3 Things to note for Beginner Investors
Simplifying Investment
Investment may seem attractive given the current environment. The pandemic is yet to be over, with over 169 million cases globally, yet the market has surpassed pre-covid levels. S&P500 has seen a one year return of 39.79%, NASDAQ with 43.93% return and a newfound interest, Bitcoin with a 256.59% return.
Many of us may feel left out when we witness others profiting from the bull run in the past year. However, investment has a certain level of risk involved. Before you decide to invest your hard-earned money or savings, it is crucial to have a certain degree of understanding of what you are getting involved in. Yes, investment is among the few ways to create an alternative source of income and beat inflation, generating substantial returns if we do it right.
3 Common Asset Classes
Bonds: they are pretty much debt issued to investors by government organisation or companies. The motivation for the issuance of debt is to fund existing or future projects. Bonds are considered with the lowest risk while comparing to the other asset classes. The reason for their risk level, in the event of a liquidation, bondholders will be the ones to receive payment before shareholders. Other factors include lower volatility in asset prices and fixed periodic coupon payment in some cases.
Equities: they are similar to owning a piece of the company. You are investing in a business with a conviction that the company will appreciate in value. Investing in stocks would also mean bearing the risk which the company is facing. Therefore, reflecting a higher risk asset as compared to bonds. Being a shareholder, you are exposed to price fluctuation, market and business uncertainties.
Funds: they are a basket or pool of assets. There is a different kind of funds such as index funds, mutual funds and exchange-traded funds. Index funds general tracks indexes such as S&P500 and seeks market average returns. Exchange-traded funds (ETFs) are passively managed as compared to mutual funds. ETFs tends to track a particular index such as the Vanguard S&P500 ETF (VOO). Mutual funds are actively managed and strived to beat the market returns.
Dollar-cost averaging (DCA) vs Lump sum
There is no one method that fits all solution. When picking an asset to invest in, we have multiple factors to consider - our financial situation and the risk exposure we are willing to accept. On top of the above factors, we have to consider our investment horizon, area of competencies and investment approach (Passive vs Active).
Lump-sum would work best if you have done your fair share of research and have a strong thesis towards your conviction in the investment. DCA is applicable if there is lingering doubt or uncertainty. DCA is also utilized by passive investors where funds are injected periodically regardless of the market environment. Both methods work perfectly fine as long as you have done your due diligence.
Based on a Forbes report, lump-sum has beaten dollar-cost averaging by 2.3% over ten years investment horizon. These, however, is base on historical records and not a reflection of the future.
Lastly, comparing both active and passive investing. An active investor would have to put in more time and effort in their research, potentially yielding a higher return on their investment. Compared to their counterpart, passive investors tend to average into ETFs such as the S&P 500 yielding an average market return.
Asset Allocation
Diversification and concentration are two different strategies we can use to manage our portfolio. Choosing either one can affect our portfolio to a certain extent in the long run.
Diversification allows you to invest across various asset classes, industries and region. Diversification allows you to spread out the risk across your investment. That said, it does lower the overall returns. Concentration is investing specifically into a particular area. Concentration is slightly riskier as you are exposed to a greater downside if you are wrong, given the limited investment within your portfolio. However, you would have a greater return compared to a diversified portfolio if your research is successful.
Choosing between these two options would have to depend on your investment goal and approaches. Do you have the time to commit to in-depth research or knowledge in a particular industry? Season investors tend to stick to a concentrated portfolio given their expertise and experience in investing. As for someone who recently started on their journey, it would be ideal to go with a diversified portfolio. Such a portfolio allow them to diversify the risk while potentially picking a winning investment in the process.
Lastly, we have to understand our risk appetite. Individual risk appetite is subjective and, different investment instrument possess different risk level. The conventional outlook of risk-reward is that investments with a higher return are correlated with a higher risk. However, if we were to conduct our due diligence, we could potentially reduce our downside while improving our upside. I have indicated the differences between the conventional way of looking at risk versus Graham’s way of interpreting risk.
Concluding
Investing may seem foreign and complicated if you have not done it before. If you have the time and desire, working on understanding investment could bring you one step closer to financial freedom. Choose a particular investment strategy and stick to it. Pen down your thesis and work with your risk tolerance and investment objectives.
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