Many average investors think they are well diversified if they own various categories of stocks (large, medium, small, international)
Problem: You are not as protected through traditional diversification as you might think. The conventional wisdom behind diversification is that if you spread out your risk to numerous holdings and asset classes, they will all be moving up and down at different times, thus reducing the risk of a major decline in your portfolio. However, what if this isn’t true? What if all of your investments are set up to move in sync with each other?
As we will examine, there is a good chance that all of your stock positions mirror each other’s movements. If this is the case, you may not be as protected through conventional diversification. Thus if your large-cap fund declines, the odds are that your mid-cap fund will follow suit. How does that help you?
First, the Importance of Asset Allocation: Around 91.5 percent of an investor’s return will be due to the specific asset classes that he or she invests in (e.g., large company stocks, government bonds, real estate, etc.), rather than any specific investment or fund he or she may choose.
This lends further credence to the idea that choosing a specific fund manager for a specific asset class is less important than you might think. Rather, what is important is the asset class itself. This conclusion has led many pension and endowment funds to develop their strategies around sound asset allocation. Diversification through proper asset allocation is one of conventional wisdom’s most common pieces of advice that it recommends to help investors reduce volatility.
Over time, as certain asset classes underperform, the idea is that others will outperform. Thus the volatility (the standard deviation or risk) of your portfolio will decrease. Reducing volatility is perhaps undervalued because with increased volatility comes the potential for irrational investor behavior, which studies have shown can lead to the significant underperformance of the overall market. In theory, asset allocation alleviates a lot of these emotions by reducing the volatility of an overall portfolio.
Again, the challenge to investors, in order for this strategy to work best, requires unemotional commitment. After all, the reduced volatility is a result of something that is counterintuitive to many investors’ mind-sets. In an efficient asset allocation, there most likely will always be an underperforming asset class providing little to no (perhaps negative) return. But remember, just because one asset class is down doesn’t mean you should remove it from your portfolio; it may be a strong performer in the subsequent year as markets change.
Most investors don’t have detailed asset class analysis like that provided by Israelsen. Unfortunately, I believe a disservice is done when the average investor gets a watered-down version of asset allocation. Take for example the asset allocation tool courtesy of Money magazine, which can be found here: http://money.cnn.com/tools/assetallocwizard/assetallocwizard.html
All you have to do is answer four questions. I answered these questions with the mentality of an average investor with a moderate to moderately aggressive risk tolerance (not conservative or aggressive). As a result, the recommended portfolio was this:
At first glance, most users of this tool would presumably assume it is a reasonable recommendation. It looks like a nice pie chart. It has different colors and is broken down into four different types of investments that we must assume provide adequate diversification. However, upon further investigation, this may not be true at all.
Running a ten-year correlation analysis reveals some surprising results. It shows that large, medium, small, and international don’t offer the investor much in the way of diversification benefits. Using four Vanguard Index funds (S&P 500 for Large-Cap VFINX, Mid-Cap Index VIMSX, Small-Cap Index NAESX, and Total International Stock Index VGTSX), we can analyze how correlated one stock index is to another. If you compare one investment to itself as represented on the matrix, it will be a 1:1 correlation, or a 1.0. We find that the least correlated asset classes are small caps to international. That pairing still has a correlation of .86, which means that it is still highly correlated.
In the past, owning different types of stock asset classes may have provided good diversification. That is no longer the case. If we head into a bear market for stocks, whatever percentages you allocated to small, medium, and large companies may matter very little, as they will most likely all decline. In other words, when one stock goes up, they all go up. When one goes down, they all go down. As the saying goes, “When the tides go out, all the boats sink.”
In the previous pie chart, we now know that 70 percent of this portfolio (which is allocated to various types of stocks) is highly correlated, and it provides little protection through diversification. So how can you do better and what should you consider for your own portfolio? To reduce the risk of volatility within portfolios, we need fewer correlated asset classes. To do this, we need to go beyond just stocks and bonds by adding a third core asset class: alternatives (discussed in chapters seven and ten of my book).
Points of Emphasis to the Individual Investor:
There is now a high correlation between large, mid, small, and international stock indexes. This can be very misleading when choosing your portfolio options within your work retirement plan. Choosing from limited options to begin with, the list of offerings provided under each of those four asset classes gives the investor the illusion of diversified investment choice. Unbeknownst to them, they may all produce similar results.
The asset classes you choose for your portfolio matter much more than the fund manager or Morningstar rating. If you are savvy with Morningstar or Yahoo Finance mutual fund filters, I challenge you to examine how many mid-cap or large-cap funds, for example, performed drastically different than their indexes in recent years. As you do these filters, it will become apparent how closely they all behave to each other.
Conclusion: In the past owning large-cap, mid-cap, small-cap, and international stock funds were believed to provide an investor with good diversification. This is no longer true.
Tim Higgins, Author of Paying for College Without Sacrificing Your Retirement and Unconventional Investing
Beyond the gloom of the weak ringgit today, many wonder just when the local currency value can rise again and if it will ever return to the lofty level of around RM2.50 to the US dollar charted back in 1997.
Those who are even more hopeful may also think the ringgit could some day retrace its October 1978 record high of RM2.10 against the greenback (see historical chart below).
Pessimists will say the weak ringgit is here to stay until and unless Malaysia is totally rid of its national debt – which is now just shy of 55% against gross domestic product (GDP) – and unlikely to disappear anytime soon.
Based on the latter premise, it is then quite astonishing how the US dollar is climbing so rapidly against most currencies around the world – given that the American national debt to GDP is now at 102%!
The trick here seems to be trade cash flow that underpins the American government’s capability to pay off its colossal debt. And judging from how most of the world’s top revenue-earning firms – from Apple to Google – are American, the US dollar has a lot of legs to tap dance around debt demands.
This widespread confidence in the easy availability and convertibility of the US dollar is what’s propping up the greenback – and fuelling demand for the US currency even as funds look to flow back to American shores to take advantage of the very small likely interest rate hike expected of the Federal Reserve.
The fund backflow is, however, seen as a short-term gain to take advantage of spikes in the US stock market and will probably flow around the world again weeks later to chase other profit factors.
Based on this outlook, the ringgit won’t stay weak for long – everyone from the World Bank to local economists agree that Malaysia’s economy is strong enough to offer to weather the temporary exodus of US dollars and is attractive enough for the American funds to return within a matter of weeks, if not months.
But that factor alone isn’t enough to drive the ringgit back to the RM2.50 level – other forces are at play too, specifically oil-based revenues.
While the Malaysian government has said the country is actually a net importer oil, the general perception is otherwise due to the nation’s extensive higher grade crude oil and gas exports.
This means Malaysia’s revenue will go up as the crude oil price rises, and so will the ringgit. This was the trend already seen two to three years back when the ringgit temporarily breached the RM3 mark to trade at around RM2.94 at one point against the US dollar.
The only real way for the ringgit to rise again significantly to historical highs is if the US dollar plunges – something that actually happened back in 2007-8, but still wasn’t seen as enough to boost the ringgit’s value.
What needs to happen is a refocus on the huge American debt mountain – a situation that has often been brushed aside dismissively, but may shift back into focus due to the stuttering economy in China.
China arguably holds the largest amount of US debt – Treasury bills or T-bills – as its financial reserves. China may soon need to cash in on the T-bills as its economy is now going through a critical stage where revenue from its mature areas have yet to be able to fund the development of its largely rural zones.
It is a situation akin to what Japan went through over the past four decades – which transformed the Land of the Rising Sun from a cash-rich nation to one with a debt pile now. The US too has gone through the same cycle, as have many developed economies.
So when China starts selling T-bills to fund its own national development – that’s when the ringgit will really soar.
As to how soon that will happen, it’s anyone’s guess – though some optimists feel China may need to start selling T-bills as soon as 2018.
In short, the fate of the ringgit’s value isn’t really in Malaysian hands any more. There are three parties who hold all the cards now – the US Fed, China’s ruling Cabinet and possibly Saudi Arabia, which has the biggest influence on crude oil price if it ever decides to cut its output.
By FRANCIS NANTHA, Source - therakyatpost.com
FOR someone who has lived through the gloomy uncertainty during the 1997/8 Asian financial crisis as the ringgit value plunged daily, there are certainly some parallels which can be drawn with the same regional currency turmoil happening now.
There was a lot to be fearful about back in 1997. Many of us were truly worried we’d lose our jobs as swathes of firms and banks teetered towards bankruptcy, as economic gains in the previous three decades looked as if they would be wiped out and Malaysia possibly slipping back to the poverty-stricken 1960s.
Until the currency peg restored some form of stability, with the ringgit fixed at RM3.80 against the US dollar on Sept 2, 1998, Malaysians lived in fear akin to the May 13, 1969 racial riots — due to student riots which erupted in Indonesia and South Korea which eventually brought down governments there.
There was every reason to panic back in 1997 as everyone scrambled to get US dollars so much so that local banks literally ran out of money — resulting in mortgage interest shooting up to over 30% at one stage and fixed deposit rates at over 20% as banks desperately tried to get cash into their kitties.
The stock market plunged with heavyweights like Tenaga Nasional Bhd shares falling from over RM10 each to become penny stocks and house values falling as many defaulted on mortgages. Anyone with cash was king.
What made the situation worse was currencies throughout Asia were falling like dominoes — which meant that it wasn’t possible to stem the losses however much money was poured into domestic economies, courtesy of massive debts from the International Monetary Fund.
Today, in 2015, the situation is far different. No one is worried about losing jobs — even those retrenched are confident of finding employment quickly. Interest rates aren’t soaring and it’s still easy to get loans. Stock markets are only dipping; panic selling is limited to just China.
So why the difference?
It all goes down to debt — specifically US dollar-denominated debt, which started as the money taps turned on during the 1980s Reaganomics and cheap US dollars flooded the world in pursuit of quick gains, leaving havoc behind when shifted out.
Such was the situation when the Thai baht peg against the US dollar was breached on July 2, 1997 — leading to other currency exchange rates falling when the greenback flowed out of Asian markets.
A similar situation is also happening now, wreaking havoc on Asian currencies, but Malaysia has been relatively insulated from debt problems because most of it is in ringgit and sukuk.
That’s why firms and banks aren’t really worried about possible bankruptcy and chasing after US dollars. Hence, jobs are safe and people are still spending like there’s no tomorrow on everything from houses to cars to the latest electronic devices.
So what if imported goods are expensive? There’s some alternative available locally or within the region. And in the meantime, local goods exported are reaping huge gains with currency exchange.
There’s really so little to panic over the weak ringgit and doomsayers are in a muddle because everything’s fine so far with the Malaysian economy.
By FRANCIS NANTHA, Source - therakyatpost.com
If you want to dramatically increase your wealth, experts will tell you that you shouldn’t save.
They’ll tell you to invest!
By putting your money into an investment vehicle such as a tax-free savings account, registered retirement savings plan, or non-registered account, you’ll have to select the actual fund or funds you’d like your money to be in.
But when it comes to investing, how do we know how much risk to take when it comes to putting our money into the market so it can work for us?
There are approximately five levels of risk to investing. Conservative funds are usually a safe choice, while an aggressive fund comes with a chance to make more money but also a chance to lose more money.
The first thing you should ask yourself is what the money is meant for.
Are you planning to use it in case of an emergency? Do you want to start saving money for when you retire and are no longer drawing an income?
Determining what your money will be used for is the first step to deciding how much risk you should take. If you need that money for a worst-case scenario situation, it’s not wise to take on a lot of risk in case your investment drops when you need the money. You may have less than you hoped.
Conversely, if you’re saving money for retirement and aren’t retiring for more than 10 years, you could take on more risk with the notion that if your investment did fall, there would be ample time to recover.
The next question to ask yourself is when will you be using this money. Are you saving for a trip next year? Do you have 30 working years left before you plan on touching your investment?
The length of time until you will be using your investment matters when determining how much risk to take. The shorter the time until you plan to use your money will lower the amount of risk you should take. More time equals the opportunity for more risk.
You’ll also want to determine how many different investments you have. If you have multiple accounts invested in the market, a great idea would be to diversify your money by spreading it over varying risks.
If you put each investment you own in the same funds, when those funds drop — which they definitely will at some point of the life of your investments — the value of your investment will drop. By putting your money into diversified funds, when some accounts go down, others might go up or, at least, not fall as dramatically as some of your other accounts.
And the final question to ask yourself is what you’re comfortable with.
You might have years to save, meaning theoretically you could take on more risk, but if that causes you anxiety or makes you nervous, there is nothing wrong with taking on a lower risk fund or funds. Go with your comfort level.
Source - winnipeg free press
When stock indexes level are high, there is always a fear that optimism could fail and markets could go sideways, blip or even show a correction. The economic tide can always turn and macro events could send the market into jitters.
One of the reasons behind diversification of portfolios is to reduce their market risk, which is why growth structured products are considered for a diversified portfolio, as geared market participation can lead them to outperform more traditional passive investments, such as index funds.
However, it is worth bearing in mind that a sideways market will still see an index fund deliver around 3% per annum from dividends.
Consider this example: if over the next six years the FTSE rises by 5% or more, there are growth structured products that will produce a 60% gain. For any investor or adviser neutral or moderately bullish over the medium term, growth structured products are an option in light of the returns potential.
Defensive nature
Multiples on participation in the rise in the underlying asset can vary widely. Also, some growth products are defensive in nature, which means that rather than the underlying asset, usually an index, needing to be higher for the product to mature with a gain, it can produce gains as long as the final level is not more than 10% down from the initial level. Other product types often also have this defensive feature.
Growth structured products usually have a cap on returns. However, as far as this is concerned, I and most investors would be delighted to achieve the maximum return.
This is not a negative, but a best case scenario when also considering the downside protection offered by structured products. Capital-at-risk products usually have a protection barrier of 40% or 50%, which the underlying asset has to fall beyond for capital to be put at risk.
Deposits offer capital protection, as do capital 'protected' products, providing the counterparty remains solvent. With the opportunity for geared exposure to a rise in the underlying asset, alongside protection to the downside, it is clear how growth product exposure could be a good way to hedge your bets on market movements.
As opposed to an auto-callable*, which can mature early if pre-defined conditions are met, growth products have a fixed term and so they have longer average terms than auto-calls.
Looking at auto-calls over the last five years, they have average terms of around a year-and-a-half to two years, while growth products have an average of around five years.
The majority of launches in the last five years have been auto-calls, but while growth products are more rare, the longer average term could be a major benefit for those that believe markets will tread water for a while, but rise over the longer term.
Maturities
Looking at the growth product maturities over the last five calendar years including 2015, it is clear that these products have performed better in more buoyant market conditions.
The growth products that matured in 2010 delivered an average annualised return of 2.73% over an average term of 4.07 years, while last year, it was 6.7% over 5.09 years.
Of the 122 growth products that matured in 2010, 78 made a gain for investors, 44 returned capital only and none made a loss. While in 2014, nearly 91% of the 217 products made a gain for investors, while 18 returned capital only and 2 made a loss.
Considering the most recent maturities, out of the 58 growth products that have matured this year to the end of April all have made a gain for investors, bar one which returned capital only.
The average annualised return of these products, which includes deposit based plans, was 6.95% over an average term of 4.83 years. The top quartile of these products made an average annualised return of 10.24%, while the bottom quartile made 4.48% per annum.
This difference in the quartile performance highlights how it is important that each product should be considered on its individual merits and potential outcomes. Product types can be a starting point for considering client needs and market views of an investment adviser.
Source - investmentweek.co.uk
*An autocallable, which is the abbreviation of "automatically callable", is a feature of an exotic option. This feature is often found in structured products with longer maturities. A product with an autocallable feature would be called prior to maturity by the issuer if the reference asset is at or above its initial level (or any other predetermined level) on a specified observation date. The investor would receive the principal amount of their investment plus a pre-determined premium (often paid out in the form of a coupon) and the autocallable product is said to be redeemed early.
One step at a time.
One summer in college I interned at an investment bank. It was the worst job I ever had.
A co-worker and I survived our days by bonding over a mutual interest in the stock market.
My co-worker was brilliant. Scary brilliant. The kind of guy you feel bad hanging out with because he makes you realize how dumb you are. He could dissect a company's balance sheet and analyze business strategies like no one else I knew or have known since. He was the smartest investor I ever met.
He went to an Ivy League school, and after college he landed a high-paying gig at an investment firm. He went on to produce some of the worst investment results you can imagine, with an uncanny ability to pile into whatever asset was about to lose half its value.
This guy is a genius on paper. But he didn't have the disposition to be a successful investor. He had a gambling mentality and couldn't grasp that his book intelligence didn't translate into investing intelligence, which made him wildly overconfident. His textbook investing brilliance didn't matter. His emotional faults led him to be a terrible investor.
He's a great example of a powerful investing truth: You can be brilliant on one hand but still fail miserably because of what you lack on the other.
There is a hierarchy of investor needs, in other words. Some investing skills have to be mastered before any other skills matter at all.
Here's a pyramid I made to show what I mean. The most important investing topic is at the bottom. Each topic has to be mastered before the one above it matters:
Every one of these topics is incredibly important. None should be belittled.
But you can be the best stock-picker in the world, yet if you buy high and sell low – the epitome of bad investing behavior – none of it will matter. You will fail as an investor.
You can be a great stock-picker, but if you only have 20% of your assets in stocks – a poor asset allocation for most investors – you're not going to move the needle.
You can be a super-tax-efficient investor. But if your stock selection is poor, you're not going to have many capital gains to pay taxes on in the first place. And if you're paying too much for advice, tax savings can be irrelevant.
A common problem for any investor to stumble on is the temptation to solve one problem without first mastering a more fundamental one. It can drive you crazy, because if you've gotten the hang of an advanced topic, you might think that you're on the road to success, but something more basic like investor behavior or asset allocation could still put you on a road to ruin. Just like my old co-worker.
Source -fool.com
Q: I am in my eighth year of retirement. A few years in, I found myself spending a considerable amount on repairs and upkeep on my old house. I also had to replace my car. Luckily, I was able to build up a reserve fund to cover costs so I didn’t have to dip into my investments for these “life happens” events. What is your advice on how much cash a retiree should have on hand to feel secure? – Karen
A: Of course, everyone should have a cash cushion to handle unexpected expenses, but retirees need a larger cash reserve than people who are still working, says Richard Paul, president of Richard W. Paul and Associates in Novi, Mich. “The stakes are higher for retirees,” Paul says. “When you’re no longer earning an income, the money you have saved isn’t easily replaced.”
If you need to tap your investments for emergencies, you risk spending down your portfolio too quickly. And if you have to sell securities in a down market, you’ll need to take a bigger chunk to get the amount you need.
Relying on your investments for unexpected expenses could also trigger some nasty tax consequences. If you liquidate money from a taxable account, the income could bump you into a higher tax bracket and cost you even more.
So, how much do you need? While the standard recommendation is to have six to 12 months of money set aside to cover emergencies, retirees should have at least 12 to 18 months of cash, says Paul. That should be enough to cover daily expenses as well as any emergencies that might crop up. “This creates a safety valve, so you’re not at the whims of the market,” he says. Use an interactive worksheet like this one from Vanguard to tally up your monthly expenses.
Exactly how much you will need depends on your individual circumstances. If you have guaranteed cash flow, say from a pension and Social Security, that covers your daily expenses, you won’t need to have as much set aside as someone who is already withdrawing money from a portfolio to cover living costs. You can’t foresee emergencies but you can plan for them. If you have an older home, for example, you can anticipate needed repairs or upgrades like a new roof. If you have any medical issues, you’ll want to keep a larger stash for medical costs. “Medicare doesn’t cover everything,” Paul notes.
Since people tend to enter retirement with most of their money tied up in investments, Paul recommends that you start building up an emergency fund before you retire. While you’re still earning, start funneling money into a savings account and move a portion of a regular investment plan into a short-term bond fund.
On the flip side, you don’t want to keep too much of your savings in cash. You won’t earn much interest in a money market fund or basic savings account, so balance that cash cushion with investments that can keep up with inflation. “You still need your money to grow,” Paul says.
Source - time.com
