Investment products have different features and risk characteristics. An important aspect of investing is understanding the product before you put your money in it. Some relevant questions you should ask, are:
• What are the product’s benefits, risks, limitations and transaction costs?
• Will the product complement, supplement or replace your existing investments?
• Will the product be in line with your capacity to take on risk (risk appetite) and investment objective (returns)?
• Will you become over exposed to a particular risk if your portfolio is not sufficiently diversified?
Understanding the Different Investment Product Classes
There are many ways to invest your money. Of course, to decide which investment vehicles are suitable for you, you need to know their characteristics and why they may be suitable for a particular investing objective. Investment products are broadly classified into Fixed Income, Equities, Mutual Funds, Currencies and Other Investments.
Grouped under the general category called fixed-income securities, the term Bonds is commonly used to refer to any securities that are founded on debt. When you purchase a bond, you are lending out your money to a company or government (corps and govies). In return, they agree to give you interest on your money and eventually pay you back the amount you lent out on the maturity date or earlier. The main attraction of bonds is their relative safety. If you are buying bonds from a stable government, your investment is virtually guaranteed, or risk-free. The safety and stability, however, come at a cost. Because there is little risk, there is less chance of potential return. As a result, the rate of return on bonds is generally lower than other securities.
Most bonds pay a regular stream of income (usually semi-annually or annually) throughout their life, which is known as “coupon”, typically expressed as a percentage of the principal amount (also known as “face” or “par” value). Upon maturity, the bonds are redeemed by the corporate or government, and you are paid back the principal amount with the final coupon instalment. Returns can be earned in 2 ways, via coupon (interest) payments and capital gains. Though the coupon rate is generally fixed through the life of the bond, the price of the bond may fluctuate.
Points to note:
• When interest rates rise, bond price will drop. And when interest rates drop, bond price will rise.
• Bonds are generally more suited for medium to long term investments (3 – 30 years). You should have sufficient financial resources to hold the bonds, preferably to maturity
• Bonds are debt instruments, so monitoring the credit risk rating and changes in economic or other factors that may affect the bond or its issuer, is advised.
• Understand how the credit ratings (AAA – BB) and collateral classification (senior, junior, secured, unsecured, perpetual) works and what they tell us about the bond or issuer
• You may lose a part of your invested amount if you sell the bond before it matures. Bond prices fluctuate depending on the perceived credit quality of the issuer and market conditions. However, you may lose all of your investment if the issuer defaults on its bond, winds up or is liquidated.
More familiarly known as stocks/shares, this also includes exchange traded funds (ETF) and stock index funds. When you purchase stocks, you become a part owner of the business. This entitles you to vote at the shareholders’ meeting and allows you to receive any profits that the company allocates to its owners. These profits are referred to as dividends. While bonds provide a steady stream of income, stocks are volatile. That is, they fluctuate in value on a daily basis. When you buy a stock, you aren’t guaranteed anything. Many stocks don’t even pay dividends, in which case, the only way that you can make money is if the stock increases in value – which might or might not happen. Compared to bonds, stocks provide relatively high potential returns. Of course, there is a price for this potential: you must assume the risk of losing some or all of your investment.
There are broadly 2 classes of stocks/shares – ordinary or common shares, and preference or preferred shares. These shares are then sorted into categories or by market capitalisation.
Large caps: also known as blue chips – large market capitalisation, well-established stable companies with strong track records. Such companies typically have strong corporate-governance practices and have generated wealth for their investors slowly and steadily over a long term. These corporates are usually among the most highly followed and well-researched on the market. Most stock indices are computed based on the weighted average market capitalisation of these large cap stocks.
Mid-caps: lie between large-caps and small-caps in terms of company size. During a bull phase, mid-cap stocks may outperform their large-cap counterparts, as these companies seek to expand by looking out for suitable growth opportunities. Investors should, however, note that the underlying stocks are more volatile than their large-cap counterparts.
Small-caps – stocks with smaller capitalisation. Small-cap stocks typically have the highest growth potential, since the underlying companies are young, and seek to expand aggressively. They are more vulnerable to a business or economic downturn, making them more volatile than large and mid-caps.
Note: Small- and mid-cap funds typically outperform large-caps during a bull market but decline more when the sentiment turns bearish.
When you buy a company’s shares, you become a shareholder of the company. As a shareholder, you may earn returns when you receive dividends or if you sell your shares above the price you bought them at. Companies may carry out various corporate actions such as bonus or rights issues, share splits and buybacks. As a shareholder, you should find out how these corporate actions will affect you.
Points to note:
• Be familiar with the factors and scenarios that affect share prices
• Understand the risks associated with the different categories of shares
• Though investing in shares can potentially yield higher returns, it also comes with more risks than fixed income
• Dedicate some time and resources to monitor the markets and corporates’ performances, and do react to corporate actions
• Build a diversified investment portfolio of companies with exposure in different sectors and geographies
• Be prepared for a longer investment horizon, so as to weather short-term price fluctuations
A mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are pooling your money with a number of other investors, which enables you (as part of a group) to pay a professional manager to select specific securities for you. Mutual funds are all set up with a specific strategy in mind, and their distinct focus can be nearly anything: large cap, mid-cap & small-cap stocks, bonds from governments, bonds from companies, stocks and bonds, stocks in certain industries, stocks in certain countries, geography etc.
The primary advantage of a mutual fund is that you can invest your money without the time or the experience that are often needed to choose a sound investment. Theoretically, you should get a better return by giving your money to a professional than you would if you were to choose investments yourself, however, there are some aspects and fees about mutual funds that you should be aware of before choosing them
You invest in a fund by buying units in the fund. There is a capital gain when the price of the units rises above the price you paid for the fund.
Some funds also pay dividends. The price of each unit is based on the fund’s net asset value (value of fund’s asset – value of fund’s liabilities) divided by the number of units outstanding. The NAV of a fund is the market value of the fund’s net assets (investments, cash and other assets minus expenses, payables and other liabilities.) The NAV is usually computed daily to reflect changes in the prices of the investments held by the fund. As the funds are managed by professional fund managers, there are fees charged. These fees make up the total expense ratio (TER) and is usually between 1%-2.5% of the fund’s NAV and should be disclosed in the fund’s factsheet.
Points to note:
• Understand the fund’s investment objective, strategy or approach
• Find out what fees are charged
• Research on the fund manager, his and the fund’s track record
• Understand the risks associated with the fund. For e.g. some funds use financial derivatives or swaps for hedging or investment. There is not only risks associated with using financial derivatives but also counterparty risks
• There is a 7 days’ cooling-off period. There is no administrative penalty for cancelling your purchase but you may suffer a loss if the fund has fallen in market value.
• Be prepared to be invested for the long term, to ride out the market ups and downs
Foreign Exchange or Forex is the largest market in the world. It has become increasingly popular over the last decade. In currency trading, you do not just trade one currency, but a currency pair. So, it is not enough to believe that a currency will appreciate or depreciate, but what other currency it is traded against. Hence, it is essential to understand the economic differences between the countries or areas which the currencies represent. Currencies are categorised into majors and minors. A major pair is one that has USD as one of the two currencies, while minor pairs do not have USD in their components. Foreign exchange traders often use the term “cross” or “cross rate” to refer to currency quotes that do not involve the U.S dollar, regardless of what country the quote is given in.
Currency trading is generally the enclave of speculators and traders as its volatile nature brings speculation opportunities. Correlations between currency pairs do affect the overall outcome of a portfolio. The value of investments can be significantly impacted by changes in global currency exchange rates. Investors should appreciate the influence that the foreign exchange market has on the assets they own and their level of currency exposure. The currency exposure of an asset, such as stocks, is the sensitivity of that asset’s return measured in the investor’s domestic currency to fluctuations in exchange rates. Currencies can also be a good way to diversify a portfolio that might have hit a bit of a rut. The appreciation or depreciation of a portfolio’s base currency impacts the overall performance of the portfolio
Top 10 most heavily traded currencies in the world, also known as G10 currencies, are also ten of the most liquid currencies. Traders regularly buy and sell them in an open market with minimal impact on their own international exchange rates. They are:
• United States dollar (USD)
• Euro (EUR)
• Pound Sterling (GBP)
• Japanese Yen (JPY)
• Australian dollar (AUD)
• New Zealand dollar (NZD)
• Canadian dollar (CAD)
• Swiss franc (CHF)
• Norwegian krone (NOK)
• Swedish Krona (SEK)
Whilst most investments fall into either the categories of debt or equity, there are numerous other investments, such as derivatives that are more complex and requires some specialized knowledge. This includes alternative investments like futures, options, structured notes/deposits, commodities, hedge funds, real estate, private equity, etc.
So before you start a conversation with your advisor, there are 3 things you need to ask yourself:
(1) What’s my risk appetite?
(2) What is my expected rate of returns and the risk I am prepared to take?
(3) What is my investment horizon?
(4) What is my investment objective? (Wealth accumulation, Wealth preservation or Legacy Planning)
Understanding these parameters will help your advisor to build an investment portfolio to achieve your goals.
* The information in this article is not intended to be and does not constitute financial advice, investment advice, trading advice, or recommendation of any sort offered or endorsed by Autumn.