basics of investment

Basics of Investment

2005

Brunei Investment Agency

Contents

When to Invest

Establishing Personal Investment Policy

Return and Risks

Horizon and Liquidity

Example - Policy

Summary

Appendix

Setting up Priorities

1. Savings for Emergencies

2. Insurance Cover (accidents, medical, life)

3. Investment

Traditional Investment

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

Bonds– Fixed Income Instrument, pay coupons (or

interest)– Eg. Government Bonds, Corporate Bonds

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

Cashflow Cycle

Raise finance through loans, issue bonds or shares

Pay off loans and interest, redeem bonds and payoff coupons, and distribute profit

through dividends

Balancing the Proportions

• How to balance the weights of each assets?

Cash

Bonds

Equity

10% ??

45% ??

45% ?

Which Ones to Buy ?

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

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

Long term bonds? Munis? Asset Backed?

Lots of Questions – Need Lots of Answers?

Answer :

Depends on your

Goals

Age

Asset Size and

Risk Tolerance ….

Contents

When to Invest

Establishing Personal Investment

Policy

Return and Risks

Horizon and Liquidity

Example - Policy

Summary

Appendix

Setting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;

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

1. Return Objective (Goals)

Finding the right Return Objective

– Eg. To double your money in 10 years.

– Steady return over long periods of time

– To get $1,000,000 in 30 years

– To get $100,000 in 6 years

– etc

Data From 1926-2001 (US)

Asset TypeAverage Return per

year

Large (Blue Chip) Stocks 10.7%

Small Stocks 12.5%

Long Term Corporate Bonds 5.8%

Long Term Government Bonds 5.3%

US Treasury Bills (Cash) 3.8%

Return in US Stock Market

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

1981 $100.00

1982 $114.76

1983 $134.58

1984 $136.47

1985 $172.40

1986 $197.61

1987 $201.62

1988 $226.62

1989 $288.37

1990 $269.46

1991 $340.34

1992 $355.54

1993 $380.62

1994 $374.76

1995 $502.59

1996 $604.44

1997 $791.86

1998 $1,003.04

1999 $1,198.90

2000 $1,077.34

2001 $936.83

2002 $717.93

2003 $907.32

2004 $988.92

Investment in US Stock Market

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

0

200

400

600

800

1,000

1,200

1,400

S&P Monthly Returns

Monthly Returns of US Stocks have been Volatile

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

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

Volatilities of Stock Market

100

200

300

400

500

600

700

Volatilities of Traditional Assets

100

200

300

400

500

600

700Equity

Bond

Cash

Volatilities of Bond Market

100

200

300

400

500

600

700

Setting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;

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

2. Risk Tolerance

• Setting Return Objectives needs Risk Parameters

– No pain No gain : No risk No Return

• What Risk to assume??

Investing in Shares of Companies

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

can go bankrupt)– Sector Risk (share price can also fall along with other

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

rest of the stocks in the same market)

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

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

Simpler solution : BUYING INDEX FUND

Return and Risk

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

Sources : Various

0%

5%

10%

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

Return

US Bonds

US Equity

Diversification : Combining Assets

Benefits of Correlation between asset classes

Stocks and Bonds rises and falls at different times

Setting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;

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

a. Time Horizon

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

• Age plays an important role for individuals.

• Example Return Objective of Setting a Retirement plan (at the age of 55)

– A person who is 25 for instance, will have a different set of risk tolerance compared to another who is already 48 years old.

Phases of Life

Setting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;

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

b. Liquidity Requirement

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

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

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

Setting up Investment Policy

1. Return Objective (Goals)

2. Risk Tolerance

Subject to ;

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

Other Considerations

• More Diversification– Alternative Asset Classes

• Other Risks– Currency, Country, Counterparties etc

• Regular Investments versus Lump Sum Investment

More Diversification

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

your overall investment without sacrificing too much of expected return.

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

Various Asset Classes and the Risk Profile

Contents

When to Invest

Establishing Personal Investment Policy

Return and Risks

Horizon and Liquidity

Example – Mr Ash Burn

Summary

Appendix

Investment Policy Example : Mr Ash Burn

1. Return Objective (Goals) :

Wishes to have monthly income of US$5,000 at the age of 56 - for 24 yearsWishes to travel a lot when retired, US$ requirement not a priority

2. Risk Tolerance

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

Subject to ;

a. Time Horizon - 31 years to go before 1st Payment

b. Liquidity Requirement - No real need of liquidity from this

investment fund

c. Laws & Regulations - US law & regulation applies

d. Taxes where applicable - No tax concessions

Investment Strategy Example : Mr Ash Burn

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

AllocationExpected Return

Volatility

US Equity Index 20% 9.2% 21.7%

Developed Market Equity Indices (non-US)

30% 6.3% 18.9%

Emerging Market Equity Index Fund 20% 11.1% 27.9%

Private Equity Fund 15% 19.0% 20.0%

Long term Fixed Income Funds 15% 1.2% 6.5%

Total 100% 9.0% 15.0%

Investment Requirement

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

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

or

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

20%

30%

20%

15%

15%

US Equity Index

Developed Market Equity Indices (non-US)

Emerging Market Equity Index Fund

Private Equity Fund

Long term Fixed Income Funds

Investment Requirement

• If Return Expectation is more moderate 6.5%, need;

– a lump sum investment amount of US$ 103,896,

or

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

Or an even better (less painful alternative)

• $4,885/year (but increasing this payment by 5% per year),

hence monthly installment will be $407 on the 1st year, $427 in

the 2nd year, and so on and so forth. At 52 for instance, he will

be paying $956/mth.

Perhaps this will be an easier option as he is assumed to earn

more as he grows older

Policy Review – Mr Ash Burn

1 year later, the investment policy is reviewed

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

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

Contents

When to Invest

Establishing Personal Investment Policy

Return and Risks

Horizon and Liquidity

Example - Policy

Summary – 4 Key Points

Appendix

4 Key Points

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

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

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

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

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

Appendix

Some useful sites on Index Funds, ETFs and financial glossary

• www.fool.com

• www.investorguide.com

• www.bloomberg.com

• www.investorwords.com