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.