Author: smartmoneyasia

When talking about asset allocation, I mentioned that your strategy will need to be different depending on whether you are investing a small amount on a regular basis, or a lump sum at one time.

I would consider these two different types of money. Regular comes from your surplus over expenditure every month. It doesn’t drain your bank account. In fact, the maximum you should contribute to long term regular investments every month should be 50% of your monthly surplus. That way you don’t suddenly find yourself with cash flow trouble when a big bill comes in. Lump sum is money over and above your emergency cash reserve that you have accumulated in the bank. When you look at your asset weighting and find that you are overweight in cash, you might decide to make a lump sum investment into medium term assets in order to correct the overall weighting.

Now if you are going to invest $50,000 tomorrow, you will probably want to be very careful about your asset allocation, particularly if you have a low appetite for risk. If you invest all this money into equities, then a sudden correction or prolonged bear market could have a major effect on your capital. You would want to make sure you were diversified across a broad range of asset classes to protect the downside.

However, if you are starting a long term savings scheme for your retirement and investing $500 a month, then equity market volatility can be your friend. I’m sure by now you have heard the term Dollar Cost Averaging? If not, then take a look at this Investopedia article, which has a great video explaining how it works. A regular investment plan like this can be broken down into three stages:

1. Capital accumulation – here’s where you take advantage of the averaging effect of buying shares every month. At this stage you can allocate 100% to equities.
2. Diversified – at some point, when you have build up a weight of capital in the investment, and when current stock prices are higher than the average price you paid for them, you should diversify into an allocation that fits your strategic risk profile. There’s no fixed time frame for doing this. You need to review annually yourself or with your adviser, and when you feel you have built up enough capital that it has become a lump sum in itself, diversify across other assets.
3. Pre-retirement – this doesn’t have to be about retirement necessarily, but when you get close to using the money you will need to switch to a more tactical allocation to preserve capital. This is typically in the last 1-3 years. During the crash in 2008, many people’s retirement accounts were hit because they were still in a growth focussed asset allocation – no problem for a young person but a disaster for someone about to retire and start spending the money.

I sometimes hear the term “set and forget” for long term investments, however you should be careful about this. Even a small monthly savings plan needs to be reviewed at least once a year to check if it’s time to move into the next allocation phase. Lump sum investments also need to be rebalanced regularly, and we will cover rebalancing shortly.

 

We know already that asset allocation is the most important investment decision you will make. So how to decide what percentage of your money should be allocated to which assets? One factor is your stage in life: Young people have time on their side and are looking to grow their money over that time. Someone nearing retirement may no longer be looking for capital growth – they are going to need income from their investments and a significant drop in value would be damaging.

Another thing to consider is your risk tolerance. This can vary wildly from one person to another, even within your family, and it’s important to understand what level of risk you are able to bear.

The first part is to determine your investor experience. This can be summed up fairly simply:

Inexperienced Investor: You have invested in a limited range of asset classes for a period of less than four years and/or your investment knowledge is low or poor. However, you do understand that prices of securities may go up as well as down.

Experienced Investor: You have invested in various asset classes for a period of more than four years and have experienced volatility. Your investment knowledge is good and you acknowledge investment risk.

Professional Investor: You frequently trade various asset classes and have done so for more than four years. As an individual you have in excess of US$1.1 million of ‘investible’ assets and have extensive investment knowledge.

So what really separates an experienced investor from an inexperienced investor? The key term here is that you have “experienced volatility”. Simply put, if you have invested in a variety of assets for four years or more then you will have lost money somewhere!

The next part is to determine your risk tolerance. If you search online you will find numerous risk profiling questionnaires. Try one or two and see what results you get. For reference, here is a typical one from HSBC, and here is a more fun one from Rutgers.

Typically risk profiles are divided into two major categories:

• Strategic – for long term planning,
• Tactical – either aggressive trading, or focussed on a specific life stage such as pre-retirement, post retirement, or income generating

We won’t get into the tactical profiles today, suffice to say that needs can change with major life events. If you are retired then long term capital growth is less of a concern and your focus is likely to be on capital preservation and generating income.

Strategic Profiles:

• Conservative – investors primarily interested in income and modest growth potential. The allocation is relatively defensive but has a modest exposure to growth assets. Looking for income and capital growth from investments.
• Balanced – investors with some time until retirement. The allocation invests in

  a much broader range of assets than a typical balanced fund, which will result in lower potential for capital loss whilst at the same time offering growth potential. Looking for income and growth from investments, but more focussed on growth.

• Growth – investors who have a longer investment time horizon, primarily interested in capital growth, and are comfortable with modest short-term capital losses. The allocation is biased towards growth assets, but still invests in a broader range of assets than a typical growth fund.
• Alpha – investors who wish to adopt an aggressive approach, with the sole aim of long-term capital growth. Medium-term losses should be expected. The allocation is almost entirely biased towards equities and other growth assets.

The names and definitions of the strategic profiles may differ depending on who you ask. Alpha may be called adventurous, for example. The important thing is to start to understand where you fit in on the risk scale so you can plan your asset allocation accordingly.

You may remember we talked a little about trade-offs already. Well another investment trade off is active vs passive strategy. This is a trade-off we are hearing more and more about these days. Fifteen years ago, almost nobody was talking about index funds and Exchange Traded Funds (ETFs). You would either buy stocks and bonds directly; or you would buy a mutual fund, run by a manager who was benchmarked against “the market”. Hedge funds were only just becoming accessible to regular investors, rather than being for sophisticated or high net worth investors only.

You may have heard about a bet that Warren Buffet made almost 10 years ago: He bet that a passive investment in the S&P 500 index would beat any given portfolio of hedge fund strategies over a 10 year period ending December 31st 2017. The only takers were an alternative investment specialist firm called Protege Partners LLC, and there is a million dollars riding on it to go to the winner’s charity of choice.

So how’s it going? Well, in truth it’s not even close. Despite starting the bet before the 2008 financial crisis the S&P 500 is sitting on a return of 85.4%. (7.41% p.a.) The hedge funds average is 22%. (2.2% p.a.)

So what can we learn from this? Well here are a few lessons:

• It’s time in the market that matters, not timing the market.
• Fees really matter – the hedge funds have performed ok, and with lower volatility. But an annual fixed fee and 20% performance fees are going to eat into investor returns.
• You have to hang in there! Think back to 2008 – the housing crisis, Lehman Brothers goes down, the stock market plunges, it feels like the end of the world…and you just invested a chunk of your savings in the S&P 500! Be honest here, would you have sat on that bet and waited? It’s easy to say yes with hindsight, but an awful lot of people sold investments at the bottom of the market, when despair was at its highest, and then sat out in fear and missed the big rebound.

So does this bet settle the active vs passive investment debate? Well, not exactly. Hedge funds vs the S&P 500 is not really a good comparison. If, however,  it was US large-cap mutual fund managers vs the index, then we would be comparing apples with apples. According to this article, 66% of large-cap managers failed to beat the index in 2016, and if you lengthen the time period, the numbers just get worse. And out of the managers who do beat the index over a three year period, only about 5% go on to beat the index over the next three years. So we can conclude that it’s very hard to beat the market.

So does this mean we should just lump all of our money into an equity index fund?Although there are worse things you could do, it’s not a very balanced approach. Getting a diversified blend of different asset types, and rebalancing this blend over time, can help smooth out returns, lower risk, and make it easier to sleep at night when the stock market takes one of its downturns. We will look at this in more detail in future posts.

 

 

Ok, we have covered the different asset classes, and we have understood that the basic minimum benchmark is inflation in our base currency. So how are these assets likely to behave over time relative to that benchmark? Well three of the asset classes are correlated to inflation and to each other, so although we can’t predict exactly, we have a pretty good idea what they will do over time in a particular base currency:

Take a look at the diagram above. It shows a rise in the cost of goods and services (inflation) over time. The first thing to note is that in the short term we really have no idea which asset will perform the best. We do know that cash will at least hold it’s value. Stocks, on the other hand, could rise or fall significantly. So, if you have a pile of money and are planning to do something important with it in the next 12 months, like make a down-payment on a house, you would be ill-advised to invest this money in the stock market. It might go down 30%! Therefore money for short term needs should stay in the bank.

Over the longer term, you won’t make money in cash. As you can see, cash tracks inflation to preserve your spending power, but it won’t increase it. If inflation is 2%, you might earn 2.5% in the bank. In Japan, where inflation is near zero, interest on a cash deposit is also very near zero. So if you want to make money over the long term, you have to take some risk.

One way you could take some more risk is by lending money to the government. The price of bonds may fluctuate over time, but in order to attract investment, bonds will pay a better return than cash. Note here that all bonds are not the same. A Japanese government bond may pay low interest, but there is little chance of default. A Venezuelan government bond may pay outstanding interest (10.43% p.a. on a 10 year issue at the time of writing), but there is a greater risk you won’t get your money back at the end of the term. Likewise corporate bonds carry higher risk than bonds issued by solid governments.

If you are looking for still higher returns, then it’s time to invest in the stock market. Although stocks are unpredictable in the short term, historically they outperform over a long period of time. This is because over time the economy and population tend to grow, and workers become more productive. This economic ground swell makes businesses more profitable, which drives up stock prices.

Although the other asset classes are uncorrelated and less easy to chart here, they can add valuable diversification. In building your own investment strategy there are a few things you need to take into account here:

The first is your base currency. The second is your time frame, which may vary from one investment objective to another. And the third is how you feel about the ups and downs in each of these asset classes, otherwise know as your attitude to risk. The better you understand the behaviour of different investments over time, the more you may find you are comfortable taking risk on a certain portion of your capital.

Striking the right balance between the different asset classes and maintaining that balance over time is know as Asset Allocation, a subject we will cover in future posts.

How do you know if an investment you have made is doing well or not? How can you tell if it’s worth paying an investment manager rather than just buying an index fund? Is 8% per year a good return?

 

The simple answer to each of these questions is, it depends what you compare it to. You need to have something meaningful to measure an investment against in order to gauge how it is doing. This is known as benchmarking. Whether you realise it or not, you are probably already familiar with some benchmarks:

• MSCI Global Index – covers global stocks
• S&P 500 – covers US stocks
• FTSE 100 – covers UK stocks
• Nikkei 225 – covers Japan stocks
• Citi World Government Bond Index – covers global bonds

So a mutual fund manager running a US Growth Stock fund might be benchmarked to the S&P 500 index. If he is underperforming the index, he is not worth paying fees to. If he is outperforming the index his fund will be popular. If he is getting a wildly different result to the index then he is doing something very strange and likely won’t keep his job for long!

So is 8% a good return? Well it partly depends on what your expectations are. The S&P 500 has returned, on average, 7.1% per year over the last 10 years, so 8% seems like a pretty good return. However, if your goal was to be aggressive and get a 20% return you might still be disappointed. In 2008 the S&P 500 fell by 37%. Even a 1% return that year would be nothing short of exceptional!

So how should the average investor benchmark their investments? I would say the basic minimum benchmark should be inflation in your base currency. Inflation is defined as the rise in the cost of goods and services over time, and is the reason we don’t just lock our money in a safe. Take a look at the table below showing the effect of inflation on $100:

We are currently living in a low-inflation environment, particularly if you live in Japan. However, if you look at the historical average, 3% is a good guide. So at 3% inflation, if you put your $100 under the mattress for 20 years you will still have $100, but it will only buy you $54.38 in goods and services. The spending power of your money has almost halved!

One thing I will stress here is that we are talking about inflation in your base currency. If you are living in Japan, but you are planning to retire in Australia, for example, don’t be fooled by the low inflation rate in Japan. Back home the current rate of inflation is 2.1% and rising. Keeping money in your Japanese bank account is not only a currency risk, but you are losing 2.1% per year in spending power!

There is no such thing as the perfect investment. They all come with advantages and disadvantages, or trade-offs.

One of the simplest explanations of these trade-offs I have heard goes as follows:

Any investment you make needs to balance three factors: low risk, high returns, and liquidity. You can have any two of these but not all three.

If you want high liquidity (easy access to the money) and low risk you are going to have to sacrifice high returns. Your money is going to be in something like a savings account.

If you want high liquidity and high returns you are going to have to take a lot of risk. This could mean an investment in stocks that could go down significantly in the short term.

If you want low risk and high returns, no-one is going to give you that unless they are able to keep your money for a long time. The best performing hedge funds and capital guaranteed products often have lock-ins, preventing investors from withdrawing their money for a fixed period.

Another trade off to consider is capital versus income. Some investments provide capital growth, but little or no income. Income generating investments may have lower prospects for capital growth. Before investing it’s important to understand which is best for you at your current stage in life.

One more trade-off to consider is absolute versus relative return. Absolute return is what an investment returned over a particular period. If a mutual fund returned 10% over the last 12 months is that a good return? Well, it depends on what the rest of the market returned. If the market returned 18%, then 10% is not particularly good. In fact in relative terms it’s a minus 8% return. Active fund managers are benchmarked in this way in order to gauge their performance. We will talk more about benchmarks starting tomorrow.