Welcome to part 2 of our Beginner's Guide to Investing! By now you should know what investing is and why you should invest. If you haven't read part 1 on why we should be investing, do check it out first!
In part 2, we will be exploring the risks of investing, what you can do to mitigate risks, and the different asset types you should invest in with relation to your risk profile. This is important because investing is a risky procedure. Knowing the risks allows you to take measured steps that you are comfortable with, given your personal risk appetite. Let's begin!
The nature of investing
Investing is naturally risky. You cannot expect to put your money into the market, achieve a gain of 8% or more and expect to lose nothing. Before you begin to invest, you have to understand this. The higher the returns you are trying to achieve with your money, the riskier it's going to get.
Makes sense, right? If you expect that a company can grow the money you put in them by 10% every year, they are naturally taking bigger risks than a company expected to grow your money by 3% every year. Perhaps they are expanding into new markets, or doing some new research that may or may not pay off - versus the safe company that's just opening a new store in an established market. The possible profits are higher, but the element of risk is higher as well.
Ventures fail. It's a fact of life. Similarly, you must expect that some of the assets you invest in will fail to give you good returns on the money you invest in them. Of course, we should seek to maximize our returns while minimizing our risks, so let's try to do just that!
The risks of investing
Let us first look at some risks present when you invest. We'll also examine some ways in which we can deal with or reduce these risks. Generally, we can classify risks into two broad types - systematic and unsystematic risk.
Systematic risk (market risk)
To put it simply, systematic risks refer to risks that affect the entire economy or market as a whole. For example, natural disasters like the 2004 Indian Ocean Tsunami or the coronavirus outbreak in 2020 can cause massive shutdowns of the economy. Law reforms, or changes in tax systems can also affect the market as a whole.
Systematic, or market risk, is what we call unavoidable risk, because the entire market is affected by it. You can't do anything about it. So the best thing to do here, as we've learnt in part 1 of this guide, is to do... nothing. Since the risk is unavoidable, we just have to trust that the market in the long run will always grow, and take a long outlook in investing.
Of course, we could try to minimize the impact of this risk by timing the market (i.e. buy low, sell high), but that is very risky since nobody can predict how the market will move in the future.
Unsystematic risk (specific risk)
Unsystematic risk, on the other hand, is avoidable. These risks are specific to a certain sector of the market, such as the oil industry or the healthcare industry. They could even be specific risks about a certain company. Since it's so specific, avoiding or reducing your losses to these kind of risks is possible.
For example, a specific risk could occur when a new oil field gets discovered. Due to the influx of oil supply being greater than the demand, oil prices begin to drop. As such, stocks belonging to oil companies fall as well. This is a specific risk of the oil sector.
How can we minimize specific risks? A solution is diversification. The general concept of it is to spread out your investments into different sectors and countries such that if one portion is affected by specific risk, the other portions will still continue to flourish, ensuring that overall, you are still making gains instead of losses. This is an important concept that we will look at in greater detail later in the guide.
Unsystematic and systematic risks can be further broken down into two kinds of risks each, and these are short term risks and long term risks. They are rather vague concepts, but understanding these risks allow us to make more rational investment decisions.
Short term risks
Short term risks are risks that occur in a short time frame, such as the volatility of stock prices on a monthly or even a yearly basis.
It's important to know that the stock market is primarily made up of human traders like you and me (not counting our AI overlords). Since humans run on emotions, any bad or good news can swing stock prices quite heavily in the short term. Panic sells and overbuys are very common in the market, and these can cause volatility in the short term.
Just look at Tesla's stock after the opening of China's gigafactory in 2020. A bit of good news and...
And look at what happened after the hype died down, and when the company faced coronavirus fears.
Crazy, isn't it? It gained nearly 600/share in a few months, and fell by 400 the next. Well, what can we do to reduce short term risk? The most sane way, in my opinion, is to focus on the long term. Remember, we believe that the market always grows in the long run. While short term volatility hurts as you see your stocks dip, in a long term outlook, this volatility is somewhat negligible.
Over the span of 5 or 10 years, if you had chosen a well managed company, the overall gains would still be positive. Any fluctuations in the short term would be overruled by the growth in the long term.
In fact, if we look at the S&P 500, which tracks the top 500 companies in America, we see that although the price fluctuates wildly throughout the years, the overall price trend over 5 to 10 years still grows terrifically.
Therefore, to minimize short term risks, one should not attempt to time the market (i.e. try to buy low and sell high), but instead invest in well run companies they believe in and trust in its long term growth.
Long term risks
Now, long term risks on the other hand are a whole another can of worms. These risks usually occur over a long period of time and can therefore be difficult to spot and mitigate. Even when you finally realize that you've incurred it, you are usually in too deep and have taken a loss.
Long term risks can include investing in something that seems profitable, but turned out to be a loser in the long run. An example of this is Hyflux, a utility company listed on the Singapore Stock Exchange (SGX). Investors were lured in by promises of a high return, but ultimately failed to realize that the company was heavily in debt, making losses and being run by poor management. When the company filed for bankruptcy in the end, investors barely got around 10% of their original investment. You can read more here.
How can you mitigate long term risks? There are two ways. The first and most obvious way is to do your own diligence. Research a company, read and understand its financials, and come to your own conclusions on the company's growth prospects. Only invest in companies that you trust will grow.
The second, and somewhat naive way, is to simply... wait it out. If you thought long term risks were long term, then up it a notch and hold your assets for an even longer term. After all, as long as you don't sell, you technically aren't making a loss on your money.
Naturally, this second method has some severe drawbacks. If the company goes bankrupt and is unable to pay you back, that's 100% of your capital gone. Additionally, that money you locked inside a company with meager growth prospects is incurring opportunity cost, since it could very well be invested somewhere else with much better returns.
Investment asset types
That was a long section on risks, but I think it's important to understand these risks before starting to invest. It's too late to regret when your money's gone, isn't it?
Now that we've gotten a preliminary overview of the risks and how to mitigate them, we can start to delve into the meatier bits. What assets can you invest in? After all this talk, where can I put my money to make it grow?
There are three main asset types that we'll be focusing on today - Stocks, Bonds and Real Estate. Naturally, there are many more options (no pun intended) in the market, but as a beginner, these three will keep you occupied for a long time.
These three have varying levels of risks, and therefore, varying levels of returns as well. Let us examine each asset type in greater detail.
You might have noticed me using this term above quite a few times. These basically make up the majority of the market. After all, there's a reason why the term "stock market" is so well known!
Stocks, also known as equity, is basically a portion of a certain company or fund. For example, if I'm buying 50 units of Microsoft stock, it means that I will own 50 shares of Microsoft. Hence, if Microsoft grows, my money will grow at the same rate and vice versa.
Amazing, isn't it? You can get invited to the company's Annual General Meetings (AGM) where you can learn about what they plan to do in the future and receive updates on the company's financials as well. You can even put in your vote for company decisions! This is because you are now an "owner" of the company as well.
The risks and rewards of stocks vary wildly, but generally, stocks are regarded as somewhat risky with a high reward. Stocks often experience quite a bit of short term volatility, with a general long term trend. Remember Tesla's stock somewhere above?
With stocks, you should be looking at a return anywhere from 4-12% of your invested capital. The average return before inflation is 10%. Sure, you could aim for a return higher than that, but know that you take on more risks and short term volatility if you do so.
Next, we have bonds. Bonds basically involve you lending your money to a company or even the government. You can think of it as debt, except now you are the one loaning out money. In exchange, they will promise to pay you a fixed interest rate every year, and repay you the full principal that you loaned them some time later.
The difference between stocks and bonds is that while money you put in stocks grow at a rate proportional to the company you invested in, bonds provide returns at a fixed rate (also known as coupon rate). Basically, when you purchase a bond, you seal a deal whereby you will lend them X amount of money, and in return they will pay you Y% of interest every year on that loan. This Y% is known as the coupon or interest rate.
Since this rate is fixed from the start and doesn't change, your returns are fixed. This is why bonds are known as "fixed income instruments". Meanwhile, stocks' returns vary based on the company's growth, and therein lies their difference.
Bonds generally have a lower risk than stocks since the coupon rate is fixed at the beginning so you know exactly how much you'll be getting. Usually, the longer you hold the bond, the better the coupon rate gets. However, due to the lower risk of knowing your returns, bonds have a lower rate of return as compared to stocks.
You can expect bonds to have a return on your money of around 3-6%, depending on the "risk factor" of the bond. AAA bonds are basically risk free, meaning that you will pretty much definitely get your principal back, while bonds rated BB and below are known as "junk bonds". These bonds can have higher rates of returns but are much more risky. They could default, meaning that you lose 100% of your money invested in them.
The last asset type we will look at in this part is real estate. These are basically investments into housing and properties, such as malls, living spaces, buildings and more.
There are two ways you could go about investing into real estate. The first way is to do it yourself, buying an actual physical property and either reselling it at a higher price or renting it out for monthly income.
The other way is to buy real estate investment trusts (REITs), which is basically you putting your money into a trust (company) that manages a whole bunch of properties. They will use your money to purchase and manage those properties, including renting it out. The proceeds will then be channeled back to you.
We won't be going into the details of the differences between the two methods now.
Real estate is generally know to have a relatively high risk and high rewards. You can expect returns to be around 8-12%, which is similar to stocks. Real estate is a popular investment asset due to its high returns and negative correlation to certain major sectors of stocks.
Remember the part about unsystematic (specific) risk? Real estate can help to diversify your portfolio as properties are tangible things that exist in reality. The income comes from actual tenants renting the property, meaning that it provides a rather stable source of income as compared to stocks, which can fluctuate wildly based on what the company is doing.
Determining your risk profile
Now that we have an overview of the risks in the market and the three major asset types you can consider investing in, you should now determine your risk profile.
We now know that different asset types (and even different assets within the asset types) have varying amounts of risks and returns. But... why should we even invest in different asset types? Well, it's all about reducing risk, of course!
Let's say the stock market crashes. People are getting laid off left and right and companies are losing sales. Stock prices fall and your stocks' value drops drastically. If you had a portion of your portfolio in bonds, well, those bonds should still be paying you a fixed coupon rate, so you are still getting income.
Or what about if the housing market crashes? House prices are falling, but the companies you invested in are still doing really well selling mobile phones, for example. Your stocks' gains can cover the losses in your real estate investments.
It's all about diversifying your portfolio enough so that your income stream doesn't completely dry out.
But... how do you determine how much to invest in each asset type? Should you go purely with stocks? Or should you mix in some bonds to offset some risk? What percentage should you mix them in?
This is what we call your risk profile. Are you prepared to lose 10% of the money you put in? What about 20%? 40%? Knowing how much you are acceptable with losing will allow you to understand your risk appetite and determine what assets you should invest in.
Remember, the higher the returns you want, the more risk you are going to have to take on. Let's take a look at some common allocations.
If you are young, you have a long horizon of investment ahead of you. You can weather losses since you will be making money with a job (hopefully). Therefore, you can afford to take higher risks and try to get higher returns. This means that you would have less bonds and more stocks or real estate.
This is only an example. You might wish take on more bonds if you want to minimize risks.
Conversely, if you are older and close to retiring, you wouldn't want to take on high risks and lose everything you've saved up so far. You would thus choose to take on more bonds and perhaps stable real estate, and reduce your holdings of stocks. This is called preservation of capital, ensuring that you will have a steady income even as you retire.
You should always shift your portfolio allocation between asset types to match the risk level you are comfortable with. As the market evolves, you might want to shift your allocation in preparation for say, a recession.
If you expect a bearish market (market going down), you might choose to take on more bonds to reduce your risk and losses. If you expect a bullish market (market growing), you might take on more stocks to maximize your returns. This is known as portfolio re-balancing, and you should do it frequently!
Of course, nobody's stopping you from going all in on one asset type. Choosing to wait out volatility and play the long term game is also a valid strategy! Just don't all in on bonds - while it is low risk, the low returns aren't doing you much good either.
That's about it for part 2 of our beginner's guide to investing! In this part, you have learnt about the various risks of investing and how to mitigate them. You've also learnt about the various asset types, and depending on your risk profile, determine your portfolio allocation between asset types.
When you're ready, continue on to part 3 where we'll learn about preparing yourself for investing!
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