Understanding investment strategies

by Benedict Koh
Nov 26, 2011

In the third of a four-part series on financial planning for different life stages, we turn our attention to investment for working adults.

Investment is a critical component of personal financial planning. It requires you to postpone current consumption and invest savings in investment instruments to grow your wealth. Through investments, you are accumulating the necessary financial resources to finance your future goals such as purchasing assets (car or house) or financing your children's education.

Furthermore, with increased life expectancies, the average person is expected to spend close to 20 years of his life in retirement. This implies that you will need substantial savings to support a comfortable retirement. It is, therefore, crucial that you start saving early and regularly, and investing these savings while you are gainfully employed.



Investment strategies for growing savings

The key drivers of wealth creation are: The initial amount of capital for investment, return earned on various instruments and holding period of investment, as illustrated in Table 1. What is obvious from these three investment strategies is that for wealth accumulation to take place, individuals must: A) invest sufficient amounts of savings during their working years; b) invest as early as possible; and c) invest in high-yield instruments.

The results in Table 1 may tempt you to invest only in high-return investment instruments, but beware that such instruments come with a high risk. This means that there is a chance that you may lose part or all of your capital from such risky investments.

The appropriate choice of investment instruments depends on both your goals as well as your risk appetite. Only if you have an appetite for risk and can afford to take losses should you invest in high-risk investments. For example, elderly investors who have school-going dependants and are near retirement should avoid high-risk investment instruments.



Asset allocation

Inexperienced investors often look for a single successful investment to grow their wealth. These are the ones who wished that they were able to identify stocks such as Google or Microsoft which saw their initial public offering (IPO) prices appreciate multiple times over.

Such strategy of betting on one stock or investment is highly risky and not recommended. Finance researchers tell us that a key determinant of returns from investments is asset allocation, which refers to the mix of asset classes that you select in your portfolio. These assets can include deposits, bonds, equities, properties; and other alternative assets such as commodities, hedge funds, structured products, etc.

Asset allocation is a form of diversification since deposits and bonds are not highly correlated with equity and properties. By including lowly correlated asset classes in your portfolio, your investment risk can be reduced significantly.

Your asset allocation should also vary with age. As you age, your risk appetite tends to diminish, which in turn affects your asset allocation. For example, investors who are in their 20s and have no dependants may aim to grow their wealth as quickly as possible. Consequently, they may wish to invest a higher proportion of their savings in stocks.

As they move into their 30s and 40s, they should be more prudent and shift more of their investments into high yield corporate bonds and money market funds. Table 2 shows some possible asset allocations for investors in different age groups.

Besides age, asset allocation also depends on the risk appetite or risk tolerance of the investor. If you are very risk-averse, then you should invest a substantial portion of your savings in low-risk instruments such as deposits and bonds. On the other hand, if you are able to take more risk, then consider investing more of your savings in equities or equity-linked instruments such as unit trusts, commodities and hedge funds.

Since investors have different goals, financial circumstances as well as risk appetite, they must engage financial advisers to perform fact finding, needs analysis and risk profiling before customising an asset allocation that suits them.

Consistent saving and investing requires a lot of discipline. Therefore, it is important to learn such virtues at a young age and continue with this habit well into adulthood. The earlier you start saving and investing, the more likely you will succeed in growing your wealth.

Sound and prudent investing allows you to enjoy the standard of living that you desire. Seldom do people attain their goals and desired standards of living through luck. They must commit their savings to investment to achieve them.

Another reward of sound investment is the accumulation of substantial wealth to cushion you against financial disasters. Should you be struck with prolonged illness or experience retrenchment, your accumulated wealth will tide you over such challenging episodes in your life.

Most importantly, you would have accumulated a significant nest egg for retirement. This will allow you to enjoy your golden years without the distress of having financial problems.



Dr Benedict Koh is a professor of finance and the director of the Centre for Silver Security at Singapore Management University. This article is drawn from Personal Investments by Benedict Koh and Fong Wai Mun (1st Edition, Prentice Hall 2011).