10 Degrees of Investment Risks

Mon, Sep 29, 2008
The Straits Times

By Lorna Tan

It is natural to feel disheartened after a bad experience. Still, even if you are one of the hundreds who lost money in now-worthless structured products linked to failed United States investment bank Lehman Brothers, do not go to the other extreme and lose your faith entirely in investments.

Instead, take a hard look at the risks and potential returns of the underlying assets in your portfolio. It is unwise to put all your money under the pillow and in bank deposits just because they are very secure. Your purchasing power will be reduced by inflation.

A sensible combination of products with varying risks levels can provide good returns. Mr Leong Sze Hian, president of the Society of Financial Service Professionals, suggests that the most effective way to optimise risk is a globally diversified portfolio of different assets like equities, bonds and commodities.

For those who are confused over the potential risk levels of different asset classes, here is a general guide, from the safest to the riskiest sort of investments available.

1 Cash

Pros: This is the most liquid form of financial asset.

Cons: You do not earn any return from holding idle cash. The purchasing value of money diminishes over time because of the effects of inflation.

Best for: Investors are encouraged to keep at least six months' worth of expense money to tide them over rainy days.
Generally, there is no need to keep too much cash because there are other assets like deposits, bonds, stocks and unit trusts that can be liquidated within a short time, with little or no penalty, depending on the prevailing market conditions.

2 Bank deposits

What: Cash that is deposited in banks to earn interest depending on the account type and tenure.

Pros: It is a liquid asset, easily accessible and earns some interest. In Singapore, deposits are relatively safe as depositors are protected by the Deposit Insurance Scheme - administered by the Singapore Deposit Insurance Corporation - which insures each depositor up to $20,000 per institution they bank with. This covers an individual's Singapore-dollar current, savings and fixed deposit accounts.
The scheme provides depositors with peace of mind and they can expect to be compensated within three weeks of an order by the regulator to pay out from the Deposit Insurance Fund.

Cons: Bank deposits in excess of what is insured by the Deposit Insurance Scheme might be lost in a bank run. Also, current bank interest rates, which range from 0.2 to 1 per cent, are unattractive. They are also unable to beat inflation, so the monetary value of deposits will diminish over time.

3 Money market funds

What: A money market fund invests in high-quality short-term instruments and debt securities. The latter are loans sold by firms and governments to borrow money.

Pros: It is a good alternative for investors who are looking for a stable, low-risk instrument with potentially higher returns - ranging between 1 and 2 per cent - than banks' savings deposits. Such funds often have no sales charge, although they come with a low management fee of about 0.5 per cent per year.

Cons: Although most money market securities are considered very low-risk investments, there is a possibility that the borrower will not repay the loan as promised. However, such a default risk becomes non-existent if it is a government bond.
Also, the interest rate earned usually does not exceed inflation.

Best for: You can use it to park money that you want to keep safe and available for spending in as short a time as a few months to as long as several years. Therefore, it is suitable for all age groups, particularly for retirees.
Still, not all money market funds are the same. When shopping for a money market fund, read the fund's prospectus and annual reports. Check to see what kinds of debt instruments the fund invests in.

4 Bonds

What: They are also known as fixed-income instruments. Issuing a bond is one option for a firm to borrow money from individual investors. It is a debt security where the issuer typically offers regular interest payouts and is obliged to repay bond holders the principal at maturity. Bond holders are debt holders. As such, they have priority over shareholders on the company's assets in times of liquidation.
Unlike money market funds, bonds have maturities that exceed 12 months from the date of issue.

Pros: With a range of potential returns from 2 to 5 per cent, bonds give a higher yield than bank deposits and money market funds. They provide regular fixed interest income.

Cons: The returns may not keep pace with inflation. Bonds are also subject to default risk of the issuer.

Best for: As they are considered a relatively safe and low-risk instrument, bonds can help bring stability to an investor's portfolio. The proportion of bonds in a portfolio is dependent on the investor's risk profile. The lower the risk appetite, the higher the percentage of bonds in the portfolio and vice versa. It is common for retirees to hold a higher percentage of bonds in their portfolios, said Ms Irene Ng, investment analyst at Alpha Financial Advisers.

5 Unit trusts

What: When you invest in a unit trust, you are pooling your money together with many other investors. For a fee, a professional fund manager invests this pool of money in bonds, stocks and other instruments to reap returns consistent with the stated investment objectives of the fund. The potential returns vary from 6 per cent to double-digit figures.

Pros: Your investments are managed by professionals. Through unit trusts, you are exposed to a wider pool of equity stocks and gain better diversification.

Cons: Ms Ng cautioned that unit trust investments are not without risks and capital can be lost. The minimum investment amount is low at $1,000.

Best for: It is often recommended for new investors and those who want to gain diversification at lower cost.

6 Equities/Shares

What: Equity investment refers to the buying and holding of company shares. Income from such investments comes in the form of regular payouts and capital gains, when the shares are sold at a profit. When the investment is in a start-up, it is referred to as venture capital investing and is generally understood to have a higher risk than investments in listed firms.

Pros: Equity investors have the potential for higher returns.

Cons: Investing in single company shares is riskier than a unit trust investment because of low diversification.

Best for: Savvy investors who do their homework and monitor the companies they invest in.

7 Complex structured products

What: These are innovative products that offer investors a return that is linked to the performance of some financial instruments such as equities, foreign exchange and derivatives.

Pros: They offer an opportunity to participate in a shared investment view. For example, you may have a bullish view of a market or security.

Cons: Your money is tied up for three to 10 years and the underlying structure is usually difficult to understand. You may lose all your capital.

Best for: Savvy investors who understand the mechanics of the underlying structure and the instruments and are comfortable with the issuer, reference entities and risks.

8 Futures

What: Futures are derivative products - that is, their values are derived from the underlying asset, for example, commodities like coffee, metals and gold, and foreign currencies.
A futures contract is a standardised contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.

Pros: It requires a low outlay with potential for high returns. It is useful for hedging certain risks and carries a low transaction cost.

Cons: It is not meant for everyone as losses can be huge.

Best for: Derivatives are only for professionals and savvy investors.

9 Forex trading

What: The foreign exchange (FX) market refers to the market for currencies. Transactions in this market typically involve one party buying a quantity of one currency in exchange for paying a quantity of another.

Pros: It is a 24-hour market and a forex trader can generate profits in good and bad times, said Ms Ng.

Cons: Constant monitoring of the FX market is required. Due to the high volatility of currencies, it requires intensive research.

Best for: Recommended only for professionals and savvy investors.

10 Hedge funds

What: These are investment funds where the fund managers have a far wider range of investing options available to them than managers of unit trusts.
For instance, hedge funds can try to take advantage of a falling market by selling financial instruments they do not own yet - a technique known as short-selling. They can also borrow money to use as capital, or invest.

Pros: The greater investment flexibility provides an opportunity for exponential returns.

Cons: There is a lack of transparency on what the holdings of the funds are. The performance of hedge funds is highly dependent on the fund managers' strategies.

Best for: High net worth investors who have capital to invest and the ability to withstand losses, said Ms Ng.
Retail investors who want some exposure to hedge funds are advised to invest in a 'fund of hedge funds', which is a hedge fund that invests in other hedge funds, so as to lower their risks. For example, DBS Absolute Return Fund gives investors the opportunity to invest in a portfolio of hedge funds managed by more than 20 specialised hedge fund managers.