Mix and match
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Published January 15, 2007 |
When investing, bear in mind that it is important to spread the risk adequately by diversifying into various asset classes, says DANIEL BUENAS
LAST week, we took a look at the importance of planning ahead and the reasons for diversifying one's portfolio.
This week, we take a closer look at diversification and some of the different asset classes that are available to investors.
An oft-said dictum is that too much of anything is bad for you, and this also holds true for investing.
If you put 100 per cent of your investment in a property or in stocks, then you become more vulnerable to changes in the market.
'Following the 1997 (Asian financial) crisis, many Asia-Pacific countries experienced a decline in the value of both real estate and local equities, and people who had focused solely on these investments suffered severe losses,' The Citibank Guide to Building Personal Wealth notes. 'By spreading your investments across different currencies, countries, industries and securities markets, you help to reduce the negative effects of a drop in market value.'
Traditionally, many investors in the region have preferred to keep most of their assets in cash, but as the guide points out, even when interest rates are high, cash as an asset class does not produce high investment returns, especially once you have taken inflation into account.
Bonds, on the other hand, produce higher returns than cash, and are relatively safer, but their returns are lower when compared to equities.
'The performance of Asian equities over short periods can be either good or very poor,' the guide notes. 'This means that this asset class can offer good tactical opportunities, but may underperform over the long term.'
In terms of asset classes, equities outperform bonds and cash in the long term, although in the short term, equities can fluctuate significantly, which makes it all the more important to spread the risk further across many sectors and markets.
REAL ESTATE
Real estate is another asset class that attracts many investors. Home and property prices can rise over time, and in many instances - including in Singapore - real estate forms the largest percentage of an investor's asset allocation.
However, real estate presents several investment challenges:
If you are living in the said real estate and don't want to move or rent, it does not generate any income.
It requires expenditure on maintenance.
It is fairly illiquid, and usually takes time to sell.
Its market value can fluctuate.
'Real estate markets are much more local than most financial markets,' the guide says. 'Prices and saleability are closely related to local laws, taxation and employment conditions, as well as to the physical location of the individual property and supply and demand.'
The guide points out that some investor portfolios in the region look like this:
This graphic tells us that:
The majority of the assets are in real estate, and are not producing a return each year (other than capital appreciation).
Cash is producing a very low inflation-adjusted return.
Trading local stocks may or may not produce good returns, but are likely to be very volatile investments.
This asset allocation does not spread the risk adequately, especially if you assume that you do not want to sell your home or let it out to tenants, but intend to live in it for the rest of your life or to pass it down to your children.
This effectively removes it from the asset allocation pyramid, which gives you an asset allocation that looks something like this:
This allocation of financial assets has:
A low rate of overall returns, because most of it is in cash.
High currency risk, as all assets are denominated in a single currency.
Low diversification, as the risks are not adequately spread.
'If the local equity markets plunge and the local currency weakens, the value of this portfolio will decline,' the guide notes.
Now, assuming that you don't plan to retire until your sixties - some 30 odd years in the future, you might want to consider an asset allocation pyramid that looks something like this:
Now, 65 per cent of your asset allocation is invested in mutual funds, which in turn invest in many companies around the world. This helps to spread the risk across many stock markets, although there is still some currency risk because the funds are denominated in US dollars and Euros.
Twenty per cent of the assets are still in local currency deposits, generating a low rate of interest. However, this is acceptable, because you know there may be times when you need to withdraw cash for unexpected needs. Most financial planners advise that a person should keep at least six months of their monthly income in fairly liquid investments as a buffer.
Ten per cent of the assets are now in premium deposits, which offer a better return than ordinary time deposits at a bank. However, they are riskier, as they involve trading in foreign currencies.
HIGHER RISK STRATEGY
Finally, 5 per cent of the assets are in local stocks. This is, as the guide calls it, 'fun money', which you use to see if you can make a profit by taking a view on individual companies. This is a higher-risk strategy, and since you make many transactions, the trading costs could also be large.
However, such a portfolio is not suitable for everyone.
'The size of your assets and income, your age, your circumstances and your financial goals are all factors in deciding how to allocate your assets,' the guide says. 'Perhaps the most important factor, however, is how you feel about taking risks.'
The figure below shows how the mix of assets you choose should vary according to your objectives and attitude towards risk.
In the figure, alternative investments refer to non-traditional or style-based investments such as hedge funds, small-cap equities, technology funds and REITs.
The main point here is to show that the way you allocate your assets should be a tailor-made and on-going process - there is no single correct allocation to suit all people.
'As your circumstances change, you may need to alter your attitude to risk and hence the asset allocation of your portfolio,' the guide says.
Information for this article was taken from the book The Citibank Guide to Building Personal Wealth |
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