This article was originally posted on DollarsAndSense.
In today’s low interest rate environment, everyone is talking about how investing can get you a higher return than just letting money “rot” in the bank. While investing is not rocket science, neither is it child’s play – people have lost fortunes and ruined their lives doing it wrong.
In this article, we discuss some basic principles that every investor should consider when they are making their investments. These principles may seem fairly straight forward, but once you are investing with real money and your emotions take over, a reminder of these basic concepts may save you from making rash decisions.
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# 1 The Relationship Of Risk And Return
One powerful relationship investors need to understand is that between risk and return. This basically means that the more risks you take, the higher the return you can should expect.
10 out of 10 people will tell you they prefer an 8% return to a 3% return. This is because most of these people do not understand why they are able to achieve the additional 5% return.
At DollarsAndSense.sg, we like to explain this in the following manner – receiving a higher return will always mean that you are taking on more risks. But receiving a lower return does not necessarily mean that you are taking on less risk. It may be that you are putting your money in a truly lousy investment.
Ask the same 10 people again and explain that they will be taking on significantly higher risks with the investment offering 8%, and you will find that not all 10 will choose to go for it anymore.
“No pain, no gain”, this is what you would commonly hear from sales people hawking risky investments. We agree that being too conservative will hinder us from achieving our financial goals. But as an investor, you will need to consider what kind of risks you would be willing to take and still get a good night’s sleep.
There is no wrong answer to how much risk an investor should be willing to take, as you go through different stages in life, your risk appetite will naturally shift. As you go from having no dependents, to getting married and buying a home and having children, it is fair to assume investors will try to take on less risks as they age.
# 2 Diversification
Everyone should know what diversification is. The concept is simple – you do not want to put all your eggs in one basket. So you buy a variety of investments so that no single investment has the ability to ruin you financially.
When you invest, you want to look at different asset classes. The common ones retail investors should look at are stocks, ETFs (Exchange Traded Funds) and unit trusts, bonds and the Singaporean favourite – properties, including REITs. Of course, there are others, but they usually need more in-depth understanding before purchase.
You invest in different asset class because you want to ensure that a crash in a certain asset class will not be exactly correlated to another asset class. While a global event would likely impact all asset classes, you can look at isolated events such as the Singapore government introducing cooling measures impacting local property prices. Other incidents such as rising interest rates or monetary policies will impact certain asset classes more than others.
Another way you can diversify is within the asset classes itself. You can buy several different stocks or bonds in different businesses and different sectors, or invest in an ETF or unit trust to achieve this. This will mitigate the impact of one sector on your portfolio – say the lagging oil and gas market right now.
# 3 Time Value Of Money or Power Of Compounding
Another important concept is understanding that the younger you start investing, the more time your investments have to grow. This is called the time value of money.
The principle behind this is that when you invest money, you get a return per year. The next year you get a return on your original investment and you get a return from the reinvested returns from last year, and the year after that, you get a return on your original investment and a return from the reinvested returns from the first and second year. You get where we are going with this.
It is this simple concept that has the ability to vastly affect the worth of people’s portfolios over a lifetime. We can take a look at the table below to see how investing $1,000 a year from an early age is able to make a huge difference over your lifetime.
The different levels of returns are just there to guide you on how they can affect your portfolio. What we’re more interested in highlighting is that is you put $1,000 in the bank every year from when you were 20 years old to when you turned 65, you would have $47,050. A tad bit more than the $45,000 cumulative total you would have put in. This itself highlights the power of compounding.
However, if you invested in stocks or bonds, you can generally expect to receive a higher return. This is how your cumulative total of $45,000 could end up as $96,500 or even $169,685.
|Age||Bank Savings Deposit 0.1% P.A ($)||3% Investment Returns ($)||5% Investment Returns ($)||10% Investment Returns ($)|
The Bottom Line
As investors, you need to understand yourself and your appetite for risks, as this will determine how much risk you are willing to take. The other half of the story is understanding how risky the investments you are putting your money into are. As we explained, we do not think receiving low returns automatically equates to taking on less risks.
Once you are familiar with the kind of risks you are taking, you can go about trying to mitigate it by employing a diversification strategy that suits your risk profile. This will further reduce the risks you are carrying in your individual investments.
You then have to keep to your plan for the long-term and not get swayed by emotions in the short-term. While doing this, you also need to monitor and make small adjustments to your portfolio as your risk appetite alters through the different life stages you go through.
Understanding and utilising these concepts will enable you to build up your wealth in the long-term and aid in fulfilling your financial goals.
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