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11-11-2012, 09:17 AM
I think this advice comes quite timely! Especially since many are chasing yields without taking risk of permanent capital loss into account. Low interest rates do contribute to such an environment, but it's not going to last forever!
The Straits Times
www.straitstimes.com
Published on Nov 11, 2012
Moneywise
Don't be fixated on high returns
In making an investment, one must guard against the risks
By teh hooi ling
There are two sides to everything in life, generally speaking. In investments, it is potential return on the one hand and risk on the other.
Between the two, arguably we should pay more attention to risk. As the wise investment adage goes: Guard against the downside and the upside will take care of itself.
But all too often, people are so bowled over by the promised return that they ignore the risks. How else do you account for investors who put their money in gold trading companies which promised a potential return of 24 per cent a year?
Yes, the return promised was very attractive. But how does the company make its money to be able to pay me that kind of return? What can go wrong? What is the downside for me? If anything happens, what is my recourse?
These are essential questions that someone who is going to part with his or her hard-earned money should ask.
When weighing investment options, one should judge the potential return relative to the risks. A friend who has been a financial planner for some 40 years shared this story with me recently.
He has a client who paid $300,000 for an annuity plan 10 years ago. The payout of $20,550 a year, or $1,700 a month, will start soon. But if he terminates his contract now, he will get $475,000 back. That works out to a return of about 4.7 per cent a year for his holding in the past 10 years. From now onwards, based on the payout of $20,550 a year on a sum of $475,000, the return is about 4.3 per cent a year for as long as he lives, or a minimum of 10 years.
The client is considering taking out the $475,000 and putting it with a fund manager who has managed to return nearly 15 per cent a year in ringgit terms from the Malaysian stock market in the past nine years.
My friend's comments to his client are:
One, you are not comparing apples with apples. The annuity plan pays out a guaranteed 4.3 per cent a year for as long as you live and for as long as the insurance firm is still around. You are free from the burden of investing and re-investing.
In contrast, by putting your capital in the stock market, you are exposing yourself to the vagaries of the market. Your capital value can go down as well as up.
Two, optimise, not maximise, return. Depending on one's stage in life, one should calibrate how much return one is going after and how much risk one can afford to take. For example, for someone who is 65, it makes sense to have an adequate sum of money that can generate a constant stream of income without the risk of capital loss. And honestly, 4.3 per cent a year with minimal risk is not a bad deal at all.
So how should one evaluate return versus risks? One way which is taught in finance textbooks is to assign probabilities to the various scenarios (from the best to the worst) and calculate the expected return of that investment option based on those assumptions.
Take the case of putting money with the gold trading companies. Say in the best of scenarios, you get the 24 per cent return plus your capital back. In the worst-case scenario, you lose all your money, that is a minus 100 per cent return. Then you assign the probability that you think scenario one will take place and probability that scenario two will take place.
Let's say, you think it's 50-50. So the expected return is 24 per cent return times 50 per cent probability for the first scenario (which works out to plus 12 per cent). For the second, it's minus 100 per cent return times the 50 per cent probability (minus 50 per cent). Add the two up and you get a minus 38 per cent expected return. Not a very good investment, is it?
Even if you assign a mere 20 per cent chance that the company would close down, your expected return is minus 0.8 per cent. Nowhere near as attractive as some people think it is.
It's a fact. Emotions tend to cloud our judgment when it comes to money matters. What are some of the factors that can cause us to overlook the risks? What are some of the irrationalities involved when we invest our money? Do high risks necessarily mean high return? Where can you find low-risk but high-return investments? These are some of the topics that we will discuss in this column in the coming weeks. Stay tuned.
The writer, a CFA, is editor of the Executive Money section in The Business Times. This is a weekly column focusing on money issues, be it saving, investing, spending or gifting. For more, please go to www.btinvest.com.sg
The Straits Times
www.straitstimes.com
Published on Nov 11, 2012
Moneywise
Don't be fixated on high returns
In making an investment, one must guard against the risks
By teh hooi ling
There are two sides to everything in life, generally speaking. In investments, it is potential return on the one hand and risk on the other.
Between the two, arguably we should pay more attention to risk. As the wise investment adage goes: Guard against the downside and the upside will take care of itself.
But all too often, people are so bowled over by the promised return that they ignore the risks. How else do you account for investors who put their money in gold trading companies which promised a potential return of 24 per cent a year?
Yes, the return promised was very attractive. But how does the company make its money to be able to pay me that kind of return? What can go wrong? What is the downside for me? If anything happens, what is my recourse?
These are essential questions that someone who is going to part with his or her hard-earned money should ask.
When weighing investment options, one should judge the potential return relative to the risks. A friend who has been a financial planner for some 40 years shared this story with me recently.
He has a client who paid $300,000 for an annuity plan 10 years ago. The payout of $20,550 a year, or $1,700 a month, will start soon. But if he terminates his contract now, he will get $475,000 back. That works out to a return of about 4.7 per cent a year for his holding in the past 10 years. From now onwards, based on the payout of $20,550 a year on a sum of $475,000, the return is about 4.3 per cent a year for as long as he lives, or a minimum of 10 years.
The client is considering taking out the $475,000 and putting it with a fund manager who has managed to return nearly 15 per cent a year in ringgit terms from the Malaysian stock market in the past nine years.
My friend's comments to his client are:
One, you are not comparing apples with apples. The annuity plan pays out a guaranteed 4.3 per cent a year for as long as you live and for as long as the insurance firm is still around. You are free from the burden of investing and re-investing.
In contrast, by putting your capital in the stock market, you are exposing yourself to the vagaries of the market. Your capital value can go down as well as up.
Two, optimise, not maximise, return. Depending on one's stage in life, one should calibrate how much return one is going after and how much risk one can afford to take. For example, for someone who is 65, it makes sense to have an adequate sum of money that can generate a constant stream of income without the risk of capital loss. And honestly, 4.3 per cent a year with minimal risk is not a bad deal at all.
So how should one evaluate return versus risks? One way which is taught in finance textbooks is to assign probabilities to the various scenarios (from the best to the worst) and calculate the expected return of that investment option based on those assumptions.
Take the case of putting money with the gold trading companies. Say in the best of scenarios, you get the 24 per cent return plus your capital back. In the worst-case scenario, you lose all your money, that is a minus 100 per cent return. Then you assign the probability that you think scenario one will take place and probability that scenario two will take place.
Let's say, you think it's 50-50. So the expected return is 24 per cent return times 50 per cent probability for the first scenario (which works out to plus 12 per cent). For the second, it's minus 100 per cent return times the 50 per cent probability (minus 50 per cent). Add the two up and you get a minus 38 per cent expected return. Not a very good investment, is it?
Even if you assign a mere 20 per cent chance that the company would close down, your expected return is minus 0.8 per cent. Nowhere near as attractive as some people think it is.
It's a fact. Emotions tend to cloud our judgment when it comes to money matters. What are some of the factors that can cause us to overlook the risks? What are some of the irrationalities involved when we invest our money? Do high risks necessarily mean high return? Where can you find low-risk but high-return investments? These are some of the topics that we will discuss in this column in the coming weeks. Stay tuned.
The writer, a CFA, is editor of the Executive Money section in The Business Times. This is a weekly column focusing on money issues, be it saving, investing, spending or gifting. For more, please go to www.btinvest.com.sg
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/