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Inquiry Posting : An introduction to Real Estate Investment 2
Return compounding frequency
Inquiry posting : An introduction to REIT
Risk tolerance vs timing of investment
Inquiry posting : Effect of floating rate versus fixed rate in real estate investment with leverage
Investment style - Market timing, averaging and rebalancing.
Demonstration - Market timing, averaging and rebalancing
Inquiry Posting : Real estate investment – factor to consider
Marking to market vs none marking to market

The important of asset allocation decision

A major reason why investors develop investment plan is to determine an overall investment strategy.

Though an investment plan does not indicate which specific stocks to purchase and when they should be sold, it should provide guidelines as to the asset classes to include and the relative proportions of the investor’s funds to invest in each classes. How the investor divides funds into different asset classes is the process of asset allocation.

Rather than present strict percentages, asset allocation is usually expressed in ranges. This allows the investor with some freedom, based on his or her reading of capital market trends, to invest towards the upper and lower end of ranges.

For example, suppose an asset allocation strategy requires that common stock be 60 to 80 percent of the value of the portfolio and that bond should be 20 to 40 percent of the portfolio’s value.

If an investor is particular bullish about stocks , she will increase the allocation of stock towards the 80 percent upper end of the equity range and decrease bond toward the 20 percent lower of the bond range. Should she be more optimistic about bonds, the investor may shift the allocation closer to 40 percent of the funds invested in bonds with the remainder in equities.

Asset allocation focus on asset classes to be considered for investment and weight assigned to each eligible asset class.

Strategic asset allocation decision assists investor on having a disciplined approach to investing.

At different time horizon, different classes of asset perform differently.

For example, safe Certificate of Deposit or high quality bond investment will sometimes outperform equities, and, because of their higher risk, common stocks sometimes lose significant value. These are time when undisciplined and uneducated investors become frustrated, sell their stocks at a loss, and vow never to invest in equities again. But once market back in bull run situation, this undisciplined investor due to emotional influence , will jump in again and buying at high price.

In contrast, there are times where disciplined investors stick to their investment plan and position their portfolio for the next bull run. By holding on to their stocks and perhaps purchasing more at depressed prices, the equity portion of the portfolio will experience a substantial increase in the future.

Asset allocation decision determines most of the portfolio’s return over time. Although seemingly risky, investors seeking capital preservation, income, or even capital appreciation over long time periods will do well to include a sizeable allocation to the equity portion in their portfolio. This is to factor in the risk of not meeting long-term investment return goals after considering inflation and taxes.

Investor make asset allocation decision in much the same manner but factor such as different social , economic , political and tax environment will cause minor different on strategy across countries.

National differences can explain much of the divergent portfolio strategy. Country with population at lower average age will tend to have greater use of equities.

Inflation rate in a country is another factor affecting asset allocation strategy. Country with relatively higher inflation rate will tend to have greater use of equities to generate higher return to compensate for losing in purchasing power due to inflation.

Investor from country with better pension plan and social benefits such as medical will tend to invest less in equities as capital appreciation is not as important to generate future income when entering spending phase as most funding requirement will able to support by pension plan and social benefits.

Country with risk averse investor and believe that equities is a form of gambling rather than investing will tend to invest less in equities market.

Country with relative liquid stock market will increase the use of equities in asset allocation decision.

In summary, Investors need to develop an asset allocation strategy which matching their risk return profile.

For an investor who is risk averse with expected lower return, higher proportion of investment fund will be allocated to lower risk investment such as Bond and Certificate of Deposit ( Certificate of Deposit is considered no risk if the amount is protected by Central Bank ) and lower proportion into risky stock investment.

In contrast, for an investor with high risk tolerance and looking for high return, higher proportion of investment fund will be allocated to stocks and lower proportion into Bond or Certificate of Deposit.

Return Measurement

To assess projected rate of return is met, an investor required return measurement, which involves calculating returns in a logical and consistence manner.

Accurate return measurement will be essential on evaluating investment plan probability of success, revise of projection or determine any contingency plan is required.

One of fundamental concept on return measurement is holding period return. ( HPR ) , the return that an investor earn over a specific holding period. The holding period can be any period from one day, one week, one month, one year and so on.


HPR = (P1 – P0 + CF1) / P0

P0 = initial investment
P1 = price of investment received at the end of the holding period
CF1 = cash paid by the investment at the end of investment period


For example, an investor purchased stock A at price of $10 and price of stock A increased to $12 by end of the period. Stock A paid $0.50 dividend by end of the period.


HPR = ( 12 – 10 + 0.5 ) / 10 = 25%


For portfolio investment, we compute the expected rate of return for a portfolio of investment is simply the weighted average of the expected rates of return for the individual investments in the portfolio. The weights are the proportion of total value for the individual investment.

An example of expected rate of return for a portfolio is illustrated as below. The expected return for this portfolio of investment would be 11.10%.

Risk Measurement And Risk Aversion

Risk means the uncertainty of future outcome or a probability of an adverse outcome.

One popular way to measure risk is to examine the variability of return over time by computing a standard deviation or variance of an annual rate of return for an asset class. Another intriguing measure of risk is the probability of not meeting investment return objectives.

One of the best known measures of risk is the variance or standard deviation of expected return. It is a statistical measure of the dispersion of returns around the expected value whereby a larger variance or standard deviation indicates greater dispersion. The idea is that the more disperse the expected returns, the greater the uncertainty of future returns.


Population variance = Σ (Xi – Χ)/ n

Population standard deviation
= (Population variance) 1/2


Another measure of risk is the range of returns. It is assumed that a larger range of expected return, from the lowest to the highest expected return, means greater uncertainty and risk regarding future expected return.

Range = maximum value of return – minimum value of return





In practice, risk may be measured in absolute terms or in relative terms with reference to various risk concepts.

Examples of absolute risks measurement are a specified level of standard deviation or variance of total return such as standard deviation below 15% is an example of absolute risk.

Relative risks measurement are a specified level of standard deviation relative to a reference. Tracking risk is an example of relative risk measurement where it specified the standard deviation of the different between a portfolio’s and the benchmark’s total return.


Risk aversion

Portfolio theory assumes that investors are basically risk adverse, meaning that, given a choice between two assets with equal rate of return, they will select the asset with the lowest level of risk or given the same level of risk, investor will select the asset with higher level of return.

Evidence that most investors are risk averse is that they purchase various type of insurance, including life insurance, car insurance and health insurance. Buying insurance basically involves an outlay of a given known amount to guard against an uncertain, possibly larger, outlay in the future.

Further evidence of risk aversion is that investor required higher return for investment which expected with higher risk. Investor requested different yield (rate of return) for different class of bond with different degree of credit risk. Promise yield (rate of return) on corporate bonds increase from AAA (the lowest risk class) to AA to A and so on, indicating that investors require a higher rate of return to accept higher risk.

This does not imply that everybody is risk averse, or that investors are completely risk averse regarding all financial commitments. The fact is, not everybody buy insurance for everything. Some people have no insurance against anything, either by choice or because they cannot afford it.

In addition , some individuals buy insurance related to some risks such as auto accidents or illness, but they also buy lottery tickets and gamble at race tracks or in casinos , where it is known that the expected returns are negative ( which means that participants are willing to pay for the excitement of the risk involved). This combination of risk preference and risk aversion can be explained by an attitude towards risk that depends on the amount of money involved where people who like to gamble for small amounts (in lottery or slot machines) but buy insurance to protect themselves against large losses such as fire or accident.

While recognizing such attitudes, the basis assumption is that most investors committed large sums of money developing an investment portfolio is risk averse. Therefore, we expect a positive relationship between expected return and expected risk.

Spend Wisely Today , Invest For Better Future Consumption

When an individual entering job market and receive the first paycheck, he or she will be excited with the money in hand and eagerly to reward himself or herself with shopping for apparels or even begin to plan on buying luxury item such as branded watch or an oversea trip.

From the perspective of time value of money and compounded grow of investment fund, an individual is advice to spend wisely in early years so that a significant portion of income can be invested every month for future consumption.

If rate of return from investment is higher than inflation rate , all else equal , future purchasing power will be higher than today.

An individual is advice to spend wisely by focusing on needs and the possibility to push out luxury items to a later date.

Besides spending wisely , an individual should practice good time management to free out some time at daily basis to follow through economic news , learning financial and investment knowledge. As financial market is dynamic, this step is crucial on mastering investment strategy to invest successfully towards achieving investment goal.

Let’s illustrate the differences by analyzing 2 individuals; Individual A is slightly conservative while individual B is slightly aggressive in spending.

Individual A focuses on conservative spending pattern during early years to generate excess income for investment.

Individual B focuses on more aggressive spending pattern during early years to enjoy better life style.

Individual A and B will enjoy same life style from year 11 onwards


Key assumption

☺ Current income at $30,000 annually with 7% annual increment for next 30 years
☺ Tax and other statutory contribution = 20% of income
☺ Basis spending = 30% of income
☺ Balance of 50% of income is use to cover for major spending plan and any excess will be contributed to investment fund.
☺ Any shortfall in annual spending will be support by accumulated investment fund
☺ Major spending plan covered
☻ Car – life cycle of 10 years
☻ House – only purchase one house for self consumption until retirement
☻ Holiday plan – increase by 10% per year from current budget
☻ Investment goal – $2,000,000 by end of year 30
☻ Investment fund annual compounded rate of return at 15%
Table below summarize details of major spending plan for individual A and B

Chart below represents income surplus available for investment or income deficit which required support from accumulated invested fund.

Income surplus : Disposable Income > Expenses

Income deficit : Disposable Income <>

Chart below illustrates that, throughout more conservative spending at early years, Individual A manages to generate higher annual investment fund as compare to individual B.

Through discipline and well manage investment strategy, the excess income has been put into action to generate more income, which is use to support major spending in years with income deficit while continue growing the fund to fulfill investment goal.

Chart below illustrate accumulated investment fund from year 1 to year 30. We can observed that individual A has significant reserve in accumulated investment fund to support major spending funding whereas individual B at borderline condition and potential running into financial distress if unforeseen expenses occurred.

By year 30, individual A and B are expected to accumulate $4,022,350 and $1,363,284 respectively in investment fund.

Individual A will be $2,022,350 above investment goal while individual B will be short of $636,716.

As individual A with surplus accumulated investment fund, he or she will has the alternative below from year 11 onwards while achieving investment goal by year 30

☺ Spend more
☺ Improve life style
☺ Less worry about unexpected expenses
☺ Upgrading to better car or accommodation
☺ Take an luxurious holiday trip
☺ Early retirement
☺ Reduce investment risk by investing in more conservative investment with lower return

As individual B with accumulated investment fund below investment goal, he or she required action below to achieve investment goal by year 30

☺ Spend less
☺ Postpone lower priority, long term goal such as holiday plan to a later date.
☺ Continue working until investment goal is achieved.
☺ Improve investment skills and resume higher risk, aiming for higher return.
(Need to achieve 18.1% compounded return to maintain same life style while
achieving investment goal of $2,000,000 by year 30)

In summary, spending wisely today, mastering financial and investment knowledge, invest income surplus for a better future

Inquiry Posting - Advise To First Time Investor

The purpose of this article is to provide guidance to first time investor.

This guideline is useful as well for investor, who is working on restructuring current investment plan and strategy.

First time investor is advice not to jump into actual investment until a detail investment plan and strategy is formulated.

First time investor should follow the steps below:

☺ Step 1 : Formulate an investment plan
☺ Step 2 : Formulate investment and asset allocation strategy
☺ Step 3 : Develop procedure to monitor investment progress
☺ Step 4 : Review investment plan to incorporate latest changes in personnel objective and constraints


Step 1 : Formulate an investment plan

Investors are advice to formulate an investment plan by establishing risk and return objectives, personnel constraints and investment goal.

Investors should get started by determining

☺ Current income and projection of future income
☺ Taxes and statutory contribution
☺ Personnel or family spending plan
☺ Major item spending plan
☺ Fund available monthly for investment purposes
☺ Investment goal
☺ Risk tolerance (low , average or high)

Risk tolerance measures the capability to accept risk, is a function of both an individual willingness and ability to take risk.

Let’s assume Individual A, with sufficient insurance and cash reserve, with personnel profile below:

☺ Age 25
☺ Current income at $30,000 and expected to grow at 7% per year
☺ Taxes and statutory contribution at 20% of gross salary.
☺ 30% of gross salary to support personnel daily expenses
☺ Major item spending plan
☻ Buy a car today at $50,000. Down payment of $5,000 with annual installment of $6,500 for 10 years. Plan to change car every 10 years. Resale value at $15,000
☻ Wedding and honeymoon expenses - $30,000. By end of year 5.
☻ Buy new apartment at RM300,000 in year 5. Down payment $30,000, annual installment of $27,000. Plan to stay in the same house until retire.
☻ Children education fees - $200,000 per year, for 5 years , from year 26 to year 30.
☺ Surplus from income will be invested.
☺ Investment goal is to achieve $2,000,000 saving by age of 55.


Table below summarized income , expenses and saving available for investment.

Step 2 : Formulate investment and asset allocation strategy

Once investment plan is established , next step is to determine required rate of return to achieve investment goal and asset allocation strategy.

Table below summarized accumulated investment fund reference to different rate of return.

To achieve investment goal of $2,000,000 by end of year 30, the investor required rate of return is 6.86% compounded annually.

Once required rate of return is established, next action is to establish asset allocation strategy.

Assuming Investor A asset classes covers Certificate of Deposit at 3% annual return and Equity at 15% annual return. His asset allocation strategy will be 67.83% allocation in Certificate of Deposit and 32.17% in Equity.


Expected return = 67.83% x 3% + 32.17% x 15% = 6.86%


Investor A will then assess his risk tolerance against asset allocation decision.

If his risk tolerance is higher and able to accept higher risk by investing greater proportion in equity, he might able to accumulate higher investment fund by end of year 30 or spending more to improve life style while maintaining investment goal of $2,000,000 by end of year 30.

If his risk tolerance is low and not able to accept 32.17% investment in equity, he need to either reduce spending to free out more saving for investment or reduce his investment goal by end of year 30.

[ Remarks : Risk Tolerance will be share in separate article ]

Let’s assume that individual A with moderate risk tolerance and able to accept the risk of allocating 32.17% in equity.


Step 3 : Develop procedure to monitor investment progress

Step 1 and step 2 represent planning stages and now investors will move into execution stage.

Investors need to assess personnel financial and investment knowhow to determine either 15% required rate of return in equity investment is achievable.

If confident level is low , investor should develop a learning plan toward enhancing financial and investment knowhow , specifying a timeline ( recommendation is not more than 1 year ) and invest only in Certificate of Deposit until ready to invest in equity. This might require investors to increase allocation to equity at later stage to compensate for lower grow in early years.

If confident level is high, investors should proceed with equity investment while in parallel, continue to enhance financial and investment knowhow to increase probability of success.

As financial market is dynamic , the investment process is on going and required regular monitoring and review.

Investors are required to establish a format to monitor each indicator below and incorporated into investment plan.

☺ Actual income versus projected income
☺ Actual versus projected taxes and statutory contribution
☺ Actual versus projected personnel or family spending plan
☺ Actual versus projected major item spending
☺ Actual versus projected fund available monthly for investment purposes
☺ Actual versus projected investment goal
☺ Actual versus projected rate of return from investment


Formulate action plan such as reduce expenses , increase allocation to equity to boost required rate of return when investment goal is fall behind projection.

If investment fund is way ahead of return projected in investment plan , investors can decide to reduce allocation to equity investment, increase spending on major item , taking a luxury vacation or stay with the plan for early retirement.


Step 4 : Review investment plan to incorporate latest changes in personnel objective and constraints

In our life, our objective and constraints will change accordingly. This changes need to be incorporated into investment plan.

Few examples :

☺ An investor received a gift of $250,000 from parent will reduce liquidity constraint. Thus, able to accept higher risk.
☺ An investor who loss his job during economy crisis might face short term liquidity constraint and required to alter his investment plan to provide short term liquidity.
☺ An individual who decided to retire earlier; entering spending phase earlier than expected might decided to reduce allocation to equity or shifting investment from high beta stock to average beta stock.

Inquiry Posting : An introduction to Real Estate Investment 1

Real estate is usually considered to be buildings and buildable land, including offices, industrial warehouses, residential buildings, retail space and residential houses and apartments.

Real estate is a form of tangible asset, one that can be touched and seen, as opposed to financial claims that are recorded as pieces of paper.

Real estate investment represents investment in an immovable asset – land and the permanently attached building and improvement to it.

Real estate can be invested privately or through pooling of funds, such as in partnership or Real Estate Investment Trust (REIT)


Why invest in Real Estate?

Potential higher return through leverage. Leverage is the use of borrowed money to increase the rate of return earned from real estate investment. In average, real estate investors have been able to borrow up to 90 percent of the value of any property owned or acquired. Leverage can be advantageous when the investment earns a higher rate of return than the interest on the borrowed money.
Leverage also enables an investor to control more property with a given amount of money. An investor can leverage by stretching out the repayment schedule or by refinancing. By maintaining high leverage, an investor may pyramid investment more quickly. Pyramiding is controlling additional property through reinvestment, refinancing and exchanging. The objective is to control the maximum value in property with the least resources. Needless to say, pyramiding carries a high risk of a total wipe-out during a recession.


Purchasing power protection. Real estate usually offers protection against inflation. Whereas most capital assets tend to lose value in terms of purchasing power or constant dollars in inflationary periods, adequately improved realty, especially apartments, shopping centers and selected commercial properties, tend to gain value as measured in constant dollars. In the absent of rent and price controls , real property, like a ship upon ocean waters, floats above its purchasing power constant dollar line irrespective of depth or rise in the level of prices. For this real-value holding power to be true of a specific parcel of income real estate, the property must be well located, have rentals that can be adjusted periodically, and not be subject to sudden sharp increases in operating costs.

Pride of ownership. Many real estate investors gain identity by being” in the game” or by being “shrewd operators”. Some investors also realize great satisfaction from owning something tangible that can be touched, felt and shown to friends and relatives.

Control. The immediate and direct control of an owner over realty enables the owner or an agent to make continuing decisions about the property as a financial asset and as a productive property. This control enables the investors to manage property to meet personal goals, whether they are to manage property to meet personal goals, weather they are to maintain the property for maximum rate of return. Many owners experience a great sense of power and independence in this control.

Entrepreneurial Profit. A last important advantage is that added value may be realized by building or rehabilitating a property. Many investors also developed property. Other investors combine real estate investing with brokerage or property management.


Key factors to consider in real estate investments

☺ Planning and zoning effects – such as establishment of Specific Economic Zone which increases demand for lands and properties.

☺ Infrastructure improvement such as extending roads, extending LRT/MRT station or better electricity supply quality will increase demand at suburban area.

☺ Number of households and income levels. Higher number of households and with increasing income will increase the demand for property.

☺ Degree of local economy activities where location with active economy activities will attract more resident to “migrate” closer to work place which increases demand for properties.

☺ Prestige consideration – Property at location which considers as higher class residential area or develops by well known developer will potential increase the demand and price appreciation of the properties.

☺ Conveniences – properties located close to transportation terminal such as LRT/MRT station, shopping mall / retail stores and school will potentially faces increases in demand.

☺ Tax consideration – Return from investing in raw land will be in the form of capital appreciation whereas for retails spaces will be from both rental income and capital appreciation. Rental income is subjected to taxes while capital appreciation might not.

☺ Facilities and Management Services – Main consideration for service apartment and condominium. High quality management, adequate facilities with reasonable management fees will increase the demand and price appreciation of the property.

☺ Quality of building which influences long term value of the property. Lower quality building with higher wear and tear will increases operating cost in the future, which reduces the value of the building.

Benefit Of Investing Earlier

As investment funds compounded over time with exponential grow, longer investment horizon will play an important role on achieving higher value in the future, all else equal.

Table below illustrate future value of an initial investment of $1,000 invested for time horizon of 5 , 10 , 15 , 20 , 25 and 30 years with interest rate compounded annually at 10% and 20% respectively , showing a significant increase in value towards the end of investment period.

An investor who invest earlier during young age will enjoy the benefits from compounded grow over time, which reduces the initial investment amount required and risk involved on achieving investment goal.

Let’s compare 3 investors at age of 25, 35 and 45 with equal investment goal, which is to achieve $2,000,000 at age of 55. Age-25 investor has 30 years to achieve his target, while age-35 and age-45 investor has 20 years and 10 years respectively.

We will determine initial investment and required rate of return (interest rate) for each investor.

Let’s assume the scenario where all 3 investors enjoy compounded grow of 10% annually while varies initial investment contribution to achieve investment goal. The initial investment contribution will take either the form of one lump sum investment or through equal monthly contribution until age of 55.

Table below illustrate the scenario.

Illustration above shown that age-45 investor who begin to invest 20 years later will required 7 times higher initial lump sum of investment contribution or 11 times higher monthly investment contribution as compare to age–25 investor to achieve same investment goal by age 55.

With lower initial investment, age-25 investor can enjoy better life style through higher spending power or reserve the cash for any investment opportunity arises in the future.


Spending Power = Income - Saving


At same level of income and lower saving , all else equal , spending power will be higher.


Let’s look at second scenario where all 3 investors either with initial investment of $1,000 monthly contribution until age of 55 or one time lump sum investment of $20,000. Annual compounded grow will be varies to achieve investment goal.

Table below illustrate scenario 2.

Illustration above shown that age-25 investor will able to achieve investment goal with lower required rate of return of 9.42% and 16.59% respectively, either through monthly contribution or one lump sum investment contribution which indicate that age-25 investor will able to reduce risk exposure by selecting lower risk investment vehicle while still able to achieve investment goal by age of 55.

For age-45 investor who only have 10 years investment horizon, the alternative to achieve investment goal by age of 55 is to increase initial investment contribution which might limited by current income, higher monthly contribution which reduces spending power or taking higher risk by targeting higher rate of return.

In summary, mastering financial and investment skills, invest at early age will increase probability of achieving financial goal in the future.

Inquiry Posting: Investment Strategy With Upside Potential And Downside Risk Probability Table

From the same set of data, unlimited investment strategy can be develop by investor, depending on investor’s creativity, risk tolerance and required rate of return.

An investor is like a game master, bounded within the rules, who can decide the strategy to play the game.

Before proceed with in depth discussion of possible strategy using upside potential downside risk data, we will use the concept of soccer game to illustrate strategy formation, providing an overview to ease understanding.

Assuming you are team manager for famous soccer team competing in Premier League.

At the beginning of the season, you are allocated with a lump sum of money as fund to form a soccer team for the season.

We will assume that the team is assemble base on the require strategy set forth by the team manager.

The team manager is empower to use any combination of most conservative strategy of 10 – 0 – 0 to most aggressive strategy of 0 – 0 - 10, to achieve the goal set forth against each opponent.

Table below summarizes all possible combination of strategies that the team manager can employed from the same team of players.

There are a total of 66 combinations of strategy, where some might look ridiculous; but as long as it meets the required outcome, the strategy can be considered as useful and productive.

Throughout our experience following through soccer game, we can observed that only 9 out of 66 combinations of strategies ( highlighted in green ) is use frequently by the manager while others might use once in a blue moon when facing extremely weak or strong opponent.
For example, strategy 1 might be use when the team is facing extremely strong opponent with low probability of winning. The team manager decided to use most conservative strategy, hoping to secure 1 valuable point from the opponent.

Strategy 66 might be used when the team is facing extremely weak opponent with high probability of winning. The team manager decided to use most aggressive strategy to concede as much goal different possible to secure 3 points while provides advantages in goal difference against other team in the league.

If we plot frequency of each strategy used into a chart, it will demonstrate a bell curve which slightly skew to the left as illustrated below.

The slightly skew to the left is another example of risk adverse behaviour of human being.

Now, let’s switch our focus from Soccer World back to Investment World, using the same concept illustrated for practical investment application.

First, we assume ourselves as Investment Manager, provided with upside potential – downside risk data (equal to a group of players) for investment strategy determination to meet our target (required rate of return).

Probability of Upside potential + Probability of downside risk = 1

Thus, when combining both upside potential % and downside risk % will equal to 100%

Next, we will put together possible combination of strategy from upside potential - downside risk data provided.

Table below illustrate possible combination of strategies with 12 out of 55 combinations of strategy is recommended for actual practice in investment world.

Recommended strategy for investing in Mutual Fund, ETF (Exchange Traded Fund) and Index Fund.

Investing in mutual fund, ETF and Index Fund is more straight forward where investor focuses only on the changes in overall market sentiment instead of individual stock.

Investor can use OVERALL market upside potential – downside risk % to determine enter and exit strategy. For Mutual Fund, this can be use as switching reference.

For example, Investor with 20% targeted annual compounded return can choose either one of the option below, depending on level of risk tolerance.

For investor with investment allocation at constant interval, recommendation is to accumulate the allocation and only invest in Mutual Fund, ETF or Index Fund when enter timing emerged.

For example, an investor who contributes $1000 constantly per month is practicing investment strategy of entering at 70% upside potential and exiting at 30% upside potential. He will only invest in Mutual Fund when upside potential is high and Cash/Bond Fund/Money Market Fund when upside potential is low. Expected rate of return is 20%.

Illustration below represents enter and exit timing for the investor investment strategy.

Recommended strategy for investing in individual stock

Investing in individual stock will be more risky as compare to investing in Mutual Fund, ETF or Index Fund due to unsystematic risk which is not diversified away.

Unsystematic risk is risk specific to each individual stock but when combine together, such as in Mutual Fund, ETF or Index Fund with a pool of stocks, will be partially or fully diversified away.

Investing in individual stock will required close monitoring of market movement, but might be rewarding with higher return.

Three recommended investment strategies, illustrated one by one as below:

☺ Use OVERALL market upside potential as reference
☺ Use individual stock upside potential as reference
☺ Use individual stock upside potential for stock selection and OVERALL market upside potential for fund allocation

Before demonstrating each recommended strategy, let’s assume upside potential percentage for 10 stocks, A to J from month 1 to 9 is provided as below

This set of data will be use to analyzed each investment strategy.

Use OVERALL market upside potential as reference

This strategy will use OVERALL upside potential as indicator, regardless of movement of each individual stock.

In this strategy, investor will decide based on OVERALL market upside potential % for timing to enter and exiting the market.

Let’s assume an investor using 70% upside potential as indicator to enter the market and 30% upside potential to exit the market.

Assume the allocated investment fund is $100,000, which will be equally invested among all stocks in the list, regardless of individual stock upside potential %.

In month 1, when OVERALL upside potential at 70%, entering market signal is triggered. The investor will invest $10,000 in each individual stock in the list.

From month 2 to month 8, when OVERALL upside potential fluctuate in between 30% - 70%, the investors will hold the stocks.

In month 9, when OVERALL upside potential breaks 30% level, selling signal triggered. All stocks in the list will be sold. The investor will be holding cash and entering the market again when OVERALL upside potential breaks 70%.

In between, investor will closely follow through the market while patiently waiting for timing to enter the market.

Table below summarized the return from this strategy.

Advantages:

☺ Easy to implement
☺ Do not required closely follow through in market changes
☺ Passive investment strategy which does not require frequent transaction.
☺ Lower risk through diversification effects.

Disadvantages:

☺ Return might be lower as compare to aggressive investment strategy.


Use individual stock upside potential as reference

This investment strategy will use individual stock upside potential as reference, regardless of overall market movement.

In this strategy, investor will decide based on individual stock upside potential for timing to buy or sell individual stock.

When an individual stock is sold, proceed from the stock sold will be reinvested in another individual stock where upside potential is meeting buying criteria.

Assume an investor with $100,000 investment fund is using the criteria of 70% upside potential as buying signal and 30% upside potential as selling signal.

From the table, in month 1, only stock A, D, E and F fall within the criteria. Thus, fund of $100,000 will be invested equally among these 4 stocks at $25,000 each.

In month 2, although stock I and stock J is above 70% upside potential, which triggering buy signal; but as all investment fund is allocated to Stock A, D, E and F, no fund is left to invest in stock I and J.

In month 6, Stock F with potential upside % falls below 30% triggered selling signal, while Stock A with upside potential above 70% triggered buying signal. Stock F will be sold and proceed from the sales will be invested in Stock A. This increase stock A investment to $59,451.

In month 9, Stock D with potential upside % fell to 29% and triggered selling signal. Stock D will be sold and proceed from the sales of $31,175 will be kept as cash until investment opportunity emerged.

The investor will hold 100% cash when all stocks fell below 30% selling signal while no stocks go beyond 70% upside potential to trigger buying signal.

Advantages:

☺ Potential higher rate of return through active portfolio management.
☺ Always “ In Play”

Disadvantages:

☺ Required closely follow through changes in each individual stocks and prompt buying or selling decision when signal triggered.
☺ Potential higher transaction turnover, which increase overall investment cost.
☺ Higher risk as focuses on individual stock or small number of stocks minimizes diversification effects.

Use individual stock upside potential for stock selection and OVERALL market upside potential for fund allocation

This investment strategy will use individual stock upside potential as reference for buying or selling signal while using market OVERALL upside potential to allocated fund between stock and cash.

In this strategy, investor will decide based on individual stock upside potential for timing to buy or sell individual stock; investor will base on OVERALL market upside potential to allocate investment fund , where a relationship between OVERALL market upside % and fund allocation need to be established.

When an individual stock is sold, proceed from the stock sold will be either reinvested in another stock where upside potential is meeting buying criteria or holding cash, depending on fund allocation.

Assume an investor with $100,000 investment fund is using the criteria of 70% upside potential as buying signal and 30% upside potential as selling signal. The investor will allocate 100% fund into stock investing when upside potential at 70% level and reduce linearly to 0% when upside potential at 30% level.

From the table, in month 1, only stock A, D, E and F fall within the criteria. As OVERALL upside potential at 70% level, 100% of investment fund will be invested in stock. Thus, fund of $100,000 will be allocated equally among these 4 stocks at $25,000 each.

In month 2, as OVERALL upside potential dropped to 65% , investment fund allocated to stock will be reduce to 87.5% ( $87,500). Stock F with lowest upside potential of 51% among Stock A, D, E and F will be sold partially to cash out $12,500.

In month 3, as OVERALL upside potential dropped to 60% , investment fund allocated to stock will be further reduce to 75% ( $75,000). Stock F with lowest upside potential of 45% among Stock A, D, E and F will be sold partially to cash out another $12,500.

In month 4, as OVERALL upside potential dropped to 55% , investment fund allocated to stock will be further reduce to 62.5% ( $62,500). Stock F with lowest upside potential of 36% among Stock A, D, E and F will be sold partially to cash out another $12,500. As Stock F is only capable to release $5,460, the next lowest upside potential stock will be sold to complete the cash out of $12,500. Stock D with next lowest upside potential of 56% among Stock A, D and E, will be sold partially.

In month 5, as OVERALL upside potential dropped to 50% , investment fund allocated to stock will be further reduce to 50% ( $50,000). Stock D with lowest upside potential of 51% among Stock A, D and E, will be sold partially to cash out $12,500.

In month 6, as OVERALL upside potential dropped to 45% , investment fund allocated to stock will be further reduce to 37.50% ( $37,500). Stock D with lowest upside potential of 35% among Stock A, D and E will be sold partially to release another $12,500. As Stock D is only capable to release $9,085, the next lowest upside potential stock will be sold to complete the cash released of $12,500. Stock E with next lowest upside potential of 45% as compare to Stock A, will be sold partially.

In month 7, as OVERALL upside potential dropped to 40% , investment fund allocated to stock will be reduce to 25% ( $25,000). Stock A with lower upside potential of 55% as compare to Stock E, will be sold partially to release $12,500.

In month 8, as OVERALL upside potential dropped to 35% , investment fund allocated to stock will be further reduce to 12.5% ( $12,500). Stock E with lower upside potential of 51% as compare to Stock A, will be sold partially to release $12,500.

In month 9, as OVERALL upside potential dropped to 30% , investment fund allocated to stock will be further reduce to 0% ( $0). Both Stock A and Stock E will be fully sold.

With 100% cash in hand , investor can decide either to stay away from stock market until OVERALL upside potential back to 70% level or continue to be “ IN PLAY” when OVERALL upside potential back to 35% by allocating $14,599 ( 12.5% of $116,792) to stock investment

Advantages:

☺ More conservative strategy through asset allocation strategy with more cash allocated into stock when upside potential is high.
☺ Always “ In Play”

Disadvantages:

☺ Required closely follow through changes in each individual stocks and prompt decision on buying or selling when signal triggered.
☺ Need close monitoring on market indicator changes.
☺ Potential higher transaction turnover, which increase overall investment cost.
☺ Potential lower return.

In summary, each strategy has it own advantage and disadvantage, incorporated into the strategy itself. Investor is advice to discover the strategy which is most suitable to individual risk and return objective and constraints profile. While implementing the strategy, follow the criteria promptly and in discipline manner.

Investment - An Overview

An investment is a commitment of funds for a period of time to derive a rate of return that would compensate the investor for the time during which the funds are invested, for the expected rate of inflation during the investment horizon, and for the uncertainty (risk) involved.

Investor will formulate investment plan based on risk and return objective together with personnel constraints, then derive required rate of return.

Once rate of return is determined, next is to look into investment strategy which included asset allocation strategy.

Through asset allocation decision, investor will determined analysis method to assist investment decision. Analysis method commonly used are Technical Analysis and Fundamental analysis to determine investment alternatives to generate required rate of return.

Technical analysis involves the examination of past market data such as prices and the volume of trading, which lead to an estimate of future price trends and, therefore an investment decision.

Fundamental analysis will involved making investment decisions based on the examination of the economy, an industry, and company variables that lead to an estimate intrinsic value for an investment, which is then compare to its prevailing market price.

On stock valuation, an investor must estimate a value for the investment to determine if its current market price is consistent with your estimated intrinsic value. To do this, the investor must estimate the value on an asset through valuation process and compare it with prevailing market price to decide weather the stock is a good alternative to buy.

The investment decision process can be compare to shopping for clothes, a stereo, or a car. In each case, you examine the item and decide how much it worth to you and its value. If the price equals its estimated value or is less, you would buy it. The same technique applies to stock except that the determination of stock value is more formal.

An investor starts investigation of stock valuation by discussing the valuation process. There are two general approaches to the valuation process

☺ The top-down, three step approaches
☺ The bottom-up, stock valuation, stock picking approach.

Both of these approaches can be implemented by either fundamentalists or technical analysts. The difference between the two approaches is the perceived importance of the economy and a firm’s industry on the valuation of a firm and its stock.

An investor, after determine the stock to buy base on valuation process, will continue to monitor the performance of the stocks, comparing the actual return against required return to determine either the condition as per investment plan is fulfill.

The Power Of Compounding

Simple interest is interest earned on the principal where interest received will not be reinvested. The interest amount receive every year will equal to interest rate times the principal. Principal is the amount of funds initially invested.

Interest received every year = interest from principal invested

Compounded interest is interest earned on the principal where interest received will be reinvested. The interest amount receive every year will equal to interest rate times principal and the interest received from reinvested interest.

Interest received every year =

interest from principal invested + interest from reinvested interest


The interest earned on interest provides the first glimpse of the phenomenon known as compounding.

Illustration below shows the different in future value for simple interest versus compounding interest base on initial investment of $1,000 and annual interest rate of 10%.



















Although interest earned on the initial investment is important, for a given interest rate it is fixed in size from period to period. The compounded interest earned on reinvestment interest is a far more powerful force, because for a given interest rate, it grows in size each period.

Illustration below shows the power of compounding. For an initial investment of $1,000 which grows at 10% annually for 30 years, the value with compounding interest will grow to 4.36 times in value as compare to simple interest.

The important of compounding increases with the magnitude of the interest rate. As interest rate increases, the compounded interest earned on reinvestment interest will grow at higher speed.

Table below illustrate investment value after 30 years for 5 scenarios , with compounded rate increases at 5% for each scenarios . With $1,000 invested for 30 years, future value increases by 3 – 4 times for every 5% increases in interest rate.

For an investor with limited investment funds, ability to master financial and investment knowledge is essential to increase compounded rate to grow the initial investment more rapidly.

As illustrated below, an investor who is capable of generating 25% compounded grow annually will receive $807,794 by end of 30 years with an initial investment of $1,000 as compare to investor with 5% compounded grow annually, will only receive $4,322.

Investment return of187 times higher, which can only achieve through discipline investment strategy and mastering financial & investment knowhow and skills.

Frequency of compounding

Frequency of interest compounded over time will determine the final value of investment. As frequency of compounding increases, all else equal, the higher the future value.

For instant, many banks offer daily compounded interest rate for both saving and mortgage. This feature of higher compounded frequency will increase the effective interest rate for saving while reduces interest expenses when principal is paid to bring down the mortgage outstanding.

Higher frequency of compounding also reduces the gap between interest rate on one month certificate of deposit as compare to one year certificate of deposit. By assuming annual interest rate compounded annually for certificate of deposit is 3.5% while annual interest rate compounded monthly for certificate deposit is 3%, effective annual interest rate for monthly compounding will be 3.03%. Thus, the gap difference is 0.47% instead of 0.5% when compare the interest rate directly.

Table below illustrate the effect of frequency of compounding to an initial investment of $1,000 for 30 years.

In summary , the higher the compounded interest rate and frequency of compounding , all else equal, future value of an investment today will grow more aggressively.

Investment knowhow and discipline investment strategy is the key factors towards the success.

Time Value Of Money

Time value of money deals with equivalence relationships between cash flows with different dates.

Money has time value in that individuals will value a given amount of money more highly the earlier it is received. Therefore, a smaller amount of money now may be equivalent in value to a larger amount receives at a future date.

Consider 3 scenarios below under inflationary environment at 3% inflation rate annually.

Scenario 1 : Paid $10,500 today and received $10,000 one year from now

Scenario 2 : Paid $10,000 today and received $10,000 one year from now

Scenario 3 : Paid $10,000 today and received $10,500 one year from now

Scenario 1 is most unlikely to be accepted by investor as the real value, measure from purchasing power standpoint, eroded by 7.54%

Real value after 1 year = 10,000 / 10,500 / 1.03 = 92.46%

Scenario 2 is unlikely to be accepted by investor as the real value, measure from purchasing power standpoint, eroded by 2.91%

Real value after 1 year = 10,000 / 10,000 / 1.03 = 97.09%

Although the amount of $ is the same today and 1 year later , but inflationary effects eroded purchasing power over time.

Some investors accept scenario 2 as capital preservation or capital protection when link together with an investment product.

Scenario 3 is most likely accepted by investor as the real value, measure from purchasing power standpoint, increased by 1.94%

Real value after 1 year = 10,500 / 10,000 / 1.03 = 101.94%

Scenario 3 increases investor’s purchasing power over time. The interest rate (r) receive in one year will be equal to 5%

Interest rate (r) = (10,500 – 10,000)/10,000 = 5%

Interest rate can be thought of in three ways

Required rate of return, that is, the minimum rate of return an investor must receive in order to accept the investment.

Discount rate, the rate used to discount the future value of the money to reflect the value today. In scenario 3, discount rate is 5%, which will discount $10,500 one year from now to reflect the value as $10,000 today.

Opportunity cost, the value that investors forgo by choosing a particular course of action. In scenario 3, if the investors decided to spend $10,000 today, he would have forgone earning 5% on the money. So, we can view 5% as the opportunity cost of current consumption.

The relationship between value today (term as Present Value, PV) versus future value (term as Future Value, FV), N years from today is

Simple interest : FV = PV [1 + r (N)]

Compounded interest : FV = PV (1 + r)N

Mastery of time value of money concepts and techniques is essential for investment decision as it will determine either the future value of an investment is meeting investment goal set forth in the investment plan to meet future consumption.

Important Of Investment KnowHow In Life

Individual engage in full time job, tight up with day to day activities at the workplace, tend to ignore the important of financial and investment knowhow. Mastering financial and investment knowhow become low priority activities in life.

To minimize effort, individual taking short cut approaches by following through speculation blindly, ending up regretting when lack behind from investment goal.

As investment fund compounded over time, it weight as compare to annual salary income become increasingly significant. To certain extend, if investment fund is managed well, return from investment can overtake annual salary income, a key step towards financial freedom.

Let’s illustrate the situation above with an example. Assume 4 individuals with condition below:

☺ Current income at $30,000 annually with 7% annual increment for next 30 years
☺ Tax and other statutory contribution = 20% of income
☺ Basis spending = 30% of income

☺ Major spending
☻ Individual A , B and C = 30%
☻ Individual D = 20%

☺ Annual investment contribution as percentage of annual salary income
☻ Individual A , B and C = 20%
☻ Individual D = 30%

☺ Expected rate of return, compounded annually
☻ Individual A = 10.33%
☻ Individual B = 15%
☻ Individual C and D = 20%


Individual A will represents worst case scenario with lowest annual investment contribution of 20% from salary income and lowest expected rate of return of 10.33%

Individual D will represents best case scenario with highest annual investment contribution of 30% from salary income and highest expected rate of return of 20%

Condition and investment grow for each individual is summarizing in table below:

Included in the table above is period required to equalize annual salary income with investment return. We can observed that individual A , with lowest contribution and rate of return , takes 30 years to complete the task whereas individual A with highest contribution and rate of return , takes only 10 years to achieve the goal.

Chart below (in partial and full scale) illustrate detail comparison from year 1 to year 30.
We can observed that individual D annual investment return achieve $3,404,043 by year 30 , as compare to $228,587 from salary income , a significant difference by 14.9 times

In summary, capability to master financial and investment knowhow, get into investment action to make our money work harder and grow faster, will be an essential step towards wealth creation in our life.

Be A Successful Investor

When asked, almost everyone's dream is to become a millionaire, enjoy luxurious life style and be financial freedom.

For dream come through, everyone, invest in financial asset, either from very conservative certificate of deposit, real estate, equity to highly risky derivatives to generate returns to meet investment goals.

But how many investors successfully making this happen? How many investors disappear as discourage investor after a while?

There is no short cut to become a successful investor. It required spending time and effort to learn up knowledge and experience.

Financial and investment knowledge can be learning through financial books, investment knowledge sharing from successful investors, financial magazine , investment seminar etc.

As financial market is dynamic and changing as a reaction to changes in economy climate and investor rational and irrational respond, experience build up will required continuous follow through on dynamic financial market changes and factors driving the changes.

Learning to become a successful investor is no different than mastering a skill on playing games. We can learn theory from books, shared experience from the expert, but without real life experience on converting theory into implementable strategy, the probability of making it happen is low.

Learning up financial knowledge is not a difficult task. It is life long continuous learning and practices which required average an hour a day; 30 minutes for reading and 30 minutes to build up experience through exposure to financial market news and always use common sense and logic to understand the factor influencing it.

A successful investor required

☺ Basis financial and investing knowledge
☺ Well define investment plan
☺ Risk and return objectives
☺ Investment constraints
☺ Investment strategy
☺ Discipline investment approach to minimize emotional decision making
☺ Details and skeptical. Always look into the detail of information, use common sense and be skeptical when the return or results is too good to be true.

We will see that although there are no shortcuts or guarantees of investment success, maintaining a reasonable and disciplined approach to investing will increase the likelihood of investment success over time.

Some common shortcut approaches investors use which causing high degree of failure.

☺ Follow speculation without any investment knowhow
☺ Decision making influence by emotional behavior
☺ Copy exactly investment strategy of other investor
☺ Focus on high return without details assessment of risk


Follow speculation without any investment knowhow

This occurred frequently during bull market when market is in strong positive sentiment. With stock price and volume breaking record high , investor will tends to be in Ponzi mindset , believing stock market will continue to advance; stock price , especially on small cap will rocket high , stock selection is not critical as every stock will make significant profit.

As to reap higher profit, investors throw in more money, enter into margin transaction and contra transaction. All kind of financial leverage method is use to multiple returns.

When the bubble burst, waken from millionaire dream , what left is stocks with significantly lower in value, margin call and debt to be deal with; a painful lesson learn that might required life long payback.


Decision making influence by emotional behavior

Investor without discipline investment strategy will face the problem of decision making influence by emotional behavior.

When market in down turn, investor with wait and see attitude without an entry strategy will tend to be driven by emotional factor on hoping for buying at renew lowering level. When market bottoming and strongly rebound, the greedy behavior will drive the investor to buy at current market price, worry about losing the opportunity to make profit.

When market in uptrend, investor with wait and see attitude without an exit strategy will tend to driven by emotional factor on hoping for selling at record high. When market peak and entering correction, the panic behavior will drive the investor to sell at current market price, worry about making losses or even get tight up on holding overvalue stock.

This unfortunate “buy high sell low” strategy can best be illustrated by “Greedy / Panic Cycle”

Copy exactly investment strategy of other investor

Some famous question investors tend to ask others

“Any recommendation of stock to buy, I would like to follow.”

“Any stock that you are buying now, I would like to buy.”

“I will follow exactly your strategy, tell me when you are buying and selling.”


Due to financial plans and investment needs are as different as each individual; Investment needs change over a person’s life cycle and how individual structure their financial plan should be related to their age, financial status, future plans, risk aversion characteristics and needs; couple with time lag (time different in between exchange of information), investment strategy is unique to each investor. The probability of success by copying exactly is most likely low in long term.

For example, a follower with $200,000 wealth copies exactly the strategy of an investor with $2,000,000 in wealth who invested $50,000 in risky asset, with the opportunity to make 5 times return or losses everything. To the wealthier investor, he believes his risk tolerance is high and able to bare the loss of 2.5% of total wealth. But for the follower, is potential 25% loss in wealth is acceptable?

Time lag reduces synchronization of action due to dynamic changes of share quote to reflect latest market information. Assume a lucky investor buying stock few minutes ahead of the follower at slightly lower price. If he decided later that the outlook of the company is not as great and decided to sell at breakeven; is the follower accept the facts to sell at a loss? If the seller decided to sell the stock and failed to communicate to the follower regarding the action and cause the follower to sell at loss later , is this acceptable to the follower ?

Is nothing wrong to ask others for opinion on stock that they are buying or their outlook about the market , investor should treat this information as reference and base on own knowhow to make investment decision and action.


Focus on high return without details assessment of risk

Investor always blindfolded and gets excited by investment which provides high return without details assessment of risk and high degree of skeptical about the trueness of the return.

As risk drives return, all else equal, a high return investment should couple with certain degree of risk, which might or might not meeting investor investment portfolio. Rarely we can find investment with high return and low risk.

Read the advertisement below, does it sound attractive to you? What is the embedded risk for each investment?


A mineral exploration investment opportunity seeking new fund would like to invite interested investor to invest $1,000 today and will be rewarded with $100 return per month for next 36 months. A simple interest return of 120% a year or if reinvestment is allowed, will be 313.8% with compounded grow.

The return is superior, what is the risk involves? Why the company spending great effort searching and managing big group of investors rather than exploring opportunity with Private Equity Funds or Venture Capital Funds?

An investment firm specializes on selling product ABC would like to share the success story with investors for joint venture opportunity to start up business. Company will provide profit guarantee where any shortfall will be compensated by the company.

The profit guarantee sounds attractive on reducing investment risk, but what is the financial position or financial strength of the company to provide the guarantee? What is the risk associated with the investment?


An individual should always find answers to any questions in mind regarding any investment opportunity before accepting it. Risk assessment is crucial before investing.

A realistic investor's goal

When asked about their investment goal, people often say, “to make a lot of money,” or some similar response.

Such a goal has 2 drawbacks:

First, it may not be appropriate for the investor.

Second, it is too open-ended to provide guidance for specific investments and time frames.

Such an objective is well suited for someone going to the racetrack or buying lottery tickets, but it is inappropriate for someone investing funds in financial and real assets for the long term.

An important purpose of well define investment plan is to help investors understand their own needs, objectives and investment constraints. As part of this, investors need to learn about financial markets and the risks of investing. This background will help prevent them from making inappropriate investment decisions in the future and will increase the possibility that they will satisfy their specific, measurable financial goals.

Thus, a well define investment plan helps the investor to specify realistic goals and become more informed about the risks and costs of investing.

Market values of assets, weather they be stocks, bonds, or real estate, can fluctuate dramatically. A review of market history shows that it is not unusual for asset prices to decline by 10 percent to 20 percent over several months. Investor will typically focus on a single statistic, such as a 10% average annual compounded rate of return on stocks, and expect the market risk of 10% every year. Such thinking ignores the risk of stock investing. Part of the process of developing a well define investment plan is for the investor to become familiar with the risks of investing, because we know that a strong positive relationship exists between risk and return.

In summary, constructing a well define investment plan is mainly the investor’s responsibility. It is a process whereby investors articulate their realistic needs and goals and become familiar with financial markets and investing risks. The results of bypassing this step will most likely be future aggravation, dissatisfaction and disappointment.

To construct a well define investment plan, an investor need to look into investment objectives and constraints.


Investment Objectives

The investor objectives are his or her investment goals expressed in term of both risk and returns. The relationship between risk and returns requires that goals not be expressed only in term of returns. Expressing goals only in terms of returns can lead to inappropriate investment practices, such as the use of high-risk investment strategies , which might not be suitable for the investor.

For example, a person may have a stated return goal such as “double my investment in 5 years.” Before such a statement becomes part of the well define investment plan, the investor must become fully informed of investment risks associated with such goal, including the possible of loss. A careful analysis of risk tolerance should precede any discussion of return objectives. It makes little sense for a person who is risk averse to invest funds in high risk assets.

Sometimes investment magazines or books contain tests that individual can take to help them evaluate their risk tolerance. Subsequently, investor can use the results of this evaluation to categorize risk tolerance and develop an initial asset allocation.

Risk tolerance is more than a function of an individual’s psychological makeup; it is affected by other factors, including a person’s current insurance coverage and cash reserves.

Risk tolerance is also affected by an individual’s family situation (for example : Marital status and the number and ages of children) and by his or her age. We know that older persons generally have shorter investment time frames within which to make up any losses; they also have years of experience, including living through various gyrations and “corrections”( a euphemism for downtrend or crashes) that younger people have not experienced or whose effect they do not fully appreciate.

Risk tolerance is also influenced by one’s current net worth and income expectations. All else being equal, individuals with higher incomes have a greater propensity to undertake risk because their incomes can help cover any shortfall. Likewise, individuals with larger net worth can afford to place some assets in risky investments while the remaining assets provide a cushion against losses.

A person’s return objective may be stated in terms of an absolute or a relative percentage return, but it may also be stated in term of general goal, such as capital preservation, current income, capital appreciation or total return.


Investment Objective: 25 years old investor versus 55 years old investor

What is an appropriate investment objective for a typical 25-years-old investor?

Assume he holds a steady job, is a valued employee, has adequate insurance coverage, and has enough money in the bank to provide a cash reserve. Let’s also assume that his current long term, high-priority investment goal is to build a retirement fund.

Departing on his risk preferences, he can select a strategy carrying moderate to high amounts of risks because the income stream from his job will probably grow over time. Further, given his young age and income growth potential, a low-risk strategy, such as capital preservation or current income, is inappropriate for his retirement fund goal; a total return or capital appreciation objectives would be most appropriate. Here’s a possible objective statement.

Invest funds in a variety of moderate-to higher risk investments. The average risk of the equity portfolio should exceed that of a board stock market index. Domestic equity exposure should range from 80 percent to 95 percent of the total portfolio. Remaining funds should be invested in short and intermediate term notes and bonds.


Assume a typical 55-years-old investor like-wise has adequate insurance coverage and a cash reserve. Let’s also assume she is retiring this year.

This individual will want less risk exposure than the 25-years-old investor, because her earning power from employment will soon be ending; she will not be able to recover any investment losses by saving more out of her paycheck. Depending on her income from pension plan, she may need some current income from her retirement portfolio to meet living expenses. Given that she can expect to live an average of another 20 - 30 years, she will need protection against inflation. A risk-averse investor will choose a combination of current income and total return in an attempt to have principal growth outpace inflation.

Here’s an example of such an objective statement:

Invest in stock, bond and certificate of deposit investments to meet income needs (from bond income, interest income and stock dividends) and to provide for real growth (from equities). Fixed income securities should comprise 55 – 65 percent of the total portfolio; of this, 5 – 15 percent should be invested in short term securities for extra liquidity and safety. The remaining 35 – 45 percent of portfolio should be invested in high-quality stock whose risk is similar to equity index.

More detailed analyses for 25-year-old and 55-year-old investor would make more specific assumptions about the risk tolerance of each, as well as clearly enumerate their investment goals, return objectives, the funds they have to invest at the present, the funds they expect to invest over time, and the benchmark portfolio that will be used to evaluate performance.


Investment Constraints

In addition to the investment objectives that set limits on risk and return, certain other constraints also affect the investment plan. Investment constraints include liquidity needs, investment time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences.


Liquidity needs

An asset is liquid if it can be quickly converted to cash at a price close to fair market value. Generally, asset are more liquid if many traders are interested in a fairly standardize product. In general, stocks and short term certificate of deposit are a highly liquid security; real estate and venture capital are not.

Investors may have liquidity needs that the investment plan must consider. For example, although an investor may have a primary long term goal, several near-term goals may require available funds. Wealthy individuals with sizeable tax obligations need adequate liquidity to pay their taxes without upsetting their investment plan. Some retirement plans may need funds for shorter-term purposes, such as buying a car or a house or making college tuition payments.

An investor at young age probably has little need for liquidity as he focuses on his long term retirement funds goal. This constraint may change, however, should he face a period of unemployment or should near-term goals, such as honeymoon expenses or a house down payment, enter the picture.

An investor at older age has a greater need for liquidity. Although she may receive regular income from pension plan, it is not likely that they will equal to work paycheck. She will want some of her portfolio in liquid securities to meet unexpected expenses or bills.


Time Horizon

Time horizon as an investment constraint briefly entered our earlier discussion of near-term and long term high priority goals. A close (but not perfect) relationship exists between an investor’s time horizon, liquidity needs, and ability to handle risk.

Investor with long investment horizons generally require less liquidity and can tolerate greater portfolio risk; less liquidity because the funds are not usually needed for many years; greater risk tolerance because any shortfalls or losses can be overcome by returns earned in subsequence years.

Investors with shorter time horizons generally favor more liquid and less risky investments because losses are harder to overcome during a shorter time frame.

Because of life expectancies, a young age investor has a longer investment time horizon than an older age investor. Thus, a young age investor will have a greater proportion of his portfolio in equities – including stocks in small firms than older age investor.


Tax concern

Investment planning is complicated by the tax code; Taxable income from interest, dividends and rents is taxable at the investor’s marginal tax rate. The marginal tax rate is the proportion of the next one dollar in income paid as taxes. Capital gain or losses arise from asset price changes. Either capital gain tax is imposed, is depends on different country tax jurisdiction. They are tax differently than income. Income is taxed when it is received; capital gains or losses are taxed only when an asset is sold and the gain or loss, relative to it initial cost, is realized. Unrealized capital gains or losses reflect the price change in currently held assets that have not been sold; the tax liability on unrealized gains can be deferred indefinitely.

Simple formula below illustrates future value of investment with taxes on dividend / interest income versus capital gains.


Estimated future value of investment for dividend/interest ( tax paid annually)

Future value = INV x [ 1 + r (1- T ) ]N

INV = amount invested today
r = expected rate of return
T = tax rate on dividend
N = time horizon of investment


Estimated future value of investment for capital gain ( tax paid when gain is realized)

Future value = INV x ( 1 + r )N x (1- T )

INV = amount invested today
r = expected rate of return
T = tax rate on capital gain
N = time horizon of investment


For a married person , jointly or separate income tax filling will also affect marginal tax rate on taxable income.


Legal and regulatory Factors

Both the investment process and the financial markets are highly regulated and subject to numerous laws. At times , these legal and regulatory factors constrain the investment strategy of individuals and institutions.

Investors are advice to understand the legal and regulatory factors imposed on the choice of investment.


Unique Needs and Preferences

This category covers the individual and sometimes idiosyncratic concerns of each investor. Some investors may want to exclude certain investments from their portfolio solely on the basis of personal preference or for social consciousness reasons . For example , they may request that no firms that manufacture or sell tobacco , alcohol , pornography , or environmental harmful products be included in their portfolio. Some mutual funds screen according to this type of social responsibility criterion.

Another example of personal constraint is the time and expertise a person has for managing his or her portfolio. Busy executives may prefer to relax during nonworking hours and let a trusted advisor manage their investments. Retirees , on the other hand , may have the time but believe they lack of expertise to choose and monitor investments, so they also may seek professional advice.