| Investment Planning |
It is the process of coming out with a plan or plans that identify investment objectives, structure and strategies that will help a person achieve his/her overall financial plan, taking into account the person's risk appetite.
As is usual in financial planning, the following would be the basic steps:
| 1. | Assess financial status and risk profile | ||
| 2. | Set objectives | ||
| 3. | Determine a plan to achieve those objectives | ||
| 4. | Execute the plan, and | ||
| 5. | Monitor and adjust the plan according to changed circumstances |
Risk profiling
Before setting out an investment plan, the investor must be clear about his/her risk profile. This may or may not be obvious and may not necessarily be what the person professes. The best is for the investor to answer a series of questions designed to establish his/her typical risk profile. From this, one can then determine what are the risk parameters beyond which he/she will not tolerate.
Why is risk profiling of an investor important? Every one of us, of course, would like to get the highest return we possibly can. But first we have to accept the risks that go with expectation of high returns. And understanding where one wants to go in terms of risk helps to prevent misallocations and about turns in investment strategy. So an investor should not go about chasing investments that have high price volatility if he/she is fearful of capital loss.
There are two guiding principles in investing that hold true most of the time and these are:
1. | The risk is higher when the reward expectation is higher, and vice versa - This stands to reason. Otherwise, everyone will simply choose investments that offer a high return and a low risk and discard those that offer a low return and a high risk. But in the marketplace, such anomalies are quickly found and priced out such that investments that entail a high risk will have to promise a high return to attract investors and those that entail low risks carry lower returns. | ||
| 2. | There is a trade off between liquidity and return - similarly, this stands to reason. The more illiquid an asset is, the less appealing it is and the return on investment is therefore expected to be higher. |
An investor can generally be classified under one of three common risk profile categories: conservative, balanced and aggressive. (Sometimes as in the case of WealthBox, these categories are expanded further like so: risk averse, conservative, moderate, brave and adventurous.)
Generally speaking, the more conservative one is, the more he/she prefers stability in value (or less price volatility), predictability in income generation, and liquidity of the asset. Conversely, the more adventurous one is, the more the person focuses on the promise of return and the more he/she is prepared to sacrifice price stability, income and liquidity. Thus, a conservative investor is not comfortable with investment losses even in the short term while an aggressive investor would be comfortable staying invested even if the investment is making losses in the short term. |
Fund objective
Besides being clear about the type of risk profile of the investor, one must be clear about the objectives for setting up the fund/s.
Different investment objectives may be set for the different underlying purposes.
Let us take the case of a fund set up for the purpose of retirement. The investment time horizon in such a case could be long (if started early enough) and may go to 25/30 years or beyond. The objective then may be to build a fund, with a target return that is at least sufficient to meet the requirements for retirement, a certain minimum liquidity level for contingencies and a spread of investments within the risk parameters that the investor is comfortable with. Given the long investment period, this return may be one that equals or betters the average capital market return. (For most developed capital markets, average return over a period that spans several economic cycles has consistently exceeded 10% p.a.)
If the purpose is say to fund a child's ongoing education, the objective may be to secure a steady income stream with little or no surprises. That may involve a more conservative approach.
If the time horizon for investing is long, there is generally more room for aggressive investing, within a person's risk parameters and so the investment approach may be more oriented to capital growth and therefore higher risk.
However, there are times when capital preservation is more important than seeking growth. Such a time would be post retirement when it is more important to preserve the capital that sustains a person's post retirement living needs when the person may not have the income generating ability that he/she had before retirement. And sustaining capital would require the investment objective to include achieving a return that is higher than inflation so that there is no loss in purchasing power. (Look out for tips in WealthBox on how to minimise tax incidence on income.)
Setting of investment funds to meet different objectives is commented on in the various fund sections.Asset allocation
Once the risk profile and the investment objective/s are known, the next things to decide on are the structure and approach, i.e. what type of assets should be considered, what fund proportion to allocate for each type, and whether to apply active or passive portfolio management techniques.
Determining the type of assets and the fund allocation for each asset class is referred to as asset allocation. One need not be confined to share investments alone but can also consider other asset classes such as property, bonds or even venture capital.
Asset allocation serves two purposes:
| 1. | diversification of risk, and | ||
| 2. | attempting to achieve an intended overall portfolio return that is commensurate with the risks taken. |
Without such a strategy, investment of funds may be directionless, based on impulse, dependent on luck and highly risky. Deciding how much to allocate for what depends a lot on the investor's objectives and his own risk profile. Thus a conservative portfolio may comprise for example 80% bonds and 20% equities or 40% rental properties, 30% bonds and 30% equities while an aggressive portfolio may comprise 80% equities and 20% bonds or 40% speculative properties and 60% equities. |  |
The various investment strategies that can be considered for asset allocation are:
| 1. | Strategic asset allocation | ||
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| The long term normal allocation that an investor decides on is often referred to as the strategic asset allocation. This approach uses a set base that provides a mix of expected returns to achieve the desired investment return. For example, if stocks are expected to earn 10% p.a. while bonds are expected to earn 6% p.a. over the long term, a mix of fifty-fifty would be expected to return an 8% p.a. yield on the portfolio. It is a passive buy and hold strategy, rebalanced only every now and then. |
| 2. | Tactical asset allocation | ||
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| A portfolio mix may be changed to take advantage of market timing where it is perceived that there are anomalies or exceptional opportunities in the short term and this would be called tactical asset allocation (or short term or temporary asset allocation). For example, the portfolio may be kept extremely underinvested with high liquidity in what is perceived as an overheated market. This would be a temporarily active strategy and will revert back to the original desired mix once conditions are perceived to have returned to neutral or normal. |
| 3. | Constant weighting asset allocation | ||
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| While the base mix is fixed in strategic asset allocation, the relative value of each constituent will change over time. So a 50:50 mix may become 60:40 over time. The constant weighting asset allocation strategy tries to address this moving mix by continuously rebalancing the portfolio so that if one asset (or class of assets) goes down in value, more of that is purchased while some of the one that goes up in value are sold. This is an active strategy using an averaging approach which does well in market reversals but underperforms if market trends continue. |
| 4. | Dynamic asset allocation | ||
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| this is the opposite of constant weighting asset allocation. Under this strategy, the portfolio is constantly rebalanced so that if one asset (or class of assets) goes down in value, more of that is sold while more is purchased of those that go up in value. This is an active strategy that adopts the go-with-the-trend approach and does well if market trends continue but underperforms when there is market reversal. |
| 5. | Capital protected (insured) asset allocation | ||
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| Under this strategy, a minimum capital value (the base value) is first set. The investment portfolio would then start with allocation of assets that are risk free or near risk free for up to the base value. Any amount above the base value is then used to invest in various higher risk assets as desired. A variance of this is that when the portfolio value drops, more and more of the higher risk assets are switched gradually to lower risk investments as the value gets closer to the base value. Often, options or forward contracts are used for the riskier portion as an attempt to generate a higher than normal return and/or used to hedge against the loss of the base value. This strategy appeals to the risk-averse type of investor. |
6. | Integrated asset allocation | ||
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| This approach refers to a comprehensive instead of a piecemeal approach. Taking into consideration a person's specific cash flows, constraints, objectives, risk parameters and outside circumstances that have changed, the optimal asset allocation structure is determined. This is better than splitting a person's investible funds to be managed by several fund managers, each with a different investment strategy if no one is having an overview on how best to optimise the overall investment structure, based on the investor's circumstances. |
 | There are other strategies that may be blends or variances of the above strategies not covered here. Below is a simple representation of how the asset allocation plan can vary for individuals who have each have a different risk profile and targeted return. | |
Diversification
Diversification for investments means minimising risk through spreading the investments. In other words, not putting all the eggs in one basket. Imagine an investor putting all his investible funds into a single asset. If the asset were to lose 25% of its value, the investor would have lost 25% of capital. However, if the investor's portfolio had been diversified so that that particular asset only formed 10% of the total, the loss would have been limited to only 2.5% of capital.
Asset allocation can be said to be part of diversification strategies. Diversification can take many routes in asset allocation. Assets can be allocated on the basis of geographical spread (local, regional), industry spread (banking, manufacturing), credit quality (bonds of various yield) and market capitalisation (large cap, small cap).
One of the routes to diversify is to invest into classes of assets (or even assets within each class) that have little or no correlation with each other. For example, the consumer products sector and the export sector have less correlation with each other than two manufacturing sectors.
One could even invest in assets that have negative correlation to each other, i.e. they tend to move counter to each other, such as a company selling ice cream and one selling umbrellas, or two funds with opposing asset allocation strategies. There does not seem to be much point in doing so though, other than for hedging purposes for a short period of time, since the movements tend to negate gains
One however has to watch out for over-diversifying. Spreading investments into too many different assets can be pointless and may simply cause more to be spent on transaction costs without any discernible benefit.
Also, there is a common misperception that when one puts money in several investments, diversification, and therefore spreading of risks, is achieved and the portfolio is ‘safe'. While this may be true to an extent, one has to watch out for knock-on effects, some of which may be endemic in proportion.
Investments spread in the same industry, e.g. banking, may not be safe. A classic example of knock-on effects was the collapse of the junk bonds market in the early 90s in the U.S.A. which triggered widespread problems for S & Ls (savings and loan associations) and forced a bailout of even some very large banks. And this seems to be the case with the recent subprime crisis.
Even investments spread across global markets can be similarly affected by the same factors based on today's open economies. So what can be done? Well, one can diversify into other asset classes, as well as take various measures such as value investing, defensive stock investing and hedging. |
Investment vehicle
Besides asset allocation, there is the issue of what vehicle/s should investments be housed in and managed.
Depending on one's personal preference and limitations, his/her investments could be under own management, under professional fund managers or in investment vehicles such as unit trust funds or exchange-traded funds or a combination of these.
Each of these choices would entail different costs and possibly different benefits. Under own management, there is of course no fee involved but there are then the questions as to whether there is time to focus on stock picks, and access to good market information. Whereas for the independently managed vehicles, professional expertise is tapped into at a cost. A combination may well be the best arrangement for benchmarking performance.
Investment techniques
After the asset allocation and vehicle have been decided, there is the question of what investments to make up each asset class or each portfolio. Picking investments is a bit of an art - some are masters at picking winners, some are poor at this but most of us could do with a few lessons on good techniques.
Not only is there the question of what investments, there is the question of how much to put for each selected one, i.e. the weightage for each. Some may place equal weightage while others may weight the industry leaders more and so on, each depending on individual preference and priorities for income and price stability.
When it comes to stock market investments, which tend to form a major part of most portfolios, there are many techniques for picking stocks to invest. In fact, too many to be covered here. Below are some of the more popular ones.
Value investing is a technique made popular by investing gurus like Benjamin Graham, Warren Buffett and Peter Lynch. What it simply means is that one picks a stock that is valued at a significant discount to its intrinsic value. The trick is to know what is the intrinsic value which is assessed based on long term strategic issues affecting the business.
Value investing is part of what the investing community refers to as fundamental analysis: the study of key factors and background information about a company and its environment.
In contrast to fundamental analysis is stock picking through technical analysis: the study of a stock's price movements through recording the history of trades in chart form and deducing from there the likely future trend. While devotees are enthusiastic about technical analysis, many do not consider this technique any more predictive of future price movements than tossing a coin.
One could also use other criteria (instead of intrinsic value) to select stocks, as in a beauty contest. For example, stock picks could be based on selecting the top twenty stocks that made the best dividend yields in the previous year and revising this each year.
The criteria could be on defensive stock qualities in anticipation of difficult economic conditions. Defensive stocks are those that tend to remain stable in price even during bad times because demand for their products (and therefore sales and profit) do not drop as dramatically as for other sectors. Examples would be food essentials, tobacco and gaming companies.
Or the opposite position would be seeking growth stocks in anticipation of good times. Growth stocks would be those that exhibit a higher-than-average growth rate even if the price appears expensive. Examples are emerging market stocks.
Another technique worth mentioning is contrarian investing. Because markets tend to overreact, when stocks rise or fall, they tend to do so more than they should, before going back to equilibrium, i.e. the point when market price reflects the ‘fair' value. This then offers opportunities for contrarian investing. The contrarian investor buys when most are selling and sells when most are buying. |
One is by way of leveraging (borrowing against the investments for the purpose of purchasing further investments).
Leveraging may be fine, to a limit, for purchasing properties based on competitive mortgage rates where there is reasonable assurance that the rental income will exceed the mortgage interest cost. But leveraging to buy shares through share financing can be dicey and has to be carefully considered because such invariably carry high financing costs.
The problem is, if cash is required for loan servicing and not met through other sources, the decision to sell investments bought through leverage and the timing of the sale may be forced upon the investor by the lender. Leveraging in an overheated market is particularly dangerous because when the downturn comes, the investor gets hit both with stock loss as well as interest charges.
Similarly, if the asset and liability maturity periods are mismatched, say a one-year loan funding a 5 year bond, timing of the sale of the investment may be forced unless there are alternative sources to repay the liability.
Another risky technique in leveraging is to borrow at a floating rate (an interest rate that moves in line with the market, e.g. KLIBOR or Kuala Lumpur Interbank Offered Rate) to invest in a fixed rate instrument. In a declining interest scenario, the fixed rate, when at a premium to the floating rate, provides an income stream but which may not only disappear but turn into a loss when interest rate levels go up.
Then there are the techniques that attempt to increase portfolio returns without increasing risk.
One of the most popular ones is known as dollar cost averaging - or perhaps here we should call it ringgit cost averaging. This is investing a fixed amount regularly and consistently, often into unit trusts, irrespective of whether the market is up or down. As markets generally move up over time, this technique achieves an averaging effect and usually assures one of a return over the long term. This is one way to minimise risk while earning a market-related return - a sensible and practical approach to investing since it can be hard (some consider impossible) to predict the right timing to invest or divest.
Another is arbitraging. Arbitraging is doing a simultaneous sale and purchase that takes advantage of the differential in price for the same investment (thus getting a return with no additional risk). An example would be the sale of a share and the simultaneous purchase of a warrant that converts into the same share (referred to as the mother share) at a price that is lower than its market price such that a profit is made even after taking into account holding cost (interest cost on holding the share).
Finally there are techniques to limit risk, while going for return and these would be referred to as hedging (not the garden variety that it may sound like).
Hedging is what one does to limit the loss, or protect a gain, in a transaction or transactions. Like insurance, one is insuring against an event that would have an adverse financial impact in consideration by limiting the downside, for a fee or premium.
This is normally done through futures or options or swaps or some other structured product that includes such derivatives, e.g. range accumulation notes. (See glossary for definition for each of these items.)
One can get protection for downside risk in an investment by making a gain out of the derivative used for hedging. Let us say an investor has a shareholding in ABC which shares have gone up in value. While the investor has faith in the long term appreciation of the shares, he is afraid of losing the gains he has built up for the shareholding. For a premium, he can purchase a put option on ABC shares that entitles him to put the shares to the option provider for a predetermined price. This enables him to exercise the put and realise a gain that will offset the resultant loss should the price of the shares go down below the predetermined price.
The techniques mentioned here serve to illustrate the complexities of investment planning and the myriad ways one could go about dealing with pitfalls in investment management. But for the pitfalls, there would be little opportunity. Luckily for smart investors, there is no such thing as a perfect market. Aberrations and price anomalies often occur in the marketplace thus providing openings for them to take advantage of, or ‘play the odds' so to speak. Of course, identifying such situations requires a lot of skill and experience. |
Investment instruments
There are so many ways one can invest and so many types of instruments one can choose from - from real estate to REITs, from private equity to unit trusts, from bank savings to bonds, from endowment to investment-linked, from local instruments to offshore, from options to commodities, and so on. |  |
Below is a rundown on the common types in the investment world. (See also the investment instruments map.)
The most common investment forms would be fixed deposits, savings and money market instruments. These are often referred to as cash equivalents (since they are nearly like cash). They are among the investments that offer the lowest level of risk since they are mostly short term and represent obligations of banks or the government.
Money market instruments may be in the form of overnight, week or other short term deposits in the money market (the place where financial institutions borrow or lend to each other) or instruments such as repurchase agreements (Repos), negotiable instruments of deposits (NIDs), bankers' acceptances (BAs), Malaysian government securities (MGS), Cagamas bonds/notes, treasury bills (T-bills) or monetary notes. (See the investment instruments map for explanations.)
Because they are low risk investments and convertible to cash at short notice, the interest paid on such instruments are usually not much better than the inflation rate so they would not be very suitable for medium and long term investment planning other than to provide liquidity and for contingency funds
The next most common investment would be shares (or often referred to as stock or equity), representing ownership in a company. This may be quoted or unquoted. Unquoted ones would not provide liquidity and would therefore require higher returns. Even quoted ones provide varying degrees of marketability, i.e. how readily one can make a disposal in the market, depending on whether they are blue chip, main board, second board, or mesdaq counters.
Besides providing a return in the form of dividends, there is the expectation of capital appreciation, which together makes up the total return on a share investment. Empirical studies indicate that shares provide a higher overall return than bonds if held for a long period of time. The flip side is that there is much more price volatility during the holding period and there is a greater risk of capital loss since as a shareholder, one ranks last in distribution, after creditors, if anything goes wrong.
Bonds, another asset class, unlike equity, represent liabilities. A bondholder is in fact a creditor to the bond issuer. The bond is a promise in writing that the issuer will pay the principal and interest on the dates due. As such, the risk of capital loss is generally lower than for shares since liabilities rank ahead of equity in distribution in a financial failure. Nevertheless, there is the risk of default, i.e. the risk that the bond issuer defaults in paying interest during the bond tenure or repay capital on maturity.
Bonds can be issued by companies or public bodies such as government agencies and in Malaysia require to be rated by a credit rating agency before they can be issued. Bonds that have the highest credit rating have the lowest risk of default and the risk gets progressively higher the lower the credit rating is.
The advantage of bonds besides the safety aspect, is the fixed income yield (even for zero-coupon bonds, through amortisation of discount). The yield is generally better than those of cash equivalents because of the longer tenure. The yield may also be better than the dividend yield of listed shares but there is no profit participation since they are debt instruments unless there are attaching convertible features.
As the price of a bond fluctuates, depending on market interest rate movements, there is a risk of loss of capital if the bonds are sold before maturity. When interest rate goes up, bond prices fall and conversely, when interest rate goes down, bond prices appreciate in value.
Hence long term investors tend to hold bonds till maturity. However, it is a commonly held fallacy that there is no loss when investing in bonds if one holds such investments to maturity and gets back the principal. If market interest rate levels have moved up during the investment period, then there is opportunity loss from not getting a higher return that became available in the market for the same risk.
One can also invest in shares or bonds through unit trusts (sometimes referred to as mutual funds).
This is an increasingly popular alternative to investment by the individual who may not have the time, expertise or access to up-to-date market information. Moreover, by pooling resources of unit-holders, unit trusts may offer advantages in terms of scale in purchase (especially for bonds which require a minimum value to trade) and diversification of risks that an individual would otherwise lack. |
Unit trusts also offer a wide choice to suit different risk profiles and objectives - there are the aggressive, growth oriented, conservative, income focused, guaranteed, specialised, sector and balanced funds and varying degrees of mix in between. Because of the great number of variations, it is important to study the fund prospectus to understand what the fund objectives are and what strategies the fund managers intend to adopt.
Alternative investments available recently are REITs and ETFs.
REITs refer to real estate investment trusts. These are collective investment pools that invest in real estate properties and whose units are traded in the stock exchange like shares. REITs have property rental as their main income stream and can enhance value for unit-holders when disposing properties for capital gain. (Look out for tips in WealthBox on tax.)
ETFs are short for exchange traded funds, recently introduced to the stock market. Like unit trust funds, they are collective investment pools that invest in shares but their units are traded in the stock exchange as shares and an ETF tries to mirror the performance and diversification of an index, like an index fund, which does limit the investor's choice. The advantages are lower transaction cost and trading at any time on a trading day as opposed to end of day for unit trusts.
An important class of long-term investments is the insurance based investment. This is an insurance product issued or underwritten by an insurance company, with a savings element and insurance wrapped in. Insurance products other than term assurance would incorporate a savings element - whole life, endowment, annuity and investment-linked.
Whole life is the most popular form of insurance combining savings with protection. It provides life cover for a person's entire lifetime and at the same time accumulates cash value (part or all of which may be guaranteed) which one can borrow against for emergencies or unforeseen needs. One may opt for the higher-premium participating whole life which entitles the policy holder to any dividends and bonuses declared out of the surplus from the insurer's designated investment pool, the idea being to secure immediate protection while leaving a portion for the insurer's experts to secure an above average return over the long term for beneficiaries.
Endowment policies are life policies that serve the same purpose as whole life but for a specific period of time and generally with a higher proportion of premium as the savings element which is then used to build up cash value that is withdrawable on or before maturity (at the end of the endowment period). Traditional with-profits endowment policies allow for participation in the surplus from the insurer's designated investment pool through periodic declaration of bonuses (reversionary and terminal). The disadvantages of endowment are:
| 1. | the premium tends to be significantly higher than whole life and | ||
| 2. | protection is no longer available after the endowment period. |
Annuities are contracts whereby, in consideration of a single premium or a series of premiums, a fixed allowance or income is paid to the annuity holder (or his/her nominee) regularly for life or over a specified number of years. The amount of premium payable takes into account a yield on investments. Such plans are good for those who want assurance that their living expenses will be taken care of for life. Annuities are popular overseas as part of retirement plans but are not easily available here because:
1. there are no tax concessions on the income stream; and 2. the guaranteed payout rate expected is above what most insurers are prepared to carry.
Investment linked insurance are policies that provide life cover linked to investment. The difference between such products and traditional or ordinary life products is that the policy-holder assumes the risks and rewards wholly for the investments managed by the insurance company, just as he/she would if investing in a fund managed by a unit trust management company. The policy-holder's nominated beneficiaries would get a guaranteed death benefit together with a share of the accumulated surpluses from the insurer's designated investment pool but there is always the risk of loss of principal. And like unit trusts, the investment pool is divided into units which prices are quoted on a daily basis. For such a product, the policy-holder has the flexibility to:
| 1. | set how much he/she wants for protection and how much for investment; | ||
| 2. | choose which investment pool he/she wants to invest in; | ||
| 3. | vary the premium along the way according to changing financial circumstances; and | ||
| 4. | top up or withdraw partially or wholly. |
In recent times, a new investment cum insurance product called universal life insurance has been introduced to cater for those who want more flexibility and less risk. This is simply the packaging of a whole life plan with an investment-linked plan.
Under such a plan, the components that represent protection and savings are transparent to the policy-holder. Unlike traditional insurance, there is flexibility to change the protection and savings components as the policy-holder's financial needs change. Such a plan typically appeals to those who want protection and who may need capital protection and/or guaranteed returns (usually benchmarked against savings rates) and yet want some growth potential for their investment.
There are many other types of investments available. The opportunity for offshore investments for the individual investor has recently opened up following Bank Negara's liberalisation of exchange controls. And with that the choice of investment products, such as structured products and master funds, has increased substantially.
Other types of investments may include time share units, real estate, precious metals, other commodities and a host of other items such as art, antiques and collectibles. Review and rebalancing The portfolio structure requires periodic review to see if it needs rebalancing in the light of changed economic and market conditions. Rebalancing involves buying and selling assets in a portfolio to bring the asset allocation for each asset class back to the desired mix, which may or may not be the same as the original mix. Review and rebalancing is essential for portfolios using strategic asset allocations because this is a passive investment approach that may overlook major changes in the environment. Those that involve active management, such as tactical asset, would need monitoring of short term market changes all the time and naturally would involve rebalancing to some degree. |
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Conclusion
Below is a summary of the basic process involved in investment planning:
 | While the process may look simple on paper, investment planning involves a lot of complexities in practice. A good investment plan not only requires the proper execution of a process, such as the one illustrated above, but inputs from knowledge of factors that may warrant changes in parameters, expectations, asset allocations, investment techniques and composition and/or weightage of component investments. |
Selection of strategies and investment instruments require skill and years of experience. One should have up-to-date information and a good feel for the economic environment and what is going on in the markets before risking any substantial part of his/her wealth. Otherwise, it would be leaving a lot to luck, and that would be akin to gambling.
Poor execution, misreading the market and wrong assumptions can lead to unfulfilled objectives and disappointment. Thus, it may be better to work with a qualified and experienced financial planner and a seasoned fund manager on portfolio structuring and fund management respectively.
Whatever the circumstances, the golden rule is: Do not invest in anything that one does not understand.
1. | Is investment planning the same as wealth planning? | ||||||
A: | Investment planning refers to the process by which a person plans his investments after defining what his objectives and risk parameters are. Wealth planning is wider and refers to the creation, accumulation and diversification of wealth. This need not necessarily be confined to investment planning but also includes planning what to set aside from income for savings. | ||||||
2. | What are present value and future value? | ||||||
A: | These are terms stemming from the concept of time value of money. A ringgit today is more valuable than a ringgit tomorrow because of opportunity cost. If one has a million ringgit today instead of a year from now, he/she could invest the money and get more than a million ringgit in a year's time. Present value refers to the value today of a future sum of money (future value) discounted by a factor such as a specified interest rate. The higher the discount factor, the lower the present value and vice versa. One can also look at it from a purchasing power perspective. If the factor is taken to be the inflation rate, then a ringgit in the future would be less than a ringgit today, in terms of what it can buy at today's prices, by a discount factor representing the inflation rate. | ||||||
3. | What are the various financial statements and the purpose for each? | ||||||
A: | There are typically three financial statements that provide a comprehensive picture of a person or an entity's financial status, namely, the profit and loss account (or income statement), the balance sheet (or statement of financial position) and the cash flow statement. The profit and loss account shows the revenue less costs and expenses, to arrive at the net result of a financial performance for a specified period, e.g. one quarter or one year. It is like a story of a performance over a period of time. The balance sheet shows the assets, liabilities and net worth, to arrive at the financial position as of a particular date. It is like a snapshot at a specific point in time. The cash flow statement shows the cash inflows, cash outflows and net changes to cash and cash equivalents for a specified period. It is like a story of how cash came in and went out over a period of time. | ||||||
4. | What is the difference between share and equity? | ||||||
A: | A share represents an official unit of ownership in a company whereas equity represents the shareholder's interest in the company, i.e. the shareholder's share of the company's net worth. | ||||||
5. | What is the difference between unsecured and secured bonds? | ||||||
A: | Unsecured bonds are not backed by any asset as security, meaning if the bond issuer defaults in honouring its obligations under the bonds, there is no recourse to recovering from the sale of assets. The recourse would be to sue the issuer or the guarantor (if any). A secured bond is a bond which repayment is secured by identified assets or class of assets. A mortgage bond is a secured bond. Its repayment is secured on mortgaged property or properties, i.e. if the obligations under the bond are not honoured, the bond-holders have a right through an appointed trustee to dispose of the property or properties pledged as security and use the proceeds to repay the outstanding sum due under the bond. | ||||||
6. | What is the difference between a shareholder and a bondholder? | ||||||
A: | A shareholder is an owner of a company jointly with other shareholders. He owns the company's equity (assets less liabilities) in the proportion that his shareholding bears to the total issued capital. A bondholder is a creditor to the company. A bond is in effect a loan supported by a promise in writing issued by the borrower to repay the amount borrowed together with interest at a specified rate on specified dates. In terms of risk, a bond is less risky than a share in the same company. In the liquidation of the company, the assets are used to pay off creditors, including bondholders first, before any residue is distributed to shareholders. | ||||||
7. | What is meant when people talk about price earnings and price to book? | ||||||
A: | These are bases that are commonly used for the valuation of shares. Price earnings refers to the relationship between the market price (or value) of a share and the earnings per share. Earnings per share represents the net after-tax profit of a company (or referred to as earnings) divided by the number of shares in issue, i.e. the amount of net profit belonging to an owner of one share. Therefore, when one says a share is valued at a price earnings multiple (P/E) of 10 times, it means the value of the share is ten times its earnings per share. Price to book refers to the relationship between the market price (or value) of a share and the book value per share. Book value per share (or often referred to as the net assets per share) is the value of net worth as stated in the books of a company that is represented by each share. Net worth (or equity) is what shareholders own - the remainder after deducting liabilities from assets and so book value per share represents what an owner of one share owns in the company. When one says a share is valued at price to book (P/B) of 2 times, it means the value of the share is twice the book value per share. | ||||||
8. | What is NTA? | ||||||
A: | NTA stands for net tangible assets. Net assets is the assets net of liabilities and represents the net worth or the owners' equity. Assets can be tangible or intangible. Intangible assets are those that are not physically in existence but nevertheless of value currently or at some point in time, for example, the goodwill or trademark of a business. Because intangible assets are hard to quantify, value or assess, valuation of a business based on net assets often excludes intangibles. Hence, net tangible assets or NTA - net assets excluding intangible assets. | ||||||
9. | How is return on equity and return on investment calculated? | ||||||
A: | Return on equity (ROE) is measured by taking the net profit (earnings) for a period as a percentage of equity (capital invested or net worth as shown in the accounts) which may be an average of the beginning and end period figure. It measures the efficiency of the use of capital funds by a business. If the ROE is high, it is indicative that the capital is being efficiently used to generate profit and conversely, if the ROE is low, the capital is not being efficiently used. However, a high ROE is only one indicator and does not necessarily signify superior profitability. Some businesses, such as consultancies, do not use much capital and therefore would naturally have a high ROE. Thus, it is meaningful to compare ROE of a business with that of similar businesses. Another important indicator is Return on investment (ROI). It measures the net profit for a period as a percentage of the cost of investment. This ratio measures efficiency of capital invested to generate profit. It is meaningful for a shareholder who invested in a company to measure the return he gets based on what he paid for the investment. Although a company may have a high ROE (indicating that the company was efficient in generating profit out of its capital funds), the high cost of the shares of an investor in the company may produce a low ROI. | ||||||
10. | What would be considered a good investment return? | ||||||
A: | Investment return varies with the risks that are inherent in the investment. Generally, the higher the return, the higher the risk. For benchmarking purposes, one may look at three significant indicators:
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11. | What is the point in buying a life policy and paying a single premium as opposed to paying regular premiums? | ||||||
A: | For those who have set aside sufficient funds for their financial goals and do not want to be bothered to pay a recurring premium, a single premium (discounted based on a rate provided by the insurer) may be attractive. By paying a single premium, most of the time, the policy-holder effectively earns a bit higher than a fixed deposit rate and enjoy protection at the same time. | ||||||
| 12. | Why do I have to pay interest for APLs (automatic premium loans) because I am using my own money? | ||||||
| A: | Although one may think of the APL as coming from the policy-holder's own money, the interest charged on an APL represents the insurance company's opportunity cost which it could have earned in other investments if it did not have to lend for the APL. | ||||||
| 13. | Is there a minimal guaranteed return for investment-linked insurance? | ||||||
| A: | No, there is no guaranteed return on investment-linked insurance and the unit holder has to be prepared to bear the risk of capital loss. | ||||||
| 14. | Can I switch my investment-linked policy to another fund type without having to surrender the current plan? | ||||||
| A: | Yes, most insurance companies allow the holder to switch at least once a year without paying a switching fee or if more than once a year, then there are extra fees. | ||||||
| 15. | How long do I have to maintain an investment-linked plan? | ||||||
| A: | There is no time limitation. You can maintain such an account indefinitely. Because of front end charges, it may not be advisable to terminate the account in too short a period of time. | ||||||
16. | As a unit trust agent, should I advise clients to switch to another fund from one that has performed poorly? | ||||||
A: | There is no magic formula for switching. Switching should be kept to a minimal considering the front end load (fee). When switching is done frequently or over short periods, any advantage in investment return is soon eaten away by transaction costs. Switching, when really necessary, should be based on good reasons such as:
It is hard to find any successful active investment management that moves and switches quickly in and out (much like the car zipping in and out of heavy traffic) that have beaten a long term passive investment. |
Approaches: Wealth Planning > Other Funds Planning >>
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