensive ﬁnancial plan. 263 Getting Financial Advice ARE YOU A GOOD CLIENT? A lot of the success of an investor has to come from the investor himself. Keep Up-To-Date Records — Do you keep your investment accounts in a special ﬁle or do you put them anywhere you can stuﬀ paper. via email. such as managing a portfolio of investments for your retirement. but he may not be around too often to help you in future. we know that ﬁnancial advisers have a responsibility to act in a prudent manner with regard to your money. take notes. you should consider paying a regular fee. or in person. Sure. Be mindful. the situation is complex enough that analysis and advice are needed. or the objective is a longterm one that requires regular monitoring and adjustments. 2. though. 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. What is generally true is that many of our ﬁnancial needs are long term and they have to be managed over the course of our lives. paying a fee makes sense when the amount invested or managed is large. In return for getting a regular dose of good advice. We need a structured process to look after these matters. that paying for advice does not necessarily mean you will get good advice. But how prudent are you yourself in making sure you succeed with your ﬁnancial objectives? Let's look at three activities that will help you help yourself — and better your relationship with your rep. 1. ask a zillion questions and then crunch all sort of numbers.
in his words. He replied that 25 per cent of his clients were. His super-charged clients keep him on his toes and as a result. mistakes can’t happen.264 MAKE YOUR MONEY WORK FOR YOU will give you a hard copy of the experience. fancy computer programme to generate reports. and if you are not so savvy with investments. super-charged investors. question his advice. And if there is ever a conﬂict between you and your adviser. and quite often. They would constantly hound him for information. Are you a super-charged investor yourself? . even give him really useful insights on investments. expect regular updates on the economy. these notes will serve as evidence of what transpired. 3. Track Commissions — Commissions can take a big bite out of your investment returns. THE BOTTOM LINE One of our mutual friends who is a very successful adviser was asked how he became so successful. So make sure you are being charged what you are supposed to be charged. he does know more than other advisers. Don’t assume that just because your ﬁnancial adviser uses a large. and can be very painful when the market is going down. you will have your notes to reﬂect on and learn.
. Your portfolio will now have to rise by 100 per cent in order for it to go back to its pre-crisis level.000. Where was your ﬁnancial adviser when all this was happening? 3.26 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 diversiﬁed portfolio. many people found their portfolios drop by 30-50 per cent in a matter of a few months.1 2. If you were one of the unfortunate ones whose portfolio fell by 50 per cent or more. If you have done this throughout the years running up to your retirement. the STI fell over 1.000. your portfolio would have to go up 100 per cent in order to get back up to $100. • Get a professional to help you.000 points. • Buy and hold because you can’t time the market.000 portfolio that fell by 50 per cent to $50. What can you do to make sure you don’t get into such a mess again? 1 If you had a $100. In the ﬁve months between October 2007 and March 2008. you will have done ﬁne. When the subprime crisis began unravelling. here are three points to consider: 1.
With a 100 per cent climb ahead. . It was only in 2006 that the STI went appreciably beyond 2400. While the STI recovered to pre-crisis levels in 2000. would he have asked you to liquidate your positions when the crisis hit? 2 Judging from their huge multi-billion losses. Or your children are going to university next year. But suppose you don’t have the time because you were planning on retiring when the crisis hit. 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. it might even be faster. We’ve seen that markets do adjust quickly and with more governments working together to avert and manage disasters.266 MAKE YOUR MONEY WORK FOR YOU Let us take the ﬁrst point. so don’t sell … hold. you may also have pure bad luck. This would be a very bad situation to be in and not uncommon at all whenever a crisis hits. you’ll see that the largest banks in the world had a tough time ﬁguring this out too. Look at the STI during these two periods: Year Level 1996 2400 2006 2400 The STI hit 2400 in 1996 on the heels of the Asian ﬁnancial crisis. your portfolio will recover. even when you have time on your side. You see. The next question is how well your ﬁnancial adviser served you during this time. the pain can be excruciating and last a long time. Well. you would be asking when your portfolio would regain its value and continue its long-term upward trend. and you just lost two years of tuition fees. Now what if you do have time to recover because you’re still young? Well-meaning ﬁnancial advisers are apt to say that given time. you may be surprised to know that this does not work all the time and when it does not work. it didn’t go much higher than the 2400 level.
Financial advisers and ﬁnancial institutions rarely emphasise selling strategies. we all need professionals to do the things we cannot do. advisers rarely downgrade its rating from “buy” to “sell”. . So the question really is. 267 Protecting Your Portfolio in Downturns and Upturns PROTECTING YOURSELF IN AN UPTURN There’s no typo here. but you have to keep both eyes and ears open. It is you who has that ultimate responsibility. When your portfolio is rising in value. but instead downgrade them from “buy” to “neutral”. Even when prospects for an investment have turned very poor. Everyone from banks and brokerages to private bankers and ﬁnancial advisers all emphasise buying strategies. The important rule is that you really can’t trust anyone 100 per cent. Many people get euphoric and blind when the market is doing well. to monitor your portfolio the way it should be monitored. Professional advice is often tainted by conﬂicts of interest and you have to understand that. “Where were you when the market was falling?” Did you keep up with the news? Did you contact your ﬁnancial adviser? Did you speak to your friends in the know about what was happening? Did you take care of your own ﬁnancial well-being? Finally. what can you do to avoid such situations in future? We will examine this very question the rest of this chapter. Tune in to the business news to listen to analysts and corporate executives.Probably not. ignore their ﬁnancial advisers. And once you have bought. In the end. they try their best to have your funds stay with them since assets under management (AUM) are a recurring source of income for them. not even your own spouse or your parents. and try counting the number of buy versus sell recommendations. They get into riskier instruments. there are a few things you can do to keep it structurally safe. or from “buy” to “hold”. give everyone they meet investment tips and throw their long-term asset allocation down the canal.
rebalance the portfolio.268 MAKE YOUR MONEY WORK FOR YOU 3 1. Buy-low. This is a strategy we can carry out quite easily by simply switching into the top-performing funds within a category every three months.Rebalance your portfolio regularly When your stock allocation rises above the recommended longterm allocation. If stocks have outpaced bonds. but also reduces your portfolio’s risk. for example.3 They showed with the help of ETFs how they were able to outperform the underlying benchmarks consistently with this momentum approach. This is a short-term momentum strategy of “buying high” that appears to be quite opposite to the buy-low sell-high tactic of rebalancing. and to do this every three months. chances are that they will do well in the near future as well.fundsingapore. is to access www. 3 Months at a Time. Studies have shown that when funds do well in the recent past. . sell-high always works. Try a short-term momentum strategy One criticism of rebalancing is that you are selling investments before they reach their highest point. com every three months to ﬁnd out which funds outperformed and to switch into that fund. Here’s an alternative. What this would entail for you for Asia ex-Japan funds. 2. it means you should sell stocks and buy bonds to return your portfolio to its long-term allocation. According to a study by Gerald and Marvin Appel. Studies show that rebalancing not only produces better results than not rebalancing.” by Gerald and Marvin Appel. 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 “Beating the Market. it was found that funds with above-average performance during a three-month period have a better chance of returning aboveaverage proﬁts during the subsequent three-month period.
then your asset allocation should reﬂect that view accordingly with larger amounts of stocks versus bonds in your retirement portfolio. • Your daughter won a university scholarship. They happen all the time and they are unpredictable. Do hang on to your long-term asset allocation. These negative and positive situations are not remote at all. Redo your risk proﬁle once a year Your risk proﬁle is meant to be a long-term indicator of an appropriate asset allocation. For example. For example. 3. particularly when you are at the threshold of the next risk level. you should redo your risk proﬁle right away and make any necessary adjustments to your asset allocation. they tend to remain on that trend for some time. You should still do your risk proﬁle once a year. • Your retirement portfolio lost 50 per cent this year. suppose: • You just won a huge lottery. • Your apartment went en bloc. if you are planning on retiring soon and your risk proﬁle was done three years ago when you were deemed an aggressive investor.when securities are on an uptrend. but please do your short-term checks 269 Protecting Your Portfolio in Downturns and Upturns . Long-term indicators can change from year to year for short periods of time. If you are deemed an aggressive investor. • You and your spouse are expecting twins. • You contract a rare disease and the doctor says you need 12 months to recover.
If the U. Sell your holdings and move to cash This is not our favourite recommendation because it means incurring selling costs and moving your funds into cash that earns you less than the inﬂation rate. then reallocate ﬁve per cent to China or an Asian investment.S. 4. 3. Move into more favourable sectors in small steps This requires some monitoring. Unexpected short-term events can permanently alter your long-term plans. PROTECTING YOURSELF IN A DOWNTURN The market is falling. then there are quite a number of absolute return unit trusts available in Singapore. 5. is faltering and China is hot. here is a list of strategies you can consider: 1. Buy absolute return investments Hedge funds are a good choice as they focus on absolute returns. use . Buy quality Buying quality such as blue chip stocks is a defensive move that works regardless of market conditions. If you are not an accredited investor. If you want to be more active about managing your portfolio. While hedge funds can short-sell stocks. and not just buy-and-hold. reallocate ﬁve per cent more to commodities or to bonds. If stocks are doing poorly. Stay diversiﬁed You should do this without question.270 MAKE YOUR MONEY WORK FOR YOU also. 2. So don’t wait for the market to be in a downturn before you invest in quality. 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.
Invest in the market through ETFs This 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. After a certain number. for example. In the event of a market downturn. commodities have been rising. The Asian ﬁnancial crisis in 1996 changed a lot of perceptions as it showed how interlinked the world’s economies are. These days. Not only is there a low correlation between stocks and commodities. 7. you could short sell STI futures. We’re not suggesting that you have four or ﬁve professional advisers to advise you on your portfolio. Sell derivatives If you want to protect your Singapore portfolio. hedge fund 271 Protecting Your Portfolio in Downturns and Upturns . your losses from your actual portfolio can be compensated by the gains from your short futures position. 8. Invest in commodities As stocks are falling. 6. unit trusts cannot. but can use derivatives to generate income and hedge market exposure in order to generate absolute returns. commodities have provided good protection against inﬂation. we have a globalised ﬁnancial system that allows billions of dollars to move from one jurisdiction to another in seconds. you have at least a mega-million dollar portfolio.various derivatives and leverage. or outside the scope of products the ﬁnancial institutions he belongs to oﬀers. 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 ﬁnancial adviser. too many cooks will ruin your soup unless perhaps. in which case you may not even need this book.
. monitor your portfolio actively and get the best ﬁnancial advice you can. We believe that as you move forward. but please actively monitor your portfolio at the same time. Yes.272 MAKE YOUR MONEY WORK FOR YOU managers taking a bad situation such as the subprime crisis to make billions. we believe in buy and hold. and the invention of technically challenging products because of innovations made by ﬁnancial engineering. you really need to pay attention more actively to the markets.
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