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.
Wednesday, September 2, 2009
Tuesday, September 1, 2009
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.
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.
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.
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.
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.
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.
Sunday, August 30, 2009
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:
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
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.
Thursday, August 27, 2009
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”
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.
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?
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.
Wednesday, August 26, 2009
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.
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.
Sunday, August 23, 2009
Investment Strategy - Capital Preservation , Capital Appreciation , Current Income and Total Return
Capital preservation
Capital preservation means that investors want to minimize their risk of loss, usually in real terms. They seek to maintain the purchasing power of their investment. In other words, the return needs to be not less than the rate of inflation. Generally, this is a strategy for strongly risk-adverse investors or for funds needed in the short-run, such as for next year’s college payment or a down payment on a house.
Capital Appreciation
Capital appreciation is an appropriate objective when the investors want the portfolio to grow in real terms over time to meet some future need. Under this strategy, growth mainly occurs through capital gains. This is an aggressive strategy for investors willing to take on risk to meet their objective. Generally, longer-term investors seeking to build a retirement or children college education fund may have this goal.
Current Income
When current income is the return objective, the investors want the portfolio to concentrate on generating income rather than capital gains. This strategy sometimes suits investors who want to supplement their earnings with income generated by their portfolio to meet their living expenses. Retirees may favor this objective for part of their portfolio to help generate spendable funds.
Total Return
The objective for the total return strategy is similar to that of capital appreciation; namely, the investors want the portfolio to grow over time to meet a future need. Whereas the capital appreciation strategy seek to do this primarily through capital gains, the total return strategy seeks to increase portfolio value by both capital gains and reinvesting current income. Because the total return strategy has both income and capital gains components , its risk exposures lies between that of the current income and capital appreciation strategies.
Capital preservation means that investors want to minimize their risk of loss, usually in real terms. They seek to maintain the purchasing power of their investment. In other words, the return needs to be not less than the rate of inflation. Generally, this is a strategy for strongly risk-adverse investors or for funds needed in the short-run, such as for next year’s college payment or a down payment on a house.
Capital Appreciation
Capital appreciation is an appropriate objective when the investors want the portfolio to grow in real terms over time to meet some future need. Under this strategy, growth mainly occurs through capital gains. This is an aggressive strategy for investors willing to take on risk to meet their objective. Generally, longer-term investors seeking to build a retirement or children college education fund may have this goal.
Current Income
When current income is the return objective, the investors want the portfolio to concentrate on generating income rather than capital gains. This strategy sometimes suits investors who want to supplement their earnings with income generated by their portfolio to meet their living expenses. Retirees may favor this objective for part of their portfolio to help generate spendable funds.
Total Return
The objective for the total return strategy is similar to that of capital appreciation; namely, the investors want the portfolio to grow over time to meet a future need. Whereas the capital appreciation strategy seek to do this primarily through capital gains, the total return strategy seeks to increase portfolio value by both capital gains and reinvesting current income. Because the total return strategy has both income and capital gains components , its risk exposures lies between that of the current income and capital appreciation strategies.
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