2. An Overview of the Basics
When we speak of investments, most people automatically think of stocks. However, the term investments can be applied to a broad variety of instruments or ownership of assets which are meant to provide a return. In this section, we briefly review the types of investments available to investors. Generally, types of investments can be broken down into the following broad categories:
• Stocks. A stock share represents fractional ownership in an ongoing business. The return of this share should generally be related to the underlying ability of that business to make profits.
• Bonds. A bond is a debt instrument which is equivalent to fractional ownership in a loan. As the owner of a loan, a bondholder is entitled to return of his principal plus an additional amount as interest on the loan. Generally speaking, bondholders are entitled to receive their money ahead of stock holders in the event of bankruptcy and liquidation of an ongoing business. As a result, bonds are generally considered less risky than stocks. However, a bond’s upside is capped as the most that can be returned to the bondholder is his principal and interest whereas the upside for a stock is theoretically unlimited.
• Commodities and precious metals. Ownership of commodities and precious metals can be in the form of the assets themselves or in the form of instruments which move in relation to the prices of these assets. Ownership of the actual assets is generally impractical given storage and transportation concerns. However, there are increasingly more and more paper instruments which allow one to benefit from price movements in commodities and precious metals. These instruments can be used for diversification as the prices of commodities and precious metals are often uncorrelated with the prices of bonds or stocks.
• Real estate. Real estate can mean ownership of actual property (buildings and land) or fractional ownership in a group of properties put into a real estate investment trust (REIT). Since any given property generally has value for someone and thus can be rented out to earn a return, property investors should invest for both rental income and capital appreciation potential.
• Private Investments/Unlisted Investments. Wealthier investors or sophisticated investors with a good understanding of what they are investing in can also make private investments in companies that are not publicly traded. This can consist of either investments into private equity funds (which are managed by professionals) or the investor can decide to invest in companies in which he or she feels he has a solid understanding. In such cases, negotiation of the terms and price of the investment will be necessary. Use of a good lawyer is probably a good idea as well.
A relatively greater proportion of this program will be devoted to the analysis and valuation of stocks as we believe this is where most users of our program will be spending their time.
2.2. Introduction to Asset Allocation
Several research studies have concluded that asset allocation (or the choice of distribution among different types of investments) can have a greater impact on returns than the choice of a specific stock investment. Some of these studies have defined asset allocation as the allocation between stocks, bonds, real estate etc. and other studies have defined asset allocation as the allocation of investments between countries or between industries.
At any rate, it is important for an investor to allocate his assets among different investment types by conscious decision rather than by a haphazard assembly. A basic investment allocation should probably consist of a basic split between stocks and bonds. Investors with lower risk tolerance and a desire to avoid volatility should probably have a higher proportion of bonds than otherwise – especially in the case of those with shorter time horizons. As the investment horizon lengthens, the average annual volatility of an investment is likely to be smoothed out as good years offset bad years. As a result, those investors at the higher age ranges or in retirement may want to consider a higher proportion of bonds. Those who require income to be generated from investments, which generally encompasses older investors, may also consider a higher proportion of bonds although income can also be generated from dividend yielding stocks.
One of the primary reasons to allocate among different assets is for diversification. The primary benefit of diversification is that it is a defense against poor results in any one part of the portfolio disproportionately affecting the total investment portfolio’s investment return. It is best to keep investment in any one specific stock, bond, etc. to less than 5% of the total portfolio. In cases where the total portfolio is too small to cost effectively achieve this diversification, it may be more prudent to purchase funds, rather than specific stock or bond investments. We will discuss funds in the next section.
Real estate and commodities/precious metals may be considered for further diversification purposes. However, adding more investment types may increase the amount of time and commitment necessary for the investor to achieve good results. In many cases, it may be best to purchase funds for real estate and commodities/precious metals exposure to make efficient use of your time. Oftentimes, commodities/precious metals are seen as inflation hedges and a certain proportion of assets can be allocated to commodities/precious metals for the express purpose of defending against inflation – when a currency buys significantly less in the future than today.
Overall, we might suggest an asset allocation guideline as follows: stocks – 50-80%, bonds – 30-60%, real estate – 0-10%, commodities/precious metals – 0-10%. These figures apply to the investment portfolio only and exclude your primary residence, if you own one. We leave private equity and unlisted investments out of our guidelines. Such investments will depend much more on the particular situation, sophistication and opportunities available to an investor. More conservative investors should have a higher proportion of bonds and a lower proportion of real estate and commodities/precious metals. Aggressive investors may want to have a higher proportion of stocks, real estate and commodities/precious metals. Note that these figures are meant only as very rough guidelines.
2.3. Do You Want to Be an Active or Passive Investor?
As we have covered the topic of asset allocation, it is now an appropriate time to discuss active vs. passive investment. Active investment is when an investor actively makes decisions about which specific investments to make. Active does not necessarily mean that investors are trading in and out of stocks and making numerous buy and sell decisions. The term is, instead, meant to convey the idea that each specific investment – ownership of a specific company’s stock or a specific company’s bond – for instance has been chosen by the investor himself.
In contrast to this, we have passive investment. This means that an investor has not chosen the specific stocks, bonds, etc. that make up his portfolio. Instead, the investor has chosen to transfer this responsibility to either a professional fund manager, or to a systematic asset allocation method. This does not necessarily mean that an investor is not active at all, as the investor must still choose which funds or which asset allocation system he wants to follow. Generally, the passive investment path will involve allocating money primarily to funds. These funds could be mutual funds that are actively managed by a professional money manager. The funds could also be index funds. Or, increasingly, the funds may be exchange traded funds.
When deciding whether to take the active or passive investment route, here are some key factors to consider:
• Time and commitment. The active investment strategy will take significantly more time and commitment than the passive investment strategy. You must decide how much time and commitment you are willing to put into your investments. As a rough guideline, an active investment strategy may involve at least a couple of hours of work per month, on average, while a passive investment strategy may involve as little as a couple of hours per year.
Note that when we say that an active investment strategy may require a couple of hours of work per month, we do not necessarily mean that the investor needs to spend time each and every month or that the investor should be buying or selling investments every month. It is merely to convey an idea of the average time commitment required. You may, instead take a couple half-days every six months to review your portfolio. It is also useful to spend enough time to understand the companies and industries you are going to make investments in and what has changed in these companies and industries as time passes.
• Total portfolio size. To achieve diversification in an active strategy, it is necessary to have at least a moderately sized portfolio. Let’s say we want to stick to the guideline that 5% or less of our money should be in any one specific stock or bond investment. If we then allocate 70% of our total investments to stocks and the shares we buy have an average US$30 share price, our total investment portfolio should be at least US$60,000 in total size. This assumes that we buy shares in lots of at least 100 to minimize transaction costs. For portfolios smaller than US$60,000, it may be better to buy funds to achieve adequate diversification. If you want to test your investment skill with active management of individual company stock and/or bonds, it may still be beneficial to allocate a portion of your money to funds to achieve adequate diversification, particularly if your total portfolio is not large.
• Transaction costs. Whether active management or passive management results in more friction/transaction costs really depends on the type of funds one buys. Generally speaking, index funds and exchange-traded funds will have lower transactions costs than actively managed mutual funds. Actively managing your own money will probably result in lower transactions costs than active mutual funds but this may result in higher transaction costs than simply buying and holding index funds. In a single year, transaction costs may not seem to make a big difference in returns but over time, the compounded effect of transactions costs could lower returns by a substantial amount.