What is investing?
Investing is how you increase your money on hand for a larger future value by putting money into an asset with the expectation of capital appreciation, regular interest earnings, or both. The goals of investment could range from protecting your purchasing power in retirement or growing your wealth for various financial goals. All investments, including investment in equities, physical assets, and even fixed income securities, are subject to some form of risks, i.e. the inflation risk.
The key to investing is to access how much risk you are prepared to take and how to manage your investments accordingly.
Four Influential Financial Theories
Traditional wisdom such as ‘Do not put all your eggs in one basket’ and ‘high-risk high-return’ are no stranger to most investors, but how much do you understand the theory behind?
1. Random Walk Theory
In his 1900, Louis Bachelier set forth his revolutionary conclusion in his doctoral thesis “The Theory of Speculation” that ‘there is no useful information contained in historical price movements of securities’. This theory raised a lot of eyebrows in 1973 when author Burton Malkiel wrote “A Random Walk Down Wall Street”, which remains on the top-seller list for finance books.
Random walk theory states that the movement of asset prices follows an unpredictable path: consider a drunken person’s path of walking where each move is randomly determined. In stock market, the path is a trend that is based on the long-run nominal growth of corporate earnings per share, but fluctuations around the trend are random. Random walk is the foundation of the Efficient Market Hypothesis, which suggests that markets are efficient and security prices are rationally determined. The logic is that if the flow of information is unimpeded and information is immediately reflected in stock prices, but news is by definition unpredictable, and, thus, resulting price changes must be unpredictable and random rather than exhibiting any systematic structure.
2. Modern Portfolio Theory (MPT)
MPT was developed by Harry Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance. MPT states that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification and reduce portfolio riskiness, also known as not putting all of your eggs in one basket.
The question arises is how to identify the best level of diversification. The optimal answer is the efficient frontier. Assuming the market only consists of two stocks, one is a high risk/high return technology stock and another a low risk/low return consumer products stock, investors can allocate different combinations such as 90% Tech/10% Consumer stock. Different combinations result in different expected returns and risks. Plotting the collection of all possible portfolios results a hyperbola, called the efficient frontier. Given the same resource, a rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. Any portfolio that lies below the curve is suboptimal.
Source: Noble Apex
3. Capital Asset Pricing Model (CAPM)
Building on the earlier work of Harry Markowitz, CAPM was introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently. MPT is the important building blocks of CAPM, which describes the relationship between risk and expected return, and provides a formula in pricing risky securities.
The idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation for taking on additional risk. This is calculated by multiplying the risk measure (beta) that compares the returns of the asset to the “market portfolio” over a period of time and the market premium (Rm- rf).
Example using the CAPM model: if the risk-free rate is 3%, a Chinese aviation stock beta is 1.2 (reflect a higher volatility than the market) and the expected return for Hong Kong China Enterprises Index over the period is 11%, then the stock is expected to return 12.6% [=3%+1.2(11%-3%)].
4. Arbitrage Pricing Theory (APT)
Created in 1976 by Stephen Ross, the APT theory predicts the relationship between returns of a portfolio and returns of a single asset through a linear combination of many independent macro-economic variables.
The APT assumes an equilibrium rate of return exists and states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:
The APT differs from the CAPM in that it is less restrictive in its assumptions. It assumes that each investor will hold a unique portfolio with its own particular array of betas, whereas the CAPM formula requires a “market portfolio”. Arbitrageurs use the APT model to profit by identifying mispriced securities. By going short an overpriced security, while concurrently going long the factor portfolios, the arbitrageur is in a position to make a theoretically risk-free profit.
Three Basic Types of Investment Instruments / Asset Classes
Comparison between Stocks, Bonds, and Derivatives
Stocks and bonds are financial instruments for investors to obtain a return and for companies to raise capital. Put very simply, stock represents an ownership (equity) stake in the company and bond is a loan to the company. Stocks offer higher risk than bonds. Derivative, on the other hand, is merely a contract whose price is dependent upon or derived from one or more underlying assets, commonly include stocks, bonds, commodities, currencies, interest rates and market indexes.
Stocks can be either common stock or preferred stock. Preferred stock is further divided into participating and non-participating preferred stock. The value of stocks corresponds to the value of the company and therefore stock price fluctuates, depending upon how the market values the company.
Stockholders assume most of the financial risk of investing in a corporation. If the company does well, the value of their shares will grow, but if the company fails, they are the last to be paid after creditors and bondholders.
Bondpar (face) value at maturity. While bonds are “safer” than stocks because of lower volatility, it should be noted that there is always a chance that company will be unable to repay bond-holders, we call that a default. In that sense, bonds are not “risk-free”.
Governments also issue bonds for many reasons. Government bonds can be denominated in the country’s own currency or in foreign currencies, and they are often referred to as sovereign bonds. The terms of government bonds depend on its creditworthy. International credit rating agencies dominated by three large players: Standard & Poor’s, Moody’s and Fitch, will provide ratings for the bonds, but they have encountered serious criticism over their failures to spot impending crises.
Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are generally used as an instrument to hedge risk but can also be used for speculative purposes. Most derivatives are traded on margins and characterized by high leverage. Buying with borrowed money can be extremely risky because both gains and losses are amplified. While the potential for greater profit exists, this comes at a hefty price – the potential for a loss of more than you initially invested.
Importance of Asset Allocation
If you can correctly predict the best performing asset or individual securities in any point of time, then you just need to put all your money into that asset, sit back, relax, and let the profit piles up. In this case, you do not need asset allocation. However, not many people have this superpower to predict stock prices, then asset allocation may be all you need as your investment strategy.
Having an asset allocation plan is crucial to achieving your financial goals. It is the investment discipline that will decide your returns. The long-term performance among top-ranked fund managers might be insignificant but what makes the difference is the tendency among investors to change the share of assets in their portfolio, often driven by greed and fear. This is a matter of investing psychology. Many investors know the benefits of asset allocation over the long-term; however, it’s easier said than done. News, the surrounding pressures and various temptations might cause investors to switch. There will be different best performing asset classes every year, but with asset allocation, investors will sure find some assets that are not as satisfactory on hands; however, chasing recent winners is more likely to fall into the loss trap.
Asset allocation is the most important investment decision which is based on the principle that different assets perform differently in different markets and economic conditions. According to a landmark study of the returns of 91 large pension plans by Brinson, Singer and Beebower in 1991, asset allocation is the principal driving force of long-term portfolio performance. Their paper demonstrated that, on average, more than 90% of the variability in portfolio returns can be attributed to asset allocation policy, with market timing, security selection and other factors collectively representing less than 10%.
Long-term Strategic Asset Allocation (Illustrative Example)
What is the best asset allocation strategy? There is no standardized solution as individual investors require individual solutions. The most important thing to keep in mind is that asset allocation is not a one-time event but a dynamic process. For retirement investing, it is a life-long process where asset allocation strategies vary in terms of risk exposure at any specific age.
The Power of Compounding
If you’re young, you may think you don’t need to invest for retirement yet in the next five or ten years. You’re wrong. No matter what your age is, now is the time to begin saving for retirement. By investing early, you maximize the amount of time available for your money to grow through the power of compounding. The process of compounding has a snowball effect on your wealth. Even modest returns can generate real growth in wealth given enough time and dedication. The more time the investment compounds, the greater compounding effect on your wealth.
Long-term compounding often applies to stock investment, where investors periodically reinvest back the dividends into their current holdings. Your reinvested shares, as you go forward, will increase your total capital base. In other words, even with only a few more shares each time, dividend reinvesting can substantially boost the total returns earned, especially in the long-term due to the effect of compounding.
The following chart shows the performance of the Hang Seng Index with and without dividends reinvested since 1973. Dividend rates were ranging from 2% to 6% over the period. Investors who had simply put their money in the Hang Seng Index would have seen their money grow by 38 times over the last 40 years, whereas those who had reinvested their dividends over that period would have made 112 times.
Volatility and Dollar Cost Averaging
Asset prices change all the time, whether going up or down and could be volatile. Volatility is the amount of uncertainty or risk about the amount of changes in a security’s value. A higher volatility means the price of the security can change dramatically over a short time period in either direction.
In financial analysis, volatility is usually measured by the standard deviation, a common measure of the risk of a mutual fund. Simply speaking, the higher the standard deviation, the riskier the fund. For a fund with a mean annual return of 10% and a standard deviation of 5%, you would expect the fund’s return to be between 5% and 15% about 68% of the time, and between 0% and 20% about 95% of the time.
Dollar Cost Averaging
In volatile markets, it’s common to feel uneasy about your investments. The dollar cost averaging approach helps comfort you in volatile markets. Dollar cost averaging is a strategy in which you invest a fixed amount of money at regular intervals. This helps ensure that you buy more units when prices are low and fewer units when prices are high. And by investing on a regular schedule, you avoid the difficult or even impossible task of trying to figure out the best time to invest. Another beauty of regular saving is that it makes you save and invest with discipline. The following provides a dollar cost averaging example – instead of making a one-off investment of $1200, you invest $100 every month.
As a result, the average cost per share ($6.8) is lower than the average market price ($7.1) over the same period. Of course, while there is no assurance that any investment strategy will prevent losses, dollar cost averaging may mitigate the risk of investing at an inopportune time.