KEON CHEE & BEN FOK 3RD EDITION H H HOW TO GROW YOUR IN NVESTMENT DOLLAR RS
KEON CHEE & BEN FOK
3RD EDITION
HHHOW TO GROW YOUR INNVESTMENT DOLLARRS
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MAKE YOUR
MRK
HOW TO GROW YOUR INVESTMENT DOLLARS
FOR YOUW
NEY
KEON CHEE & BEN FOK
3RD EDITION
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© 2006 Marshall Cavendish International (Asia) Private Limited.
© 2008 Marshall Cavendish International (Asia) Private Limited. 2nd Edition.
Reprinted 2010
© 2011 Marshall Cavendish International (Asia) Private Limited. 3rd Edition.
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National Library Board Singapore Cataloguing in Publication Data
Chee, Keon.
Make your money work for you : how to grow your investment dollars / Keon Chee & Ben
Fok. – 3rd ed. – Singapore : Marshall Cavendish Business, c2011.
p. cm.
ISBN : 978-981-4328-61-6
1. Finance, Personal. 2. Finance, Personal – Singapore.
3. Investments. 4. Investments – Singapore. I. Fok, Ben, 1961—
II. Title.
HG179
332.024 — dc22 OCN690062488
Printed by KWF Printing Pte Ltd.
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To Sarah,
For making bubbles fl oat
and the sun shine.
Keon
To my wife, Sharon,
For the encouragement, and to
my children, Jeryn and Samuel,
for the love and laughter.
Ben
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Introduction 8
Part 1 : Basic Investment Concepts1 Why Learn About Investing 11
2 The Major Types of Investments 20
3 The Risks and Returns from Investing 28
4 Managing Crises and Diversification 40
Part 2 : Investing In Traditional Assets
5 Investing in Unit Trusts 56
6 Selecting and Managing Your Unit Trust Investments 67
7 Investing in Individual Stocks 84
8 Selecting and Managing Your Individual Stock Investments 95
9 Investing in Individual Bonds 110
10 Selecting and Managing Your Individual Bond Investments 122
Part 3 : Investing In Alternative Assets11 Investing in Exchange Traded Funds (ETFs) and Index Funds 132
12 Investing in Real Estate 138
13 Socially Responsible Investing 150
14 Investing in Commodities 161
15 Investing in Gold 172
16 Investing in Hedge Funds 181
17 Investing in Art and Collectibles 191
18 Understanding Basic Derivatives 197
19 Understanding Structured Products and Other Derivatives 210
20 Understanding Currency 220
Part 4 : Special Topics
21 Investing for Kids 231
22 Investing During Retirement 237
23 Protecting Your Wealth with Insurance 243
24 When Things Go Wrong 249
25 Getting Financial Advice 254
26 Protecting Your Portfolio in Downturns and Upturns 265
Contents
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We belong to the sandwich generation. Our children depend on us, as do
our parents. For our children, we are seeing the price of a higher education
rising faster than the rate of infl ation. For our parents, we are possibly
looking at hundreds of thousands of dollars in costs for treating major
illnesses they run the risk of contracting. Th e sandwich generation is being
chewed on at both ends.
We are struggling to support ageing parents and pay university tuition
fees for our children. And this is probably the worst situation you can fi nd
yourself in — when you have to depend on others to support you in your
retirement years.
In the future, you will either have enough money or you will not. If you
don’t, chances are that your neighbour living next door to you will. People
living in Singapore and in Asia overall are getting wealthier and wealthier.
In the year 2009, Singapore saw the highest growth in millionaire
households, up 35 per cent, followed by 33 per cent for Malaysia, 32 per cent
for Slovakia, and 31 per cent for China (2010 Global Wealth Report by Th e
Boston Consulting Group). Singapore now has the highest concentration of
millionaire households in the world. And Asia-Pacifi c, excluding Japan, is
expected to generate millionaires at nearly twice the global rate.
It is horrible to retire when you don’t have enough money, and even worse
if everyone around you has enough and you can’t even get by. Th at is why
learning how to invest is so important. For many people, it could make the
diff erence between a blissful retirement and a painful one.
Th e investment environment has become very diverse in the last few
years. We are seeing a rise in derivatives and currency trading by the public,
commodity prices far outpacing stocks and bonds, hundreds of structured
products being made available at any one time and challenging market
conditions with infl ation, lower real returns and a subprime crisis that is
taking years to clean up. Th is is why for this third edition, we have added two
Introduction
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new chapters, revamped one chapter and expanded on previous chapters in
the hope of better describing what is out there.
To succeed at investing, you need to keep two things in mind. First, you
need to keep abreast of what is happening in the investment markets. Once
you are armed with the basic knowledge of investing (which we hope you
will gain from this book), knowing what is happening in the markets will
become not only less strenuous but also an enjoyable pastime. Second,
if you have never invested before, you need to take the plunge yourself.
Th ere is nothing like direct experience. Only when you handle your own
money will you be able to appreciate and understand fully the complexities
surrounding the money markets. Finally, and most importantly, investing
is your responsibility, not anyone else’s. It is neither the government’s
responsibility, nor that of your remisier or fi nancial adviser’s.
And when you do succeed, you will probably want to spare a thought for
the less fortunate. Social enterprise and socially responsible investing are
taking root in Singapore and around the world and not a moment too soon
as income gaps around Asia have become particularly worrying. Singapore’s
Ambassador, Tommy Koh, described “social inequity” as one of Asia’s three
biggest challenges, along with corruption and the environment.
Despite headline hogging news about Asia’s booming economies, vast
pockets of paralysing poverty remain. Dr. Ifzal Ali, Chief Economist of the
Asian Development Bank, estimates that 42 per cent of Chinese live on the
equivalent of less than $3 a day. In India, three-quarters of the population
(more than 800 million people) survive each day on less than the cost of a
Starbucks latte. All told, 60 per cent of all Asians still live in poverty.
In the future, you will either have enough money or you will not. Th ere
are many exciting things you can do today to make sure that you will have
enough — and better still — be able then to spare time and money to
help others.
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BASIC INVESTMENT CONCEPTSWe start with the basic concepts you need to know to understand and appreciate the art of investment.
While there are many reasons for investing, retirement is by far the most important one. In this section, we will look at the main types of investment assets and discuss whether they are appropriate for you.
We will show how investment risks and returns are calculated so you can assess the performance of your investments.
Finally, we find out how crises affect investment performance. The findings may surprise you.
1PART
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Why Learn About Investing
Congratulations! You have accumulated $1 million in cash and assets,
and you are planning to retire next year at age 55.
But here is a reality check. Your son, Brian, will be going to the
U.S. in two years’ time to do a course in computer science. Th e
cost of this four-year programme will amount to $200,000. Your
mum is 78 and healthy. Your dad is 82 and has lung cancer. His
expected cost of treatment is $100,000. Th at is $300,000 to be
deducted from your retirement cheque. Th en, there is $400,000
tied up in your executive condo. Your million-dollar retirement
now looks a lot less attractive.
Th is story may not refl ect your situation completely, but the
underlying facts are real. We are marrying later, and consequently,
by the time we near our retirement, our children may still be
fi nancially dependent on us, as may our parents.
But let us not allow such grim facts to get us down. Th ere are ways
to get around our various commitments, and prudent investing is
one of them.
WEALTH ACCUMULATION — THE NUMBER ONE REASON WE INVEST To plan successfully for retirement, we must have a clear picture
of when we want to retire (the earlier the better) and how much
retirement funds we want to have (the more the better). Being
strapped for cash when we are past our peak earning years is not
going to be fun.
Suppose you are now 40 years old and plan to retire at age 60 and
want a monthly income of $5,000 for 25 years. How much money
would you need to accumulate in your retirement fund? Assuming
these funds are invested at a modest rate of return of 2.5 per cent,
you would need to accumulate $1,114,537 between now (at age 40)
and retirement (at age 60). Th at is a huge sum of money!
01
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If you keep your savings under the pillow, you would need to set
aside even more — $1.5 million. If you invest and achieve six per
cent returns, you halve your burden to $776,034. At higher and
higher rates of return, your burden starts to look lighter and lighter.
Th at is the whole idea behind investing — to reach your fi nancial
objectives with the least amount of eff ort and time possible.
TABLE 1.1.TOTAL FUNDS NEEDED TO PROVIDE $5,000 MONTHLY INCOME
FOR 25 YEARS
Rate of Return Funds Needed
0.0% $1,500,000
2.5% $1,114,537
6.0% $776,034
12.0% $474,733
Source: Authors’ own computations
TWO MYTHS ABOUT RETIREMENT
Myth 1: I Will Live Till 80 and Th at’s It
We have one of the highest life expectancies in the
world at over 80 years. However, the number 80 is
somewhat misleading. It’s not a fi gure cast in stone.
For example, a woman who has reached 65 years of
age can reasonably expect to live on till 85 years.1
Th is means that the longer we live, the more
money we will need during retirement. While we
should plan for our fi nancial needs based on 80
1Koh Eng Chuan, “Measuring Old Age Health Expectancy in Singapore”, in
Singapore Department of Statistics newsletter, 3rd quarter, 2000.
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years as a base mark, it is best we plan for a few
extra years — till age 90 or more. So give yourself
more leeway when making your investment plans.
Myth 2: I Will Be Spending Less During Retirement
After subjecting your mind and body to 40 years of
hard labour, you probably want the best vacations,
the best doctors and the best foods. No doubt you
could spend less by downgrading your lifestyle, but
this is surely not something you want.
Don’t fall into this self-fulfi lling trap. If you plan
to spend less during retirement, you will end up
with less. Expect to spend more, plan for it and you
will end up with more.
CHOOSE YOUR INVESTMENTS WISELYWhen we invest, there is a multitude of instruments we can put
our money into. Historically, some have given higher returns than
others. Choosing the right instruments that provide the best returns
can make all the diff erence to your retirement.
You can invest in two main investment categories: fi nancial assets
and real assets. Real assets — such as real estate, jewellery or art —
are tangible; you can touch and take physical possession of them.
One drawback of owning real assets is that they are generally harder
to buy and sell. For example, selling a house takes time because it is
a big-ticket item and potential buyers need time to evaluate. Or if
you wanted to buy an antique fountain pen or a rare painting, you
may have to go to a specialised auction house such as Sotheby’s.
Financial assets — such as stocks, bonds and unit trusts — are
fi nancial claims on assets. Rather than taking physical possession
of the asset, your ownership is documented by a legal document.
So when you invest in a stock, you receive a certifi cate that
acknowledges your claim as a shareholder of the company. Unlike
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real assets, fi nancial assets are easy to buy and sell through organised
exchanges such as the Singapore Exchange. As you can probably
sense, the scope of investment opportunities is too huge to cover in
this book. For this reason, our primary focus is on fi nancial assets.
RETIRING A MILLIONAIREConsider this: If you contribute $500 per month to your CPF
Ordinary Account (CPF OA)2, after 40 years, you will have
contributed $240,000. Since the Ordinary Account earns 2.5 per cent
annual returns, after 40 years, you will have accumulated $411,709.
Th at’s nearly $172,000 in interest. Not bad.
If, instead, you invested the $500 per month over the same period
while earning 6 per cent interest, you would have accumulated
$995,745. Th at is almost $1 million. You can retire a millionaire!
But if you had annual returns of 12 per cent over the same period,
you would have close to $5.9 million ($5,882,386 to be exact). You
would retire a multimillionaire!
TABLE 1.2. RETURNS SCENARIOS
Instrument Rate of Return Accumulated
Keep under pillow 0.0% $240,000
CPF OA 2.5% $411,709
STI 6.0% $1 million
S&P 500 12.0% $5.9 million
Source: Authors’ own computation
2 Th e Central Provident Fund or CPF is Singapore’s mandatory social security
savings plan towards which working Singaporeans have to contribute. Such plans
are commonly found in other countries. In Malaysia, it is the EPF or Employees
Provident Fund. In Hong Kong, it is the MPF or Mandatory Provident Fund.
Given the wide disparity of possible results, we ought to fi nd
out which of these investment returns are realistic and which are
not. Based on the history of fi nancial markets, all three return
possibilities can actually be achieved.
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Th e interest rate for CPF OA is 2.5 per cent. Between 1990 and
2005, the Singapore Straits Times Index (STI) of common stocks
yielded an annual return of about 6 per cent. In the U.S., over the 75
years between 1930 and 2005, the Standard & Poor’s (S&P) index of
large-company common stocks yielded about 12 per cent.
WHAT ABOUT RISK?If we were given these three investment choices, the obvious choice
would be the S&P 500, which provides the best returns. Our decision
making would then be a simple process of choosing the investments
with the highest returns.
But we have yet to talk about risk. Risk is the possibility of losing
money on our investments. Th e CPF OA rate of 2.5 per cent is an
almost unchanging rate. It may move up a little, or go down a little,
but it will never hit negative, which means that we can’t possibly
lose money. Putting our money into the Ordinary Account can be
considered risk-free.
FIGURE 1.1. S&P 500, JANUARY 1996 TO DECEMBER 2007
(Source: Standard and Poor’s)
1800
1600
1400
1200
1000
800
600
400
200
0
A
B
CAAAAA
BBBBBBBBBBBBB
CC
Jan-9
6
Sep-
97
May
-99
Jan-0
1
Jan-0
6
Feb-
03Ju
l-03
Dec
-03
May
-04
Oct
-04
Jun-9
6
Feb-
98
Oct
-99
Jun-0
1
Jun-0
6N
ov-0
6
Nov
-96
Jul-
98
Mar
-00
Mar
-05
Nov
-01
Apr
-97
Dec
-98
Aug
-00
Aug
-05
Apr
-02
Apr
-07
Sep-
02
Sep-
07
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TABLE 1.3. RELATIVE RISK LEVELS
Investment Choice Risk Level
CPF OA Low
STI Medium to High
S&P 500 Index High
Source: Authors’ own illustration
Look at Figure 1.1 (page 15), which plots daily prices of the S&P
500 for the period January 1996–December 2007. Investors who
bought around the third quarter of 2000 (indicated by B) and sold
in 2003 (indicated by C) would have lost a lot of money compared
with those investors who bought at the beginning of 1996 (indicated
by A). Investing in the S&P 500 produces winners and losers, and
along with that, a sense of unpredictability.
We can see that looking at returns without considering risk is
clearly a major mistake for any investor. But we are sure you will
agree that if you want to seek out the best returns, you will have to
tolerate some risk. What history tells us is that there is a positive
relationship between risk and return, and we can assign relative risk
levels to the three investment choices as follows:
BIG MISTAKES CAN SET YOU BACK — PERMANENTLY
An investor needs to do very few things right as long as he
or she avoids big mistakes.
~Warren Buff et in Berkshire Hathaway, Annual Report, 1992
Even smart people can make silly mistakes when it comes to
investing. Do not take investment lightly — one mistake can set
you back for a long time.
Just to illustrate, let us tell you about someone we know. Michael
was a very successful investor who made $2 million in the markets
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over the last four years. In January 2001, he went to the bank to
deposit a cheque. Th e manager serving him suggested he invest
some money in a technology unit trust. Michael said no and left.
Back home, Michael brought out his charts and found that the
fund was trading at 50 cents to its initial off er price of $1. In other
words, the fund had already lost 50 per cent of its initial value,
which appeared cheap to Michael. IT sector news was robust and
a recovery was expected. Being an IT buff and bullish about the
sector, he invested $2 million the next day. Th e technology fund
was the fi rst ever unit trust he owned. In six months, the price of
the fund dropped to 25 cents. His paper loss was over $1 million.
Th ere are a few lessons to learn from Michael’s experience. Th ere
are two we would like to highlight. One, avoid the big obvious
mistakes by doing your homework. Even a successful investor like
Michael should have kept this in mind as he went in impulsively. In
the end, he took four years to earn $2 million in investment returns,
but lost half of it in only six months. Second lesson: learn to take
responsibility. Michael blamed the bank, the IT sector analysis he
read, his bad luck, etc. He admitted only much later that it was his
own mistake and he was responsible for it.
Three Mistakes to Avoid When InvestingTh ese mistakes are common yet some of them are not so obvious.
1. Keeping Too Much Cash
According to statistics from the Monetary Authority of Singapore
(April 2010 MAS Monthly Statistical Bulletin), over $320 billion
now sit in savings accounts and fi xed deposits. Th is works out to
$60,000 per person, young and old.
Financial advisers recommend putting away six months’
salary in the bank in case of rainy days. Th e reason is that if an
emergency arises, such as the loss of your job or a major illness,
these savings can tide you over while you look for another job
or settle medical bills.
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You may not need so much ready cash, especially if you are still
a good way ahead of your retirement age. We recommend you
save three months’ salary. First, some of this money can be
invested in fi nancial assets such as bonds and unit trusts, since
they can be liquidated almost any time, with little or no penalty.
Second, if you have a working spouse, there should be suffi cient
“back-up” income in the event of an emergency.
Keeping too much cash means you are earning less, and
anticipating emergencies that occur only infrequently in reality.
2. Skimping on Life Insurance
If you or your spouse dies or suff ers a major illness, you have to
make sure your dependents will be provided for. Who cares then
if your investments are making 10 or 15 per cent returns if you
do not have enough funds for your immediate needs?
While you may have some life insurance coverage through your
employer, such coverage is not portable. If you get laid off , you
lose the coverage. Imagine getting laid off when you have medical
problems. Getting a new policy would be extremely expensive,
sometimes even impossible if you are in poor health.
How much insurance do you need? One rule of thumb is
to get at least fi ve times your earnings, plus the total amount
of your mortgage, with a little to spare to cover your children’s
basic education.
Having enough life insurance is so essential that you shouldn’t
even think about investing unless you are already suffi ciently
covered.
3. Taking Care of Others Before Yourself
Many people often go the distance for family members and forget
to take care of themselves. For example, once you are faced with
the monumental task of saving for your child’s university
education, it is easy to forget about saving for your own
retirement. Th is is a big mistake.
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Saving for retirement should always come fi rst. You and your
child can fi gure out ways of getting through school when the
time comes, whether through loans, co-payments or otherwise.
What you want to avoid is channelling all your surplus funds
into your children’s education, only to discover later that you
have little left over for yourself. By all means, provide for your
children, but do spare a thought for yourself.
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20
The Major Types of Investments
Consider this: Two months ago, both you and your aunt decided to
make an investment in FoodMall, a food wholesaler. You invested
$10,000 in its common stocks, while your aunt bought $10,000 worth
of FoodMall warrants. You now sell your shares for $12,000, realising
a 20 per cent return. But your aunt managed to sell her warrants
for $20,000 — a 100 per cent return. Clearly, there is a diff erence
between common stocks and warrants. Th e type of security we put
our money into matters.
In this chapter, we will introduce the diff erent types of investments
that are commonly bought and sold by investors — stocks, bonds,
derivatives and unit trusts. We will be brief in our introduction
because we will be discussing each of these investments in greater
detail in later chapters.
THE THREE MAIN TYPES OF BASIC INVESTMENTSOne of the most important factors in deciding where to put your
money is how soon you think you’ll need it back. Also, what is your
overriding motive in investing? Do you need your money safe and
secure at all times? Do you need it to grow? Or do you need it to
produce a regular income?
Your answers to these questions point to the type of basic
investment that is most suited to you. Th ere are three main types:
1. Stocks or equities
2. Bonds or fi xed income securities
3. Money market investments
Each of these is attuned to the three things you need from your
investments: growth, income or safety.
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21Stocks or EquitiesIf you own common stock of company A, you have an ownership
interest in the company. If only a few individuals hold a company’s
shares, the fi rm is said to be privately held. Many companies
choose to go public by selling common stock to the general public
on a stock exchange. Companies go public because they can
raise additional capital that way, since there will be a far bigger
buying audience.
If you buy 100 shares of A’s common stock, you would own
100 per cent of the company, where “n” is the total number of
common stock shares. As a stockholder, you have a residual claim
on the company’s earnings and assets. When a company generates
earnings, you are entitled to the earnings that remain after all
expenses have been paid. Such expenses include staff salaries and
payments for those who hold fi xed income securities (including
preferred stockholders). In other words, as a holder of common
stock, you will be the last in line when the company pays out its
earnings. As a stockholder, you also have a residual claim to assets
in case the company goes bankrupt and liquidates its assets. In that
case, you will be entitled to the remaining assets only after all other
claims (including those made by holders of preferred stock) have
been satisfi ed. Th is is much like eating the leftovers at a wedding
dinner when everyone else has eaten.
As owners, the holders of common stock are entitled to
elect the directors of the company and to vote on major issues.
Stockholders also have limited liability, meaning that they cannot
lose more than their investment in the company. Hence, should
the company run into fi nancial diffi culties, creditors can only
claim against the assets of the company, and not the assets of
individual stockholders.
Stock Returns Th e returns from owning stock come from two sources. Cash
dividends are earnings that are distributed to shareholders. Unlike
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22bonds, stocks do not guarantee the timing or the amount of
dividends. At any time, they can be increased, decreased or taken
away altogether.
Th e other source of returns is capital gains. Th is is the main
reason people buy stocks. Th e value of your stock may rise when the
earning prospects of the company are favourable. And, of course,
your shares may also lose value if the company performs poorly.
Stock Risk
As a group, stocks generally move up and down in value more than
any other type of investments in the short term. People are usually
afraid of purchasing stocks because they hear about bear markets,
corporate scandals and stock market crashes. But this should be a
concern only to investors who need their money back within a few
years. In fact, over the longer term, you stand a greater risk of losing
money if you don’t invest in stocks.
Bonds or Fixed Income SecuritiesBonds are loans issued by companies and governments to borrow
money, and they have two main characteristics:
1. Th ey have life spans greater than 12 months at the time of issue.
2. Th ey typically promise to make fi xed interest payments according
to a given schedule.
Bonds are hence also called fi xed income securities.
Bonds have their own unique terms. Let us work with an example.
Suppose you buy bonds with a face value of $10,000. Th ese bonds
mature in two years and pay 4 per cent interest annually. Th e 4 per
cent interest equates to $400 a year. Th e face value of the bond, or
the principal amount of $10,000, will be returned to you when the
bond matures in two years.
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23Bond Returns
Th e returns from owning a fi xed income security come in two
forms. Th ere are the fi xed interest payments and the fi nal payment
of principal at maturity. Secondly, there is the potential for capital
gains when you sell a bond before its maturity at a price higher than
when you purchased it. Imagine a see-saw. Th e price of a bond rises
when interest rates fall, and there is thus the possibility of a capital
gain from a favourable movement in rates. Of course, inversely, a rise
in interest rates will produce a loss.
Bond Risk
Besides interest rate risk, bonds have default risk. Default risk refers
to the possibility that the borrower will not make the promised
payments. Th is risk is almost non-existent for Singapore government
bonds, but for many other issuers, such as private companies, the
risk of default is very real.
Money Market SecuritiesMoney market securities are similar to bonds, except that they are
short-term investments. Th ey have two main characteristics:
1. Th ey are loans issued by companies and governments to borrow
money.
2. Th ey mature in less than a year from the time they are sold,
which means the loan must be repaid within a year.
Some of the most common money market securities include
Treasury Bills (issued by the government and considered the safest
investments around), fi xed deposits, bank savings accounts and
certifi cates of deposit.
Money Market Returns
Money market investments maintain a stable value, pay interest and
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24can be easily converted into cash. Of the three types of investments,
money market instruments pay the lowest rate of return.
So why bother with them? For the same reason you leave large
chunks of your uninvested money in a fi xed deposit — safety.
When you buy a money market investment, you are pretty sure you
will get your money back with some interest. Th e chances of losing
money — whether from the government or the bank defaulting
on its payments or a loss in principal value of the investment —
are very low. In other words, when you invest in a money market
investment, you are taking very little risk and your expected return
should refl ect the amount of risk that you have taken.
When is a money market investment appropriate? When you need
to use the money in a year or so, and you want to know that the
money will be there with few surprises.
Money Market Risk
Beware of infl ation. Th e longer you leave your money in a fi xed
deposit, the higher the risk of infl ation eating away the purchasing
power of your money. Money market investments are safest when the
money is needed in the short term. Th e very same safe investments
become high-risk the longer they stay invested.
Stocks are on the opposite track. Th ey are high-risk investments in
the short-term, but are lower-risk investments in the long-term:
TABLE 2.1. RISK COMPARISON OF STOCKS AND FIXED DEPOSIT OVER TIME
Investment 1 Year 10 Years
Fixed Deposit Lower Risk Higher Risk
Stocks Higher Risk Lower Risk
Source: Authors’ own illustration
For example, according to a study by U.S. investment management
fi rm, T. Rowe Price, that looked at the S&P 500 index (a basket of
stocks that represents the largest 500 companies in the U.S.) from
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251926 to 2002, in any one-year period, there is about a 27 per cent
chance of losing money. If the holding period is three years, the
odds of losing money fall to 14 per cent. And if the holding period
is a whole decade, the chances of losing money goes down to just
4 per cent.
DERIVATIVESStocks and bonds are fi nancial assets. When you invest in a fi nancial
asset such as a stock in Company X that is currently priced at $10,
you receive a contract stating that you have a legal claim on the assets
of Company X. If the company does well and its share price rises to
$15, you have a direct claim on the company’s assets that is now
worth $15, the share price.
A derivative is also a financial asset, but it differs from stocks
in one fundamental way: the value of the derivative is based on
the performance of an underlying financial asset that you do
not own.
OptionsOptions are one of the most common types of derivatives. Th ere
are two main types of options — calls and puts. A call option gives
the buyer the right to purchase a specifi ed number of shares, say
100, of a particular stock at a specifi ed price (called the exercise
price) within a specifi ed time frame. A put option does the reverse
— it gives the buyer the right to sell 100 shares at a specifi ed price
within a specifi ed time frame. A defi nite advantage for the buyer of
an option — whether a call or a put — is that there is no obligation
to exercise the option.
Let us illustrate with a simple example of a call option. Suppose
that you want to own 1,000 Microsoft shares at $30 each. If you are
fortunate enough to have this large amount of money ($30,000) on
hand, you can pay up right away and own the shares.
But suppose you do not have this sum of money to invest directly,
and your roommate is willing to sell you the right to buy the 1,000
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26shares at $30 each. For this right, he will charge you a fee of $1,500
and this right lasts three months. In eff ect, your roommate has
sold you a call option.
If you buy the call option, the value of your investment now
depends on the underlying asset — the share price of Microsoft. If
the price of Microsoft goes up, so does the value your call option.
Th e reverse is true as well. If the price of Microsoft goes down,
your derivative falls in value.
When you buy a call option, you pay the seller $1,500 for the
right, but not the obligation, to buy the shares at $30 each. If you
change your mind because you found a better deal elsewhere, you
can just walk away. You will lose only $1,500, which is called the
option premium.
UNIT TRUSTSDirect investment in stocks, bonds and derivatives is not for
everyone. It requires time to research good buys and a fair amount
of skill to sieve the duds from the winners. Th is is not a simple task,
given the infi nite number of investment choices available.
Indirect investment through unit trusts provides a very attractive
alternative. When we invest in a unit trust, we pool our money
with that of thousands of other investors. For as little as $1,000
and a relatively small fee, a professional investment manager
invests our money in money market securities, bonds and stocks,
to reap the greatest possible returns consistent with our objectives.
Th e range of companies and securities invested in will be far more
diverse than we could achieve on our own.
As with stocks and bonds, unit trusts provide us with a wide
range of investment choices. Th ere are more than 500 unit trusts
to choose from in Singapore. Add to these the funds available from
places such as the U.S., the U.K. and Malaysia, and we have an
awesome number of choices.
Some unit trusts, such as global equity funds that invest in
the top companies in the world, have very broad objectives.
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27Some others have a very specifi c focus. For example, some funds
focus on high-yield bonds, a particular market segment such as
biotechnology, or a specifi c country such as Th ailand.
With unit trusts, we can choose funds that match our risk profi le.
Stock funds are for the more risk-tolerant investors who want their
money to grow over a long period of time. Bond funds are for
those who want current income and do not want investments that
fl uctuate as widely in value as stocks do. And if we need the money
in the short-term and we do not want our invested principal to
drop in value, money market funds can be chosen.
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The Risks and Returns
from Investing
Th e rewards from investing do not come free. Th ey are accompanied
by the four-letter word, risk. Th ankfully, history off ers us two
important lessons we should know about. First, there is a reward
for accepting risk, and when good investment choices are made,
that reward can be substantial. Th at is the good news. Th e bad news
is that greater rewards usually go hand in hand with greater risks.
Th e fact that risk and return are intricately linked to each other is
probably the single most important lesson in investing.
Returns are easily understood because it comes down to a number
— how much did the investment make? Whether the number is 80
per cent, or -20 per cent, its message is clear. What is not so clear
is the concept of risk. We all want high rewards and we all want to
bear low risk for it, but we intuitively know that high rewards and
low risk seldom go together.
In this chapter, we lay the groundwork to understanding the
nature of risk and returns, and learn how to measure them. We
will mainly consider buying shares in this chapter although the
calculations are the same for any investment.
RETURNSWhen you make an investment, your gain or loss is called the return
on your investment. Th is return has two parts: income and capital
gain (or loss).
Th e dividends from shares and interest from bonds you receive
constitute the income portion of your returns. Th e capital gain part
of your return comes from the profi t you earn when you sell your
investment at a price higher than what you paid for your purchase.
03
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29Measuring Total Returns Over One PeriodSuppose you buy stock of Xanadu for $10,000 on 1 January. During
the year, you receive cash dividends of $500. On 31 December, you
sell your stock at $12,000. Your Total Return is 25 per cent:
Total Return (1 year) = (Income + Capital gain) / Purchase Price
= (500 + 2,000) / 10,000
= 25%
If you sell the stock at $9,000, your loss is 5 per cent:
Total Return (1 year) = (500 – 1,000) / 10,000
= -5%
Measuring Total Returns Over Several PeriodsSuppose you become completely enamoured of Xanadu. You stay
invested for 10 years and re-invest the dividends you receive.
Table 3.1 is a record of the last 10 years:
TABLE 3.1. XANADU RETURNS OVER 10 YEARS
Year Total Return 1 + Total Return
Year 1 25% 1.25
Year 2 -15% 0.85
Year 3 -20% 0.80
Year 4 -10% 0.90
Year 5 -5% 0.95
Year 6 5% 1.05
Year 7 10% 1.10
Year 8 15% 1.15
Year 9 25% 1.25
Year 10 20% 1.20
Source: Authors’ own computation
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30To calculate Total Return for the entire period, we fi rst add the
fi gure “1” to each yearly Total Return number, then multiply all of
these together. (After that, simply subtract “1” from the product)
Th e result is this:
Total Return (10 years) = (1.25 x 0.85 x 0.80 x 0.90 x 0.95 x 1.05
x 1.10 x 1.15 x 1.25 x 1.20) – 1
= 1.45 – 1
= 45%
Hence, every $1 invested at the beginning would have returned
you $1.45 at the end of the 10-year period, or you would have a
Total Return of 45 per cent over 10 years.
Measuring Annualised ReturnsHow much did your Xanadu stock earn you on an annual basis?
Th e calculation looks complicated, but it is not that bad. What is
important is that you understand what the end result means.
Th e Annualised Return for Xanadu over a 10 year period is:
Annualised Return = (1.25 x 0.85 x 0.80 x 0.90 x 0.95 x
(10 years) 1.05 x 1.10 x 1.15 x 1.25 x 1.20)1/10 – 1
= 1.451/10 – 1
= 3.8%
If the calculation seems complicated initially, do not worry. Unit
trust fact sheets and annual reports already calculate this number
for you.
Here is what the end result means and this is important for you to
understand. Th e Annualised Return is a compounded rate of return
over 10 years. It means that after staying invested for 10 years and
after having reinvested all your dividends, your return on an annual
basis is 3.8 per cent.
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31RISKA risky investment is one where there is a strong likelihood that
actual returns will diff er from what was expected. Th e more those
returns fl uctuate, the greater the risk.
Th ere is a positive relationship between risk and return — the
higher the risk, the more returns we should expect. Th e opposite is
true as well. At the same time, you cannot reasonably expect high
returns if you are only willing to assume a small amount of risk.
Supposing then that you want to avoid risk at all cost, you could
deposit money into a fi xed deposit account to earn a safe and known
amount. However, this return is fi xed, and you cannot earn more
than this fi xed rate. In this case, risk has eff ectively been eliminated,
but so have your chances of earning a higher return.
Where Does Risk Come From?Risk consists of two components:
1. Diversifi able (or Non-systematic) Risk
2. Non-Diversifi able (or Systematic) Risk
Th at is, Total Risk = Diversifi able Risk + Non-Diversifi able Risk
Diversifiable Risk
We wish we could spare you the egg-and-basket routine, but in
this instance, it is very useful in explaining diversifi able risk. If
eggs were your money and baskets were investment choices, then
putting all your eggs (money) in one basket (a single investment
choice) is a risky proposition. Anything unpleasant that happens to
your one and only invested asset would negatively aff ect your entire
investment portfolio. But if you were to diversify by placing your
money into several investment baskets, then chances are good that
your entire investment portfolio will be stable enough to withstand
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32an unexpected shock from any one sector. In short, diversifi able risk
has these three characteristics:
1. It can be diversifi ed away.
2. It can be controlled or reduced.
3. It is unique to a stock or industry.
A diversifi able risk is easy to identify. Let’s look at a few examples.
1. Business Risk
Th is is the risk of doing business in a particular company,
industry or environment. For example, a semiconductor
manufacturing company faces risks inherent in the electronics
industry. An investor can control business risk by investing in
other industries.
2. Liquidity Risk
A security with poor liquidity means that the security is diffi cult
to buy and sell in the secondary market without incurring price
concessions. A Treasury Bill has little or no liquidity risk, whereas
a highly priced collectible such as a 1899 Coca-Cola bottle has
high liquidity risk because it can be a challenge to fi nd buyers
and sellers. An investor can control liquidity risk by investing in
assets with high liquidity.
3. Country Risk
Country risk refers to all the negative things that can happen to
a country’s economy as a whole, including political crises, wars
and recessions. If you are like many Singaporean investors who
invest most of their money domestically, take note. Despite
receiving consistently favourable risk ratings by Political and
Economic Risk Consultancy, Ltd. (PERC), Singapore is still
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33 subject to country risk. An investor can control country risk by
diversifying his portfolio internationally by placing funds in
several countries.
Non-diversifiable (or Systematic) Risk
An investor can construct a diversifi ed portfolio and eliminate part
of total risk (i.e. the diversifi able or non-systematic portion). What is
left is the non-diversifi able portion called market risk or systematic
risk. Th is is any risk that, left in the portfolio, will be directly related
to the overall movements of the general market or economy. Like
non-systematic risk, systematic risk also has three characteristics:
1. It aff ects all securities.
2. It cannot be diversifi ed away.
3. It cannot be controlled or reduced.
Virtually, all securities have some systematic risk, whether bonds
or stocks. Th ere are three systematic risk factors:
1. Interest Rate Risk
Security prices tend to move inversely with movements in interest
rates. When interest rates go up, security prices come down, and
other things being equal, all securities will be aff ected. Even if you
hold a well-diversifi ed portfolio of Singapore stocks, a sudden
surge in interest rates will bring down the value of each of the
securities in your portfolio.
2. Market Risk
Th is is the risk that comes from fl uctuations in the overall
market as refl ected by an aggregate stock index such as the STI.
Poor market sentiment as a result of wars, recessions or plain
old pessimism are often mirrored by declines in the overall
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34 market. All securities will be aff ected no matter how
fundamentally sound the companies are.
3. Infl ation Risk
When infl ation rises, all securities are aff ected. Infl ation erodes
the purchasing power of your invested dollars, such that what
you expect to receive in the future would be worth less today
in real terms. Infl ation also positively aff ects interest rates. When
infl ation rises, interest rates generally rise as well because lenders
will demand more for their loss of purchasing power.
It is important to understand that an investor cannot escape non-
diversifi able risk because the risks of the overall market cannot be
avoided. If the stock market falls sharply, most stocks will be adversely
aff ected. Or, if the interest rate or infl ation soars, most stocks will fall
in value. Th ese market movements do occur.
Measuring RiskRisk is the chance of losing money when you sell your investment.
Th is is the defi nition that most of us are familiar with although we
will refi ne the defi nition later in this chapter. But for now, let us keep
to this familiar defi nition.
If you put your money in the Post Offi ce Savings Bank (POSB)
and you suddenly need to cash out after six months, what are the
chances that you would lose money? Zero, unless POSB defaults.
Your entire principal sum will be returned to you, plus interest.
Risk is calculated by a method called standard deviation (SD). Let
us work out a numerical example. Suppose you keep your money in
POSB for three years, and each year, the return is constant at one
per cent. Th e average return per year is:
Average Return = (1 + 1 + 1) /3 = 1%
Notice that each year’s return does not deviate from the three-
year average. Hence, Standard Deviation = 0
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35A zero standard deviation means that there is no risk, and
no volatility. At any time, you will be able to cash out, knowing
exactly what you will get. No surprises, ever. (To be sure, standard
deviation is an academic defi nition that refers to the uncertainty of
returns — whether negative or positive. In reality, there is no such
thing as zero risk. Risk can arise from POSB folding, infl ation rising
out of control, and many other situations.)
Let us take another example. Suppose investment ABC had total
returns of 5 per cent, 20 per cent and 35 per cent over the last three
years. Th e Arithmetic Mean is 20 per cent (5 + 20 + 35) / 3. Notice
that the fi rst return deviates from the mean by -15 per cent (5% –
20%), the second by zero (20% – 20%), and the third by 15 per cent
(35% – 20%).
To compute the standard deviation of investment ABC, we square
each of the deviations, add them up, divide the result by the number
of returns minus 1, and take the square root of the result:
Note that by itself, standard deviation is not as meaningful as
when it is compared with those of other investments. If the standard
deviation of POSB returns is zero and investment ABC’s standard
deviation is 15 per cent, we can conclude that investment ABC is a
riskier investment because its returns are far more uncertain than
POSB savings’.
Standard deviation can be calculated very easily on a spreadsheet
or fi nancial calculator so this ought to be the fi rst and last time you
(5 – 20)2 = 225
(20 – 20)2 = 0
(35 – 20)2 = 225
Total = 450
Standard
Deviation = √[450 / (3 – 1)]
= 15%
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36will need to go through a worked-out example. Th e main point is
that the returns from an investment such as Xanadu, for example,
are inherently more uncertain than the returns from putting your
money in POSB. And the more uncertain the returns are, the higher
the standard deviation.
The Risk-Return Trade-OffNow if we were to line up some of the most traditional investment
choices such as stocks, bonds and derivatives, we could create a
ranking of their standard deviations. Th e following are listed in the
order of increasing standard deviation and risk, with Treasury Bills
having the lowest of each:
• Treasury Bills
• Government Bonds
• Corporate Bonds
• Common Stocks
• Derivatives
Figure 3.1 puts together our fi ndings on risk and return. What
it shows is that there is a risk-return trade-off . At one extreme,
we have Treasury Bills, which are virtually risk-free. At the other
end of the continuum, if you are willing to bear a high level of risk,
you may then expect to earn what is called a risk premium. Risk
premium is the additional return beyond the risk-free rate that one
expects to receive for taking on risk.
Th e return we expect from an investment in a risky asset can thus
be expressed as:
Expected Return = Risk-free Rate + Risk Premium
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37FIGURE 3.1. RISK-RETURN TRADE-OFF
DerivativesCommon StocksCorporate
BondsGovernment BondsTreasury
Bills
RiskPremium
Risk-freeRate
Ret
urn
s
Line A
Risk
R
ond
Stoco k
Source: Authors’ own illustration
In Figure 3.1., Line A is drawn from the risk-free rate to show
the risk premium. If, for example, the expected return of common
stocks is 8 per cent and the yield off ered by Treasury Bills is 2 per
cent, the risk premium will be 6 per cent:
Expected Return = [ Risk-free Rate + Risk Premium ]
8% = 2% + 6%
Risk-Adjusted ReturnsLook at the returns and risk of these two investments in the utility
industry (Table 3.2 on page 38).
Which do you prefer? If you decide by returns alone, then
company A is the clear choice. Company A generated 10 per cent
returns compared with company B’s 6 per cent. If you decide by risk
alone, then company B is the clear winner. Company B generated
a tiny 2 per cent standard deviation compared with company A’s
5 per cent. How do you break the tie?
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38A risk-adjusted measurement takes an investment’s return and
divides it by its standard deviation:
Risk-adjusted Return = Return / Standard Deviation
Investments with higher risk-adjusted returns are generally
considered superior to investments with lower risk-adjusted
returns because they off er more returns for each unit of risk taken.
Company B is considered superior because it off ers three units of
return for every unit of risk taken.
You may have come across measurements such as the Sharpe,
Treynor, Jensen’s or Information Ratios. Th ese ratios all provide
risk-adjusted returns.
TABLE 3.2. RISK-ADJUSTED RETURNS OF UTILITY COMPANIES A AND B
Investment Return Standard Deviation
Return/Standard Deviation
Utility Company A 10% 5% 10/5 = 2.0
Utility Company B 6% 2% 6/2 = 3.0
Source: Authors’ own illustration
MORE ON RISKEarlier, we defi ned risk as the chance of losing money when you sell
your investment. At this point, we need to make two refi nements to
this working defi nition.
In investments, risk is defi ned more broadly as the chance of
receiving a return that is diff erent from the return we expected
to make. Risk, in fact, includes not only bad outcomes, such as
lower than expected returns, but also good outcomes such as
higher than expected returns. Th us, if the expected return of an
investment is 5 per cent, the risk that you will earn a 10 per cent
or zero per cent return is exactly the same. In other words, using
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39standard deviation, you do not distinguish between downside risk
and upside risk.
For this reason, some investors may not be completely
comfortable with standard deviation as a measure of risk. Th ey may
use a measurement called the semi-variance, where only returns
that fall below the expected return are considered. Or they may go
for simpler yet commonsensical proxies for risk. For example, it
makes sense that stocks of technology companies are riskier than
those of food companies. Others prefer to create ranking categories.
(For example, those ranking money market instruments as lower
risk, and technology stocks as higher risk).
Th e risk we have defi ned so far relates to actual returns being
diff erent from expected returns.
Th e second refi nement to our understanding is that there are
investments whose expected return is known ahead of time. For
example, when you buy a bond that pays a fi xed interest payment
every six months and the return of principal at maturity, you can
tell ahead of time what your actual return will be.
Hence, in general, it is important for investors to understand that
the risk of an investment is indeed broader and more varied than
what is typically understood — that risk equals the potential that
actual returns will diff er from expected returns.
MANAGING INVESTMENT RISKTh e best way to manage risk is to allow yourself ample time. Start
investing now rather than later. When you have time on your side,
more of your money can be invested in stocks rather than bonds and
money market instruments because you will have a larger capacity
to ride the ups and downs of the stock market.
Finally, the way you divide your investments depends on your
specifi c situation and goals. Spend some time thinking about the
best way to divide your money, based on your needs and the type
of risk you can take. Th is exercise will make a big diff erence to your
investment success.
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40
Managing Crises and
Diversification
We have a crisis today. Oil prices are at historical highs. Terrorists
can strike anywhere and at any time. Th ere is uncertainty regarding
a sustainable global economic recovery. High infl ation is causing
problems all over the world.
How do you react to these crisis points? Would you sell or stay put?
If your answer is “stay put”, you might be doing the right thing.
In this chapter, we learn that historical events do indeed have a
signifi cant impact on fi nancial markets. Uncertainty often clouds
judgement, sending even the best of us into panic and gloom. But
history shows that negative events do not necessarily spell doom
for investors.
While past performance cannot guarantee similar future results,
historical evidence suggests that most investors can benefi t by
staying put.
Of course, some investors are skilled at anticipating market
movements. Th ey would buy on ups and sell on downs. But how
many people can do that consistently? Th e big question for many
of us is whether it makes sense to stay invested regardless of
market fl uctuations. According to a study by asset allocation expert
Ibbotson Associates, the answer is “yes”.
TABLE 4.1. $1 INVESTED IN S&P 500: STAYING PUT OR MINUS BEST
35 MONTHS
Value in 1996 (Stay Put Th roughout)
Value in 1996 (Minus 35 Best Months)
$1 invested in 1925 $1,371.00 $12.50
Source: Ibbotson Associates
04
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41Th ey found that a dollar invested in the S&P 500 in 1925 grew
to $1,371 in 1996. Th at’s a compounded annual return of 10.6 per
cent. But when the best 35 months (less than 4 per cent of total time
invested) were removed from the analysis, the same dollar grew to
only $12.50, a compounded annual return of only 3.6 per cent.
So, unless you are confi dent of predicting accurately the best and
worst months for your investment dollar, stay put.
STAYING PUT IN THE FACE OF CRISESTh is century has seen many crises and disasters, including two world
wars, the 9/11 attacks and the 1997 Asian economic crisis. Crises
will continue to take place today and in the future. What would you
do when the next crisis hits? If you are still not convinced about
staying put in the market, here is more information to consider.
Ned Davis Research tracks the reaction of the Dow Jones
Industrial Average (an index on major U.S. industrial stocks) to
political, economic and military crises since World War I in 1914.
Th ey found that staying put makes sense because each time a
crisis hits, the index will fall, then rebound to near pre-crisis levels
within three months. (Th e average drop in the market during crises
was -6.1 per cent, and from there, the Dow rallied on average 5.2
per cent after one quarter). Instead of being fearful during market
downturns, you should be getting “greedy”, because crises provide
tremendous opportunities for investing.
TABLE 4.2. DOW JONES INDEX DURING AND AFTER MAJOR CRISES
EventMonth/
Year
%
Change
1
Month
Later
3
Months
Later
6
Months
Later
12
Months
Later
Exchange
closed WWI7/14 -10.2% 10.0% 6.6% 21.2% 80.2%
Bombing at
JP Morgan
offi ce
9/20 -5.5% 2.4% -14.9% -9.5% -17.3%
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EventMonth/
Year
%
Change
1
Month
Later
3
Months
Later
6
Months
Later
12
Months
Later
Pearl
Harbour
bombing
12/41 -6.5% 3.8% -2.9% -9.6% 5.4%
Korean War 6/50 -12.0% 9.1% 15.3% 19.2% 26.3%
Suez Canal
crisis10/56 -1.4% 0.3% -0.6% 3.4% -9.5%
Cuban missle
crisis10/62 1.1% 12.1% 17.1% 24.2% 30.4%
Martin
Luther King
assassination
4/68 -0.4% 5.3% 6.4% 9.3% 10.8%
Kent State
shootings5/70 -6.7% 0.4% 3.8% 13.5% 36.7%
Nixon’s
resignation8/74 -17.6% -7.9% -5.7% 12.5% 27.2%
USSR in
Afghanistan12/79 -2.2% 6.7% -4.0% 6.8% 21.0%
Falkland
Islands war4/82 4.3% -8.5% -9.8% 20.8% 41.8%
U.S. invades
Grenada10/83 -2.7% 3.9% -2.8% -3.2% 2.4%
U.S. bombs
Libya10/83 2.8% -4.3% -4.1% -1.0% 25.9%
Financial
panic ’8710/87 -34.2% 11.5% 11.4% 15.0% 24.2%
Invasion of
Panama12/89 -1.9% -2.7% 0.3% 8.0% -2.2%
Iraq invades
Kuwait8/90 -13.3% -0.1% 2.3% 16.3% 22.4%
Gulf War 1/91 4.6% 11.8% 14.3% 15.0% 24.5%
Gorbachev
coup8/91 -2.4% 4.4% 1.6% 11.3% 14.9%
U.S. currency
crisis9/92 -4.6% 0.6% 3.2% 9.2% 14.7%
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DIVERSIFICATION: THE RANDOM WAYTh e easiest way to reduce risk is to diversify, by applying the Law of
Large Numbers. By randomly adding a large number of securities
to a portfolio, the exposure to any particular source of risk becomes
smaller and smaller.
Random diversifi cation is like investing in stocks selected by darts
thrown at an SGX stock report. When you randomly diversify, you
care only about selecting as many stocks as possible without caring
about criteria such as expected return or risk. Can such a naive
strategy work? Th e answer is “yes”.
EventMonth/
Year
%
Change
1
Month
Later
3
Months
Later
6
Months
Later
12
Months
Later
World Trade
Center
bombing
2/93 -0.3% 2.4% 5.1% 8.5% 14.2%
Oklahoma
City bombing4/95 1.2% 3.9% 9.7% 12.9% 30.8%
Asian stock
market crisis10/97 -12.4% 8.8% 10.5% 25.0% 16.9%
Bombing
of U.S.
embassies in
Africa
9/98 0.0% -11.2% 4.7% 6.5% 25.8%
WTC and
Pentagon
terrorist
attacks
9/01 -14.3% 13.4% 21.2% 24.8% -6.7%
Enron
testifi es
before
Congress
1/02 -3.0% 10.5% 4.3% -9.5% -17.7%
Iraq War 3/03 2.3% 5.5% 9.2% 15.6% NA
Mean -6.1% 3.9% 5.2% 9.2% 15.1%
Source: Ned Davis Research Inc.
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TABLE 4.3. STANDARD DEVIATIONS OF RANDOM PORTFOLIOS OF NYSE
STOCKS
No. of Stocks in Portfolio
SD of Portfolio Returns
Ratio of Portfolio SD to Single Stock SD
1 49.24 1.00
2 37.36 0.76
4 29.69 0.60
6 26.64 0.54
8 24.98 0.51
10 23.93 0.49
20 21.68 0.44
30 20.87 0.42
40 20.46 0.42
50 20.20 0.41
100 19.69 0.40
200 19.42 0.39
300 19.34 0.39
400 19.29 0.39
500 19.27 0.39
1000 19.21 0.39
Infi nity 19.16 0.39
Source: Meir Statman, “How Many Stocks Make a Diversifi ed Portfolio?”. Journal of Financial and Quantitative Analysis, September 1987, p.355
Table 4.3. shows the standard deviations for equally weighted
portfolios, each containing diff erent numbers of randomly selected
New York Stock Exchange (NYSE) stocks.
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45Column 1 lists the number of stocks in each equally weighted
portfolio. In a 10-stock portfolio, each stock has a 10 per cent
weight; in a 20-stock portfolio, each stock has a 5 per cent weight,
and so on. In column 2, we see that the standard deviation for a
portfolio of one stock is about 50 per cent. What this means is
that if you select a single NYSE stock randomly and put all your
money into it, your standard deviation of return would be about 50
per cent per year. If you were to select randomly two NYSE stocks
and put half your money in each, your average annual standard
deviation would be about 37 per cent.
Column 3 measures how risky a portfolio is relative to a one-
stock portfolio, which is obviously the riskiest portfolio. If you sink
your money into a 20-stock portfolio, your annual risk would be
about 22 per cent, and it would only be 44 per cent as risky as a
one-stock portfolio. Stated another way, a 20-stock portfolio is 56
per cent less risky than a one-stock portfolio.
Th ere are two important observations to note:
1. Standard deviation declines as the number of stocks increases.
By the time we have 20 randomly chosen stocks, the portfolio’s
volatility has declined from 50 per cent per year to about 22
per cent per year.
2. Standard deviation declines at a decreasing rate as the number
of stocks is increased. With a portfolio of 20 stocks,
diversifi cation’s maximum eff ect has been realised, and there
remains very little incremental benefi t to be gained by adding
more stocks. Adding 20 more stocks (a 40-stock portfolio) will
further reduce standard deviation by only an insignifi cant 1.22
per cent (from 21.68 per cent to 20.46 per cent).
Figure 4.1 (page 46) illustrates these two points. Plotted is the
standard deviation of the return versus the number of stocks in the
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46portfolio. Notice that risk reduction from adding securities slows
down as we add more and more securities.
Hence, spreading an investment across many assets will eliminate
some or most of the risk, but not all. Th e risk that can be diversifi ed
is appropriately called diversifi able risk (non-systematic risk). And
the risk that stubbornly remains and cannot be diversifi ed is called
non-diversifi able risk (systematic risk).
Source: Authors’ own illustration
Number of Stocks
Sta
nd
ard
De
via
tio
n
Non-diversifi able Risk
Diversifi able Risk
1 2 4 6 8 10 20 30 40 50 100 200 300 400 500 1000
60.0
50.0
40.0
30.0
20.0
10.0
00
Diversifi able Risk
FIGURE 4.1. PORTFOLIO DIVERSIFICATION
DIVERSIFICATION: THE BETTER WAY Harry Markowitz was the fi rst person to formally show how portfolio
diversifi cation works to reduce portfolio risk. He showed how the
inter-relationships between security returns — called correlation —
could be used to diversify a portfolio so that risk is minimised while
returns are maximised.
What is Correlation?Correlation measures the extent to which the returns on two assets
move together. If the returns on two assets tend to move up and
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FIGURE 4.2. PERFECT POSITIVE CORRELATION (CORR = +1.0)(( ))
Source: Authors’ own illustration
Time
Ret
urn
s
Asset XAsset Y
down together, we say they are positively correlated. If they tend to
move in opposite directions, we say they are negatively correlated.
If there is no particular relationship between the two assets, we say
they are uncorrelated.
Th e correlation coeffi cient is used to measure correlation, and it
ranges between -1.0 and +1.0:
Corr = +1.0 perfect positive correlation
Corr = 0.0 zero correlation
Corr = -1.0 perfect negative correlation
Perfect Positive Correlation
Figure 4.2 shows the returns of two assets with perfect positive
correlation. If asset X has positive returns, so does asset Y. And if
asset X has negative returns, so does asset Y. Do note that perfect
correlation does not mean that the two assets move by the same
amount; correlation is a measure of direction, not magnitude.
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48
FIGURE 4.4. ZERO CORRELATION (CORR = 0.0)( )
Source: Authors’ own illustration
Ret
urn
s
Time
Asset X
Asset Y
Perfect Negative Correlation
In Figure 4.3, the returns of the two assets X and Y move in
opposite directions. If asset X has positive returns, asset Y will have
negative returns.
Source: Authors’ own illustration
FIGURE 4.3. PERFECT NEGATIVE CORRELATION (CORR = -1.0)
Time
Ret
urn
s
Asset X
Asset Y
Asset X
Asset YA t Y
Zero Correlation
If we know that the returns of X are positive, but have no idea what
the returns of Y are likely to be, there is zero correlation.
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49Understanding correlation helps us improve the diversifi cation
process of reducing portfolio risk:
1. Combining securities with perfect positive correlation with
each other provides no reduction in portfolio risk. We should
avoid securities that are positively correlated as the total risk is
then higher.
2. Combining securities with zero correlation with each other
does provide signifi cant risk reduction, although portfolio risk
cannot be eliminated completely.
3. Combining securities with perfect negative correlation can
eliminate risk altogether.
4. To see how correlation works, suppose you invest 100 per cent
of your money in banking stocks. As a group, banking stock
returns are highly positively correlated. Good prospects in the
industry will see the group rise as a whole. And when prospects
are poor, your entire portfolio will suff er as well.
In reality, securities typically have some positive correlation with
each other. Although risk can be reduced, risk usually cannot be
eliminated. As an investor, you should hence fi nd securities with
the lowest amount of positive correlation as possible.
DIVERSIFICATION USING STOCKS AND BONDSOne of the most eff ective ways to diversify is to invest in the two main
asset classes of stocks and bonds because of their low correlation
with one another. How much money should you allocate to each
asset group?
Th e ideal asset allocation diff ers from person to person and is
based on the individual investor’s risk tolerance. A young executive
typically has a higher risk tolerance than a retiree. Th e young
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50executive, therefore, may have an asset allocation of 80 per cent
stocks and 20 per cent bonds (since stocks are riskier than bonds),
while the retiree may have a less risky allocation of 20 per cent
stocks and 80 per cent bonds.
Th e idea is to mix and match stocks and bonds in the proportion
that generates the highest return possible based on the amount of
risk we are able to tolerate. In general, the higher our risk appetite,
the higher will be the proportion of stock in our portfolio, vis-à-vis
bonds.
Two questions you could be asking thus far:
1. What returns can I expect from a diversifi ed portfolio of stocks
and bonds?
2. How can I create a diversifi ed portfolio of stocks and bonds if I
do not have much money?
We will answer these two important questions in the next section
where we talk about investing in the major investment types. We
end this chapter and this section by fi nding out how much risk you
can take as an investor — that is, your risk tolerance.
FINDING OUT YOUR RISK TOLERANCEAre you a conservative investor or an aggressive investor? Th e answer
to this question determines the amount of risk you can tolerate and
hence the type of asset allocation appropriate for you. To keep things
simple for now, let us work with just stocks and bonds.
The Risk Profile Questionnaire ApproachRisk profi le questionnaires ask pointed questions to fi nd out your
risk tolerance. Th ere is no one single version but many. Th e CPF
Board has one. Your bank offi cer has one. Your insurance adviser has
one. Chances are that you are likely to see a diff erent version from
every company you deal with.
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51Despite the many versions, risk profi les all have the same objective
— they ask you questions to fi nd out the appropriate balance of stocks
and bonds for your investment allocation. Questions in general ask:
1. Your Ability to Take Risk
How old are you? When do you need the money? How long will
your assets be invested? Th e younger you are or the longer your
investment time horizon, the higher the amount of risk you can
aff ord to take.
2. Your Appetite for Risk
Th is is the amount of risk you are comfortable with taking. Do
you sleep soundly at night when your investments fall in value?
Are you patient enough to see your investments grow over the
long-term?
3. Your Overall Financial Situation
How much money do you already have? Th e richer you are, the
more willing you are to take on risk.
Sample Risk Profile
Below is a sample risk profi le. Answer the six questions by circling
the choice that best represents your investment situation.
Questions 1 and 2 ask your age and investment time horizon,
two objective factors that test your ability to take risk. Th ey have
each been given twice the number of points as the other questions
because age and time horizon tend to weigh more heavily in
considering one’s tolerance for risk.
Th e other four questions are more subjective; they test your
appetite for risk. Add up the points from the six questions to
determine your risk tolerance score.
Th e possible range of scores is 8 to 24. In general, the higher your
score, the more comfortable you are with taking risk, and the higher
the proportion of stocks your portfolio should contain.
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52 RISK TOLERANCE QUESTIONAIRE
1
How old are you?
a. (6 points) Below 40 years oldb. (4 points) 40 to 54 years oldc. (2 points) 55 years or older
2
When do you plan to use the money you have invested?
a. (2 points) Within 3 yearsb. (4 points) 4 to 9 yearsc. (6 points) 10 or more years
3
Given two hypothetical unit trusts, how would you invest?Unit Trust A — Gives an average annual return of 5% with minimal downside in any one year.Unit Trust B — Gives an average return of over 10% but portfolio can fall 20% in any one year.
a. (1 point) 100% in Unit Trust Ab. (2 points) 50% in Unit Trust A and 50% in Unit Trust Bc. (3 points) 100% in Unit Trust B
4
How do you feel about losing money?
a. (1 point) I hate losing money and I am willing to accept lower returns.b. (2 points) I do not mind moderate risk. It is OK to see some fl uctuation in my returns, but not too much.c. (3 points) I am willing to take high risk because I believe returns will be higher over the longer term.
5
You accept that your portfolio will fl uctuate in value over time. What is the maximum loss you could accept in any one-year period?
a. (1 point) 5%b. (2 points) 15%c. (3 points) 30%
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6
Suppose the market lost over 25% in value in just one day today. How will that aff ect you?
a. (1 point) I would be so upset that I would not be able to sleep.b. (2 points) I will fi nd out what happened from the news or from my contacts. I might be tempted to sell.c. (3 points) I would not be overly bothered as it is probably a short-term fl uctuation.
Calculate your total score and record it here:
TOTAL SCORE: _______
Th en check Table 4.4 below for your risk profi le and the matching
allocation for stocks and bonds. Th is sample risk profi le has fi ve
allocations.
TABLE 4.4. RISK PROFILE AND INVESTMENT ALLOCATION
Total Score Risk Profi le % Stocks % Bonds
8–10 Conservative 20% 80%
11–13Moderately conservative
40% 60%
14–16 Balanced 60% 40%
17–19Moderately aggressive
80% 20%
20–24 Aggressive 100% 0%
Source: Authors’ own illustration
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54Your Target Investment Allocation
Before moving on, use the following checklist to record your target
investment allocation.
Check one:
_________ Aggressive
_________ Moderately Aggressive
_________ Balanced
_________ Moderately Conservative
_________ Conservative
_________ % Stocks
_________ % Bonds
You realise that risk profi le questionnaires and the recommended
allocations for equity and bonds are not an exact science. As we
mentioned, you will not fi nd two risk profi le questionnaires that are
exactly alike.
Risk profi les, nevertheless, give you a fi rst level guide to what
your risk tolerance is, from which the appropriate asset allocation
of stocks and bonds can be determined.
Remember that a particular asset allocation is appropriate only at
a certain point in time. When you get older and your circumstances
change, your risk tolerance will change and your asset allocation
must evolve along the way.
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2PART
INVESTING IN TRADITIONAL ASSETSThe best way to benefit from this section is to invest in something — if you have not already done so. Suppose you had $2,000 or $20,000 to invest. How exactly do you begin?
We recommend unit trusts as a start because they offer instant diversification and professional expertise at a low initial price. Then, when your skills and confidence are better developed and you are ready to do more, investing in individual stocks and bonds will be an appropriate next step.
MYMWFY (3rd Edition) 4 Jan.indd 55 1/25/11 8:14:07 AM
Investing in Unit Trusts
Many investors start out with unit trusts. Even experienced investors
with large portfolios make generous use of unit trusts. Investors
today have a lot of choices. Th ere are over 3,200 funds available to
investors in the Singapore marketplace (www.fundsingapore.com)
— six times more than the number of stocks listed on the SGX.
Unit trusts fall into two main categories:
1. Equity Funds (or stock funds)1 — unit trusts consisting of stocks,
2. Fixed Income Funds (or bond funds) — unit trusts consisting
of bonds.
Equity funds invest in the equity of companies and are for the
more risk-tolerant investors who want their money to grow over a
long period of time.
Fixed income funds are for those with a smaller risk appetite.
Th ey invest in the debt of governments and corporations. Fixed
income funds off er current income and do not fl uctuate as widely
in value as equity funds do.
If you need a brief refresher on some of the more popular types
of unit trusts found in the Singapore market, refer to the unit trust
glossary at the end of this chapter.
You should have, by now, fi gured out what sort of investor you
are. If you have not, answer the risk profi le questionnaire found in
Chapter 4. Th e next step is to fi nd out the type of equity and fi xed
income funds to invest in.
1 An equity fund (as compared with a stock fund) is actually the more common
name for a fund containing mainly stocks. A fi xed income fund (as compared with
a bond fund) is the more common name for a fund containing mainly bonds. We
will use both these terms interchangeably.
05
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TABLE 5.1. RECOMMENDED ALLOCATION OF EQUITY FUND INVESTMENTS
Type of Equity Fund Recommended Allocation
U.S. Equity Fund 30%
European Equity Fund 30%
Asia ex-Japan Equity Fund 30%
Japan Equity Fund 10%
TOTAL 100%
Source: Authors’ own recommendations
FIGURING OUT THE TYPES OF EQUITY FUNDS IN WHICH TO INVEST If you invest all your money in Singapore and the Singapore economy
tumbles, your entire portfolio will fall. Th at is because the stock
market is sensitive to what happens to the economy as a whole.
Now, if you split your money 50-50 and say, invest in both
Singapore and the U.S., then it is likely that when Singapore falls,
the U.S. might rise or when Singapore rises, the U.S. might fall.
Economies do not rise and fall at the same time. (It is the reason we
place our money in diff erent asset classes, namely stocks and bonds.)
Th at is why it makes sense to diversify our investments across
countries. Th is process is called global diversifi cation.2 We can
easily achieve this by investing in four types of funds, each
representing one of the four major economic regions of the world,
in the following proportions:
2 Th e act of diversifying your money into equity funds and fi xed income funds is
called asset class diversifi cation. Global diversifi cation then takes each asset class
and diversifi es it across the globe — into global equities and global fi xed income.
According to the IMF World Economic Outlook, these four
regions represent 75 per cent of world gross domestic product
(GDP), which is a measure of economic output. Th e economic
output of each is weighted roughly in the percentages given above.
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58Th ese GDP fi gures are not static of course. Th ey go up and down,
but in general, unless there is some long-term structural change
in the economic outputs of the four regions, we can simplify the
recommended allocation to 30-30-30-10.
Japan is set apart from the rest of Asia, the reason being that
Japan is itself a very large and developed economy — the third
largest in the world. Even though it is not geographically a region,
its economic status qualifi es it as such. Funds invested in Asia fall
mainly into two fund categories: Asia ex-Japan and Japan.
FIGURING OUT THE TYPES OF FIXED INCOME FUNDS IN WHICH TO INVEST Now that you have fi gured out the types of equity funds in which
to invest, fi guring out the types of fi xed income funds to invest in is
a walk in the park. Th e same principle of diversifi cation holds true,
with a few exceptions:
• Asian Fixed Income Fund
In the equity fund allocation, we had Asia broken down into Asia
ex-Japan, and Japan. In this fi xed income fund allocation, both
regions are clumped together because Japan’s fi xed income funds
are not sold in Singapore, whereas all-Asia fi xed income funds are.
• Singapore Fixed Income Fund
Singapore bonds are typically of the highest quality and have
very low risk compared with other types of fi xed income funds.
Th ey also have little exchange rate risk and provide good
stability for your fi xed income fund portfolio.
Always bear in mind that the allocation to each type of equity
and fi xed income fund is not an exact science. Treat what has been
discussed as a general guideline. Generally, in order to create a
globally diversifi ed equity or fi xed income portfolio, you should be
investing in all the major economic regions in the world.
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Type of Fixed Income Fund Recommended Allocation
US Fixed Income Fund 30%
European Fixed Income Fund 30%
Asia Fixed Income Fund 30%
Singapore Fixed Income Fund 10%
TOTAL 100%
Source: Authors’ own recommendations
TABLE 5.2. RECOMMENDED ALLOCATION OF FIXED INCOME FUND INVESTMENTS
HOW DO GLOBALLY DIVERSIFIED UNIT TRUST PORTFOLIOS PERFORM?Here is a study that summarises the important points we are making.
Look at Figure 5.1 on page 60, which is based on 32 years of data. Th e
uppermost 100 per cent equity line is based on the highest amount
of risk taken by the Aggressive Investor. You can see that returns
fl uctuate up and down quite a bit, and are very volatile.
Starting with a 100 per cent Equity portfolio, we can lower
risk by adding fi xed income funds to our portfolio as seen by an
increasingly fl atter return line on the graph. Notice that adding
fi xed income funds to the equity portfolio also reduces the returns
we can expect.
As we add fi xed income in 20 per cent increments, returns
fall gradually to 5.4 per cent (for a 100 per cent Fixed Income
portfolio).
You must treat the return numbers shown in Table 5.3. (page 60)
as mere guideposts to what can be expected of asset allocation in
general. It is impossible to use any historical fi gures to project the
future with 100 per cent accuracy. Taking a diff erent period for
study would yield diff erent results, but the pattern of higher returns
from portfolios with higher concentrations of equities can almost
always be expected to occur.
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60
TABLE 5.3. ANNUALISED RETURNS OF VARIOUS EQUITY-FIXED
INCOME COMBINATIONS
Equity-Fixed Income Fund Allocation Annualised Return
100–0 9.0%
80–20 8.4%
60–40 7.7%
40–60 6.7%
20–80 5.6%
0–100 5.4%
Source: iFAST Financial Pte Ltd, “Rebalancing With Bond Funds”, (24 Febuary 2003)
FIGURE 5.1. PORTFOLIO VALUE STARTING WITH $10,000
Source: iFAST Financial Pte Ltd, “Rebalancing With Bond Funds”, (24 February 2003)
$
Yr1970 1974 1978 1982 1986 1990 1994 1998 2002
300,000
250,000
200,000
150,000
100,000
50,000
0
100% equity40% bonds, 60% equity 80% bonds, 20% equity
20% bonds, 80% equity 60% bonds, 40% equity100% bonds
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TABLE 5.4. RECOMMENDED ALLOCATION FOR A CONSERVATIVE INVESTOR
WITH $50,000 TO INVEST
Equity Funds Recommended Allocation
Investment Amount
US Equity Fund 30% $3,000
European Equity Fund 30% $3,000
Asia ex-Japan Equity Fund 30% $3,000
Japan Equity Fund 10% $1,000
TOTAL Equity Funds (20%) $10,000
TOTAL Fixed Income Funds (80%) $40,000
TOTAL Invested $50,0003
Source: Authors’ own recommendation
3Th e minimum amount needed can be calculated as the minimum investment
amount per fund ($1,000) divided by 20% (equity fund allocation) x 10% (smallest
equity fund allocation) = $1,000 / (0.2 x 0.1) = $50,000.
HOW TO BEGIN INVESTING WHEN YOU DO NOT HAVE MUCH MONEYIn order to create your portfolio so that it includes all the above
recommended fund types, you will probably need between $10,000
and $50,000. Th is is because most funds require a minimum
investment of $1,000.
For example, if you are a conservative investor (20-80 equity-
fi xed income fund allocation), you could organise your portfolio the
following way:
If you have less than $5,000 to invest — buy a global balanced
fund (also called an Asset Allocation fund). Th ese funds invest in
both equities and bonds in almost equal proportions.
Global Balanced Fund 100%
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62
TABLE 5.5. RECOMMENDED SEQUENCE OF BUYING FOR ONE-AT-A-TIME
PURCHASES
Equity Fund Fixed Income Fund
1 Global Equity Fund Global Fixed Income Fund
2 Asia ex-Japan Equity Fund Asian Fixed Income Fund
3 U.S. Equity Fund Singapore Fixed Income Fund
4 European Equity Fund U.S. Fixed Income Fund
5 Japan Equity Fund Europe Fixed Income Fund
Source: Authors’ own recommendations
If you have less than $10,000 to invest – buy two funds, a global
equity fund and a global fi xed income fund. For example, if you are
a moderately aggressive investor (80-20 equity-bond allocation),
your portfolio can look like this:
Global Equity Fund 80%
Global Fixed Income Fund 20%
If you have more than $10,000 to invest — you can begin by
buying individual fund types in sequence. As you have more and
more money available for investment, you may buy another fund in
another category.
Th e following is a suggested buying sequence. While you may
not be following your recommended investment allocation to a tee,
you should still end up with a reasonably well-balanced portfolio.
Do this until you have enough money to take full advantage of the
allocation that applies to you.
So, if you have more than $10,000 to invest, buy them in the
following order:
We suggest you start off with a global fund in order to obtain
instant global diversifi cation. You may be thinking that this is tricky
to pull off , but it is not. You see, you do not have to be precise as
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63to how to allocate your money as long as you conform to these
guidelines at the start.
Succeeding in your investment allocation has less to do with
being precise in the way you allocate your money than in making
sure you are invested in diff erent fund types, so that you will always
have some money in categories that are doing well.
Following this approach also frees you from the stress of worrying if
you are too heavily invested in weak areas. Your challenge is deciding
how to invest money so that it becomes available in the future.
From our experience, the above guidelines will help you reach your
desired investment allocation in a sensible and stress-free way.
UNIT TRUST GLOSSARYTh ere are more than 3,200 funds available to investors in the
Singapore marketplace, of which two out of three are equity funds.
Equity Funds (Also Called Stock Funds)An equity fund is a unit trust that invests in stocks (or equities). A stock
represents a share of ownership or equity in a company. While the
stock market is known for its ups and downs, equities have historically
provided higher returns than bonds over a long-term period.
International Equity Funds
An international portfolio of securities promises less risk and
greater diversifi cation than one that is purely domestic. A 100 per
cent domestic portfolio consisting only of investments in Singapore
makes your entire portfolio vulnerable to any Singapore market
downturn. International equity funds are of several types:
• Global Equity Funds invest in promising companies anywhere
in the world.
• Regional Equity Funds invest in the stocks of a single geographic
region, such as Asia, Europe or Latin America. Th e share prices
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64 of these funds typically fl uctuate more than the share prices of
broadly diversifi ed global equity funds.
• Single-Country Equity Funds invest in the stocks of a single
foreign country such as China, Singapore or the U.S. Th ese
funds are considered riskier than regional funds because of their
narrower focus.
• Emerging Market Equity Funds invest in countries that are
moving towards an industrialised economy or to a free-market
economy. Th ese markets off er the potential for faster economic
growth than established markets, but they also present
substantial risks. Examples of such countries are Brazil, Mexico,
Indonesia and South Africa.
Keep in mind that emerging markets and single-country funds
can fl uctuate widely because of their narrower focus, and they are
not for everyone. If you wish to diversify internationally and seek
safety, it is best to consider global and regional funds before single-
country and emerging market funds.
Sector Funds
Sector funds invest in a specifi c industry such as technology or
healthcare. Investing in a narrow segment is higher risk, because if
fortunes in that sector fall, the whole portfolio becomes vulnerable.
Sector funds are attractive if you already hold a diversifi ed portfolio
and you want to take on more risk because these funds can
sometimes achieve spectacular returns.
Index Funds
Index funds are unit trusts that closely track and replicate market
indices such as the Straits Times Index. Th e fund manager does
not actively seek the best investments to outperform the market.
As a result, they are cheaper to own as they have lower operating
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65expenses. One drawback of index funds is that they do not off er any
chance of above-market returns.
Indexing is a passive form of fund management that has been
successful in outperforming most of the actively managed mutual
funds in the U.S.
A close relative of the index fund is the exchange-traded fund
(ETF), which trades like a stock on an exchange, thus experiencing
price changes throughout the day as it is bought and sold. We have
devoted a chapter to index funds and ETFs.
Fixed Income Funds
Fixed income funds invest in bonds issued by companies and
governments.
Like equity funds, there are fi xed income funds that invest globally,
regionally, in emerging markets and in individual countries. We
do not need to explain these fund types. Many other types of fi xed
income funds exist. Here are two:
1. High-Yield Fixed Income Funds
Such funds seek higher returns by investing in high-yielding,
lower-quality corporate bonds.
2. Mortgage-Backed Funds
Th ese funds seek to maximise income by investing in mortgage-
backed securities. Such securities are bonds backed with
a claim on specifi c property, and are thus of lower risk than
unsecured bonds that are not backed by any asset.
Other Types of FundsMoney Market Funds
Closely related to bonds are very short-term loans (between three
and 12 months) known as money market instruments. Singapore
government Treasury Bills, commercial paper and corporate bonds
maturing within a year are some examples.
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66Money market funds are good for your portfolio because they
tend to be used like savings accounts, where the goal is not to
generate maximum income, but to preserve capital.
Balanced Funds (Also Called Asset Allocation Funds)
Such funds combine about equal proportions of stocks and bonds
in a single fund. In this sense, balanced funds provide the best of
both worlds, off ering the growth potential of equities and income
from bonds.
Offshore Funds
Th ese are funds that are registered outside Singapore in places such as
Luxembourg and Dublin. Th e benefi ts provided by these jurisdictions
are well-developed regulations to register and operate funds and a
low-to-no-tax requirement on both capital gains and income.
Feeder Funds
A feeder fund is a fund that is registered locally and invests in an
off shore fund. Rules have now been relaxed and fund houses today
can bring off shore funds directly into Singapore for sale, thereby
eliminating the expenses incurred by registering a feeder fund.
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Selecting and Managing Your
Unit Trust Investments
You have by now an equity-fi xed income fund allocation that matches
your risk profi le. You know the type of equity funds and bond funds
that will diversify your investment portfolio across the world. It is
time to select good unit trusts in each fund category and to manage
your portfolio over the longer term.
As there are several hundreds of funds available, the process of
fi nding good funds must be undertaken with care. Th at is because
fund distributors can typically fi nd some performance measure that
they can beat, such that all funds appear to be “good” funds. For
example, a fund may be shown as having beaten all its peers during
the last one year. Impressive in itself — until one fi nds out that the
fund lost out in every other measurement over the last 10 years.
Not all funds are good, but there are many that are, and the
challenge is fi nding the ones that are right for you. If you have a
fi nancial adviser helping you, make sure you ask why he is positive
about any particular fund. Better still, do your homework fi rst. We
will show you how you can get a list of good funds later.
SOURCES OF INFORMATION ON FUNDS If you want to select your own funds, there are four main sources of
information available:
1. Th ird party fund analysis from Lipper,
2. Banks,
3. Online distributors of unit trusts such as Fundsupermart,
DollarDex and Finatiq, and
4. Financial advisers.
06
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68Each of these sources uses similar criteria to evaluate funds. If the
fund you are interested in buying is rated highly by at least two of
these sources, chances are that you have found a good fund.
THIRD PARTY FUND RATINGSAs a start, we prefer to consult the ratings provided by Lipper. Th is
organisation does not sell unit trusts. Th at is why we can expect them
to off er objective, independent ratings. Use the following criteria as
a fi rst cut. Keep in mind that the steps outlined below are based on
actual screenshots at a certain date. So be sure to expect diff erent
results when you do your own search.
Review Top-Performing FundsHere is how you can generate a list of top-performing equity funds
with at least a 5-year record.
Go to www.fundsingapore.com
• Click on the Basic Search tab
• Make the appropriate selections:
Universe – select Unit Trust
Asset Type – select Equity
Th is produced 1,963 Fund Type Matches that are “Unit Trusts”
of type “Equity” (Figure 6.1., as at mid-2010). To narrow our search
to the top-performing equity unit trusts over a 5-year period, make
the following selections:
• Time Frame – select 5 Year
• Total Return – select 5
• Consistent Return – select 5
• Preservation – select 5
• Expense – select 5
Th is produced 15 Lipper Leader Matches (Figure 6.2.). Click the “15
Matches” icon and the fi rst 10 Lipper Leaders (Figure 6.3.) appears:
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69FIGURE 6.1. SETTING CRITERIA TO FIND ALL EQUITY UNIT TRUSTS
Fund Type Matches: 1963
CPF Account type
Ctrl=click selects multiple options
HIGHER RISK
MEDIUM TO HIGH RISK
LOW TO MEDIUM RISK
LOWER RISK
CPF Account type
Aberdeen Asset Management Asia Limited
AIMS AMP Capital Industrial REIT Management Ltd
Alliancebernstein (Luxembourg) SA.
Allianz Global Investors KAG mbH
Universe
Unit Trusts
CPF Included
All
CPF Account type
All
Select An Asset Type
Equity
FIGURE 6.2. SETTING CRITERIA TO FIND TOP PERFORMERS OVER 5 YEARS
Source: www.fundsingapore.com
SGP Lipper Leader Matches 15
Historical Performance
Choose the Lipper Leader Rating from the categories below that match your
investment goals. You can make multiple selections.
Select a Time Frame Overall 3Years 5Years 10Years
SELECTALL
S
SELECTALL
S
SELECTALL
S
SELECTALL
S
4
4
4
4
3
3
3
3
2
2
2
2
1
1
1
1
5
5
5
5
Total Return
ConsistentReturn
Preservation
Expenses
4 3 2 15Highest Lowest
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70 FIGURE 6.3. DISPLAYING THE LIST OF TOP PERFORMERS
Lipper Leader Ratings — What They Mean
Funds are ranked against their Lipper peer group classifi cations each
month for 3-, 5-, 10-year, and overall periods. For each measure:
Rating Position in Peer Group
‘5’ Top 20% of funds
‘4’ Next 20% of funds
‘3’ Middle 20% of funds
‘2’ Next 20% of funds
‘1’ Lowest 20% of funds
Th is is what each of the measures1 mean:
• A high rating for Total Return denotes a fund that has provided
superior total returns (income from dividends and interest as well
as capital appreciation) when compared to a group of similar funds.
Th is measure is for investors who want the best historical return,
without looking at risk and may not be suitable for investors who
want to avoid downside risk.
1 adapted from www.lipperleaders.com
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71• A high rating for Consistent Return identifi es a fund that has
provided relatively superior consistency and risk-adjusted returns
when compared to a group of similar funds.
• A high rating for Preservation is a fund that has demonstrated
a superior ability to preserve capital in a variety of markets and
minimize downside risk relative to other fund choices in the same
asset class.
• A high rating for Expense identifi es a fund that has successfully
managed to keep its expenses low relative to its peers.
About Your List of Good FundsAs you can see, fi nding good funds is really easy. You should go
through this exercise every six months to see how your fund is
performing or what other good funds have come within range of
your radar. We will teach you how to read some of the performance
statistics later in this chapter.
On the other hand, if you prefer to let your fi nancial adviser do
the selection for you, do not forget to ask how he generates his
list and why he thinks the funds are good. Be careful not to follow
recommended funds blindly. Treat your list of funds as a source of
names for further investigation.
ADDITIONAL TIPS ON IDENTIFYING GOOD FUNDSHere are other suggestions to help you avoid mistakes when making
buying decisions.
Should Big Funds be Avoided? It is common to hear investors say that big funds — those with over
$500 million or $1 billion in size — should be avoided altogether. Th ey
argue that when a fund gets that big, it is very diffi cult to be nimble.
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72Let us take Singapore funds for example. Prudential’s PruLink
Singapore Managed Fund, which invests 70 per cent in Singapore
equities and 30 per cent in Singapore bonds, had a fund size of
$3.1 billion in July 2010. It is the largest fund invested in Singapore
securities. Th at must seem too big for a Singapore fund.
But did you know that there are nearly 100 companies on the
Singapore Stock Exchange valued at $1 billion or more? Th at Singtel
alone has a value of over $55 billion? Now the Prudential fund does
not seem so big after all.
In fact, fund managers look long-term and close their funds to
further subscription if they feel their fund is too large. After all,
they will not want a fund so large that they cannot manage it well
enough to bring in good results.
Should Small Funds be Avoided? Suppose for the last three years, a fund averaged $10 million in size
and its expense ratio is 2 per cent. Th at means $200,000 is available
to pay for the fund manager’s salary, the salary of research staff ,
electricity, PCs and other operating expenses. Do you think that is
enough?
Experience points to funds getting closed when their size is too small.
Funds have to be a certain size to be feasible for the fund manager.
For the investor, it makes sense too for the fund to be big enough
because small funds are expensive to run. Mercer conducted a
study on CPFIS funds in 2001. What the study found is that smaller
funds are a lot more expensive to run than bigger funds:
TABLE 6.1. BIG FUNDS HAVE SMALLER EXPENSE RATIOS
Fund Size <$5m $5–10m $10–50m >$50
Expense Ratio 3.1% 2.4 2.2 1.8
Source: Expense Ratios: Analysis of Trends, Oct 2001, Mercer Article No. 5 – Oct 2001
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73
TABLE 6.2. CPF’S EXPENSE RATIO THRESHOLD
Equity Risk Type of Unit Trust Max. Expense Ratio
Higher risk Equity funds 1.95%
Medium to high risk Balanced funds 1.75%
Low to medium risk Bond funds 1.15%
Lower risk Money market funds 0.65%
Source: www.cpf.gov.sg
Should Funds with Large Expense Ratios be Avoided?It depends. Just as a Lamborghini takes more fuel to run than a 150cc
Vespa scooter, some funds are inherently cheaper to run, such as
index funds whose expense ratios are as low as 0.3 per cent annually.
Th en there are specialised funds that focus on particular sectors
such as technology and healthcare; these funds tend to be more
expensive to run because they require heavy resources for research
and analysis. It follows then that given two funds of the same type,
it makes sense to avoid, or to think thrice, about funds with larger
expense ratios.
Th e CPF Board is so concerned about expense ratios eroding
investment returns that at the end of 2006, it announced that unit
trusts and Investment-Linked Policies (ILPs) cannot accept CPF
monies if their expense ratios exceed certain benchmarks. From 1
January 2008, expense ratios cannot be higher than those shown
in Table 6.2.:
If you have already invested in funds that exceed these benchmarks,
the CPF Board will not require you to sell or switch your investments
although it will likely off er you opportunities to switch from these
funds for free within a certain time frame.
In the end, remember that expenses is just one of the factors
(although a big factor!) that aff ect your returns. It is usually
worthwhile to pay more for a fund that gives you superior
performance even if they are expensive to own. So if you come
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74across a fund that has a high expense ratio, don’t write it off just
yet. Ask yourself or the salesperson why it has higher charges, and
accept nothing less than a good and convincing reason. It may be
a specialised fund or it has a superior performance record. Other
than a really good reason, drop funds that have high expense
ratios.
Should You Invest in New Funds? Th e easy answer to this perennial question is, “I won’t invest in a fund
that has not been around for at least three years.” Some investors
would like to see how funds have performed relative to their peers
as well as in good and bad markets.
Still, there are those adventurous souls amongst us who would
consider taking the plunge each time a new fund or stock is available.
If you are one of these risk-loving investors, ask yourself the following
questions and be comfortable with your answers:
• Is your portfolio already diversifi ed? Do you now want to add
risk? If yes, go ahead and take some risk. If not, then you are
taking a big risk with your money. Remember, your fi rst duty
is to have a portfolio protected by diversifi cation. Th en you
can set aside some money or a portion of your portfolio to
include riskier, even speculative, investments.
• Does the fund manager already have a track record elsewhere?
If he is a newly minted MBA or just old enough to shave, do not
touch the fund.
• Are you going to set aside the time and eff ort to monitor these
new fund investments? Our advice to you is that while it might
be worthwhile buying a new fund that is run by an established
fund manager, you are advised to monitor its performance more
regularly than you might an aged fund.
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75MONITORING FUND PERFORMANCEOne of the great things about owning a unit trust is that you are paying
someone (about $200 per year for a $10,000 investment) who is very
qualifi ed and smart to worry about how your money is invested. But
you still need to check periodically on how the funds you own are
doing. You do not want to fi nd out 10 years from now when you need
the money that the fund you bought has turned into a pumpkin.
How Often Should You Check?Every six months is usually a good bet. If you really want to get into
your investments, you might do it monthly, but those who review
their investments too often might overreact to short-term market
movements.
Th e fact is that every fund, even the best ones, will underperform
its peers periodically. For example, if you are checking a fund every
month and you see that it is underperforming for the last four
months, you might pull the trigger and sell the fund. But as so often
happens with good funds, the underperformer comes back alive
and produces quarter after quarter of dazzling results.
So, review your funds every six months, and do not leave your
funds alone for more than one year. Reviewing fund performance
only takes a few minutes when you use a website like www.
fundsingapore.com.
Th e second thing to do when you monitor your portfolio is to
rebalance it, if necessary. Suppose you started off with a 90-10
equity-bond portfolio. During the next six months, the portfolio
shifts to 70-30 equity-bonds because equity prices have fallen and
bond prices have risen. To rebalance it back to 90-10, you would
simply sell off part of the bond portion and use the proceeds for the
equity portion to return the portfolio back to a 90-10 allocation.
WHY REBALANCING MAKES SENSERebalancing forces us to put into practice the “Buy Low, Sell High”
principle. For example:
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76• Th e equity portion had fallen sharply and we rebalanced by
buying low.
• Th e bond portion had risen sharply and we rebalanced by
selling high.
Rebalancing also forces us to add bonds when interest rates rise
(bond prices fall) and sell equities when the stock market goes up.
Th ese are very wise things to do.
Does Rebalancing Work Over the Long-Term? In the iFAST study we examined in Chapter 5, the 100 per cent equity
portfolio produced a 9 per cent annualised return over 32 years.
Well, this portfolio was actually rebalanced every year. Whenever
equities fell relative to fi xed income, equities were bought and fi xed
income was sold. If the strategy had been buy and hold, the return
produced would only have come to 7.3 per cent.
How Often Should You Rebalance? You may want to set some rules. For example:
• Rebalance right away when any of the major regional stock
indices such as the S&P 500 or Nikkei 225 has moved up or
down by more than 20 per cent.
• Rebalance right away when interest rates have moved up or
down quickly by more than 2 per cent.
Rebalancing: Points to ConsiderWhile the mechanics of rebalancing are straightforward, sometimes
the cost or inconvenience of rebalancing may outweigh the
benefi ts.
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77Transaction Costs
Th is is the most obvious drawback. How much does it cost to switch
funds? Th e transaction costs can be high enough to stop you.
Fortunately, switches between funds of the same family are
usually cost-free. Better yet, you may want to try something called
a wrap account. When you have a wrap account off ered by some
fi nancial advisers, you can rebalance for free among funds from
several fund managers.
Time and Effort
If you have a large number of funds and the amount to rebalance is a
mere few hundred dollars, it may not be worth the trouble. Perhaps
you should wait another six months. In any case, you cannot reach
that conclusion without going through exactly where your portfolio
stands today. Even if you do not want to rebalance, you should review
your portfolio every six months.
Change in Risk Profile
As your time horizon nears, your risk profile will change. When
you are 10 years away from your objective, your risk profile is
likely to be more aggressive. This may call for an 80-20 equity-
fixed portfolio.
As you get closer and closer to your objective, your profi le will
become more conservative and your portfolio will take on more
and more fi xed income and fewer and fewer equities. Bear in mind
that the risk profi le you started off with is not going to be the same
profi le you end up with eventually. Ask yourself each time when you
rebalance — has my risk profi le changed? After every few years, the
answer should be “yes”.
One criticism of rebalancing is that when a fund does well, you
will be removing those positions that can go up even higher.
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78
Can You Count on Past Performance?If you had picked any one of the top-performing Lipper Leaders fi ve
years back, you will have come out a winner. But we are investing for
future results, not past. Th e question we need to answer is, “Is past
performance indicative of future results?”
If your answer is “yes”, then you believe that any of these three
dream performers should be winners again in the future. You
believe that relying on fund rankings (when you want to buy a
fund or to check if you should sell a fund because it is not ranked
favourably anymore) is a good strategy.
If your answer is “no”, then you are saying that these top
performers will probably not be able to hold their position in the
future. Many experts believe this to be true. Th ey say that past
performance is pretty much worthless when it comes to fi guring
out the future.
Unlike reports that measure the reliability of cars, investment
performance is very diffi cult to predict. Economies go up and
FIGURE 6.4. DON’T FORGET TO REDO YOUR RISK PROFILE
Source: Authors’ own illustration
> Aggressive80% Equity20% Fixed Income
10 years 5 years 3 years
Balanced60% Equity40% Fixed Income
>Conservative20% Equity80% Fixed Income
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79down, funds change, managers and sectors such as technology can
blow hot, then cold.
In fact, underperforming after being a hot fund is common.
Nobel Prize Laureate in Economics, William Sharpe, in an article
on past performance, for example, discussed Barkdale and Green’s
fi ndings: funds that fi nished in the top 20 per cent over the past fi ve
years were the least likely to fi nish in the top 50 per cent over the
next fi ve years:
TABLE 6.3. TOP PERFORMERS MAY NOT STAY ON TOP FOR VERY LONG
Performance Over 5 Years Top 50% Finishers Over Next 5 Years
Top 20% Performers 44.8%
Second 20% 47.7%
Th ird 20% 51.5%
Fourth 20% 52.3%
Fifth 20% 0.99%
Source: www.efmoody.com/investments/pastperformance.html
We believe that while the past is not indicative of the future,
it still does a decent job, but we have to be careful. To make our
choices more bullet-proof, we rely on the following rules of thumb:
• Buy funds with good track records with as long a history as
possible. If fund A is the top performer over the last three years
and fund B is a steady performer over the last 10 years, we
would choose B.
• Buy funds with lower expense ratios, all else being equal. If fund
A’s expense ratio is 2.5 per cent and fund B’s is 1 per cent,
fund A will cost 1.5 per cent more to run per year. If you hold
the fund for 10 years, you lose out on 15 per cent of returns.
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80• When it comes to investing, it is important to examine current
trends, rather than past ones. For example, technology is part
of a long-term trend even though it fl uctuates during shorter-
term cycles. China is a long-term growth opportunity even if it
might overheat and have high infl ation.
• Most of all, diversify your assets across the diff erent asset
classes, across the globe, and across diff erent fund managers,
and stick to a strategy that keeps your retirement goal in
perspective.
IS THERE A RIGHT TIME TO SELL?Newspapers and fund distributors have little trouble telling you what
funds to buy and when, but fi nding advice on when to sell a fund can
be much harder to come by.
More often than not, investors tend to sell their funds for the
wrong reasons. So, is there really a right time to sell? It is generally
accepted that the best time to sell is when you have reached your
profi t goal. But as we will see, there are also situations where the
fund ought to be sold, even when it is not profi table.
You Need the MoneySometimes there will be emergencies in your life when you need
money and you have little choice but to sell your investments. Despite
the urgency, you should still weigh your choices. Can you get a loan
that charges you a rate of interest lower than the rate of return you
are getting on your investments? If you can, it might be best to hold
off selling your investments.
Your Objective is Met If you set out a clear target of accumulating $100,000 in 10 years
for your daughter’s education, then when your $100,000 target is
attained, sell your investments.
Sure, your investments could skyrocket after you sell, but can you
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81stomach the alternative? Suppose you hung on and the market falls
sharply and you end up with insuffi cient money for your objective.
Th e best thing to do when you reach your objective is to sell.
Your Fund is UnderperformingIf your fund is not doing well, fi nd out why. One of the worst reasons
for selling a fund is when its category is going through a tough time.
If equity funds have gained 8 per cent this year and fi xed income
funds have lost 6 per cent, you might think fi xed income funds do
not belong in your portfolio. Th is is the best way to shoot yourself
in the foot.
But as you know from Chapters 1 and 2, allocating your money
appropriately in equity funds and fi xed income funds is far
more important to investment success than chasing after the
hottest funds.
Here is a good rule to follow when a fund is underperforming
its peers: “Never sell a fund unless it has underperformed its
peer group for two years in a row.” A good fund underperforming
its peer group in any one year is a common thing. But when a
good fund underperforms for two years in a row, something is
probably wrong.
Drastic Change in Fund SizeFund size can change dramatically during bull and bear markets.
Sometimes funds that get big very quickly can be a problem. Here
is an example. Suppose fund manager Tommy is great at picking a
portfolio of 20 company stocks. His success brings a lot of attention,
resulting in a large infl ux of investor money.
Th e problem is that with so much more money, he may end
up owning a majority of several stocks, which leads to liquidity
problems, because as a major shareholder of the stock, his moves
are going to be closely watched by the market. To get around this
problem, he has to hold more stocks. His job is much tougher now
because he is forced to fi nd 40 or 50 good stocks.
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82On the other hand, it is also diffi cult for a small fund to survive.
Th is is because the fund managers will have a tough time meeting
expenses and investors will be paying high expense ratios.
The Fund Manager LeavesA good unit trust is often backed by a solid fund manager. If the
fund you hold is run by a star manager and the manager leaves,
think about selling the fund if the replacement is not known to be
a performer.
Selling a fund right away because of the fund manager’s departure
is generally a mistake. Th e fund management company surely
wouldn’t replace its star performer with a slouch or loser.
Th is does not mean you should blindly ignore a change in manager.
Watch your fund more closely after the change. If its performance
lags far behind for a few quarters, you may want to sell all or part
of the fund more quickly than you would in normal conditions. (We
should mention that in Asia, fund management companies tend to
adopt a team approach to investing rather than rely on individuals.
Th is makes monitoring manager turnover less meaningful.)
Conversely, a manager’s departure can be a good thing as well. If the
fund has been underperforming its peers, a change in fund manager
may encourage an investor to hold onto the fund more tightly.
YOU NEED TO REBALANCE YOUR PORTFOLIO If you have an asset allocation you want to stick to, you may need to
rebalance your holdings by selling and buying securities in order to
return your portfolio back to its desired allocation.
Th ere is another time when you may want to rebalance, and that
is when your risk profi le changes. If your retirement is fi ve years
away and your risk profi le has turned conservative, your current
portfolio may no longer be appropriate.
If you are thinking about selling a fund and the primary reason
for selling it is not on the list above, you may want to reconsider.
Selling a unit trust is not something you do without a great deal
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83of consideration. Remember that you originally invested in the
fund because you were confi dent of it — make sure you are clear on
your reasons for letting it go. But if you have carefully considered
the pros and cons and you still decide to sell it, do it and do not
look back.
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Investing in Individual Stocks
When you buy a unit trust, you are entrusting someone else to make
decisions for you and you lose control over what to buy and sell,
and when. Investing in individual stocks requires time and money to
manage them eff ectively.
Th e good news is that by combining both methods of investing
— unit trusts and individual stocks —you can take advantage of the
opportunities that both ownership methods off er.
And fortunately, buying and selling stock is a relatively simple
task, as seen by the millions of stocks that are traded among
investors every day. You begin the process by opening a trading
account with one of the 20 or so brokerage companies in Singapore,
and you can begin submitting orders to buy or sell.
But before you do, let us fi rst beef up on more details.
INVESTING IN INDIVIDUAL STOCKS AND BONDSAssuming you already have a diversifi ed unit trust portfolio that
you plan to hold for retirement or some other objective, then you
could allocate up to 20 per cent of your total invested money in
individual stocks.
For example, if you have $50,000 in total to invest, you can
allocate up to $10,000 or 20 per cent in individual stocks.1 We
feel 20 per cent is a safe guideline. If these investments suff er a
major setback, such as a 30 per cent drop, the eff ect on the overall
portfolio is just minus six per cent (-30% x 20%).
Th is guideline is, of course, not etched in stone. For example,
you could build a globally diversifi ed portfolio consisting of
individual stocks, bonds and other supplementary investments for
your retirement.
1We recommend that up to 20 per cent of your total invested money be invested in
individual stocks, bonds, more speculative and other supplementary investments
that need not form part of your long-term retirement portfolio.
07
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TABLE 7.1. MAJOR DIFFERENCES BETWEEN COMMON AND PREFERRED STOCK
Common Stock Preferred Stock
Voting Rights Always Seldom
DividendsNot fi xed or promised
Fixed. Can be suspended if company has net loss.
Maturity PerpetualNormally perpetual. Sometimes the company can terminate the issue or investors can convert to common stock.
Price Movement
More volatile
Less volatile
Source: Authors’ own compilation
COMMON VERSUS PREFERENCE STOCKMost stocks sold in Singapore are common stock. If you buy a
common stock, there is no guarantee that you will make money. You
bear the risk that the stock price might go down or that it would not
pay any dividends. It is possible that you could lose a big chunk of
your initial investment.
For the risk that you take, you stand to make money if the company
does well. In fact, over time, stocks have always outperformed bonds,
often by a comfortable margin.
Owners of preference stock are also shareholders. Unlike common
shareholders, preference shareholders benefi t from a fi xed dividend
that does not increase even if the company has a boom year.
Of the 500 companies on SGX Mainboard and Catalist, there are
just about fi ve preferred stock issues traded. For this reason, our
focus will be on common stock.
Types of Common StockCommon stock returns come in the form of dividends and capital
appreciation — an increase in the share price. But not all stocks are
the same. Some pay dividends, some do not. Some have stable prices
while others have volatile prices.
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86One way to diff erentiate stocks is to observe how closely a
company’s prospects is tied to the economy:
FIGURE 7.1. A TYPICAL BUSINESS CYCLE
As the business cycle (see Figure 7.1.) moves from bottom to peak
during an expansion, diff erent industries benefi t diff erently from the
economic changes that accompany the cycle.
Cyclical Stocks
Cyclical stocks are the most sensitive to business cycles. Th ey do best
during expansions, but do badly during recessions. Airline stocks
are typically cyclical. People postpone travel when the economy is
slow, but when the economy grows, travellers can suddenly appear
in droves at the travel agent’s offi ce.
Defensive Stocks
Defensive stocks are the least sensitive to business cycles. Food and
utility stocks are defensive because people will still eat and turn on
the electricity during market downturns. On the fl ip side, defensive
stocks underperform during expansions — people would not
suddenly eat a lot more or keep the lights on all night.
Peak
RecessionExpansion
Bottom
Source: Authors’ own illustration
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87Growth Stocks
Growth stocks perform better than the industry average, and growth
may occur regardless of the business cycle. A growth stock usually
pays little or no dividends, but puts profi ts back into the company to
fi nance new growth. Investors buy growth stocks for their potential
price appreciation and not for dividends. While the prices of growth
stocks usually rise in value more than those of other types of stocks,
they also decline in price more signifi cantly.
Value Stocks
Value stocks are stocks that are underpriced by the market for
reasons that have nothing to do with the business itself. Value stocks
are good investment opportunities that may have been oversold or
may be temporarily out of favour.
Blue-Chip Stocks
Blue-chip stocks are solid performers that generate some dividend
income, decent growth and, most of all, safety and reliability. Consider
blue-chips if you want to invest in a stock for the long-term and you
do not have much tolerance for risk.
Speculative Stocks
Speculative stocks are typically unproven young companies. Prepare
for a rollercoaster ride if you invest in a speculative stock. Th ey may
be erratic, but can be winners in the making when there are, for
example, promises of technological breakthroughs.
Interest Rate Sensitive Stocks
Interest rate sensitive stocks are greatly aff ected when interest
rates change. Utility companies have huge fi xed costs in plant and
equipment, and they typically pay a lot of bond interest. When
interest rates rise, the cost of servicing its loans rises and this has a
downward eff ect on its stock price.
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88Income Stocks
Income stocks pay a higher-than-average dividend. Companies whose
stocks fall into this category are typically in stable and mature industries
such as utilities and tobacco. While income stocks may not have the
growth potential of growth stocks when prices are rising, their prices
tend to hold up more when growth stock prices are tumbling.
International Stocks
International stocks are stocks of foreign companies. Many of the
world’s largest companies have their headquarters overseas. While
buying shares of foreign companies can pose a challenge for some
investors (we will discuss some of these challenges in the next
chapter), many large companies are listed on the Singapore Stock
Exchange. In any case, the easiest way to own international stocks is
to buy international unit trusts.
SELLING NEW STOCK THROUGH AN IPOIt is the dream of every entrepreneur to take the company he started
from private to public ownership. Th e road to an Initial Public
Off ering (IPO) often begins with an entrepreneur who comes up
with an idea for a product or a service and raises money from his
own family and friends to start up a business.
If the business grows, the entrepreneur often seeks a second
level of funding called venture capital that is provided by wealthy
investors and investment companies. Venture capitalists expand the
private ownership of the business by sharing the risks of the new
business in exchange for the privilege of helping to run the business
and sharing in its profi ts.
The Primary Market — Buying an IPOGoing public means that the business sells new stock that previously
did not exist. Th is is done in the primary market, which is the fi rst
part of a fi nancial market and is part of the process of getting listed
on a stock exchange.
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89Th e management of the IPO goes to an investment banker who
agrees to underwrite the stock issue, that is, to buy all the public
shares at a set price and to resell them to the public at a higher
price for a profi t. Th ese underwriters advise the company on the
valuation of the company, the number of shares that should be
issued and the price per share.
IPO shares are sold during a subscription period, which typically
lasts up to a few weeks. Some IPOs are so hot that they can be
completely sold out in just a few days, and become oversubscribed.
The Secondary Market — SGXAt the end of the IPO subscription period, the shares trade in the
secondary market such as the Singapore Exchange (SGX), the only
formal exchange for stocks in Singapore. Once shares start to trade
in the secondary market, the share price can rise and fall, depending
on investor expectations. At this time, the original issuers receive no
additional cash from these secondary market transactions.
READING THE STOCK PAGETh is is an adaptation of a quotation from a mainboard-listed company,
which we shall call Stock X.
52-wk
high
52-wk
lowCompany
Last
sale
Vol
‘000
Day
High
Day
Low
Net
P/E
M Cap
$Mil
222 188 * Stock X 210 789 213 210 18.6 6071
Source: Authors’ own computations
Th e highest and lowest prices for the past 52 rolling weeks
are reported daily. Th e range between the high and low is an
indication of the stock’s volatility or price movement. Th e more
volatile the stock, the more you can profi t or lose in a relatively
short time. For example, the price ranged between $1.88 and
$2.22, or about 18.1 per cent.
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90
Th e stock was issued with a par value of 10 cents. Th e * on
the left of the company name indicates that it is one of the
index stocks that make up the STI. Th e last sale or closing
price was $2.10. Volume of 789,000 refers to the number of
shares traded the previous day.
“High” and “low” reports the highest and lowest prices
for the previous day. Th e daily diff erence is usually small
compared with the 52-week spread.
Th e price-earnings ratio (PER) shows the relationship
between the stock’s price and the company’s earnings for the
previous year. It is obtained by dividing the current price per
share by the earnings per share. Stock X’s P/E of 18.6 means
that its current price of $2.10 (last sale) is 18.6 times the
previous year’s earnings per share. Th is implies that earnings
per share is 11.29 cents (barring any rounding error):
P/E = 18.6
2.10 / E = 18.6
E = 2.10 / 18.6
= 11.29 cents
If you were to buy up all the outstanding shares of the
company, you would have to fork out $6.071 billion — its
market capitalisation. It is calculated as the number of
outstanding shares multiplied by the current share price.
BUYING AND SELLING SHARES IN THE SECONDARY MARKETOpening an AccountTh ere are a few ways to trade shares in the secondary market. If
you know exactly what you want and are more a “do-it-yourself ”
investor, you can trade shares through an online brokerage such
as Phillip Securities (www.poems.com.sg). Commissions for online
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trades are usually lower than for offl ine trades done through dealers
and remisiers who are representative of the brokerage. Trades
commonly cost a minimum of $25 for online and $40 for offl ine,
and the cost increases based on various contract value sizes.
In order to trade shares, you fi rst have to open an account at the
Central Depository Pte. Ltd. (CDP), which handles the clearing
of trades. Once you have your CDP account, you can approach
a member stockbroking company to open a sub-account and
begin trading.
Opening a Cash or Margin AccountYour broker will need to know if you want a cash account, margin
account or both. Cash accounts require you to pay in full after a
purchase is made. A margin account allows you to borrow money
from the brokerage company to buy more securities. Th is is called
leverage and is not for everyone because you can double or triple
your profi ts as well as losses.
HOW THE CDP WORKS
Imagine that you paid $20,000 through your broker for 1,000
shares of BigCo. One week later, the price of BigCo has doubled
and your shares are now worth $40,000. Elated by your windfall,
you call your broker and ask him to sell your shares. But your
broker tells you that the individual who sold you the BigCo
shares failed to deliver the shares to your broker.
Now if your BigCo shares were traded through a regulated
exchange like SGX, the integrity of your share purchase is
guaranteed by CDP. CDP provides the clearing and depository
function for the Singapore share market — it guarantees and
clears all securities traded on SGX. Brokerage fi rms act as
intermediaries between you, the investor, and the CDP.
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92Brokerages in Singapore typically off er a margin equal to 3.5 times
your cash amount deposited. Hence, a deposit of $10,000 cash
translates into a margin account of $35,000 to buy up to $35,000
worth of securities.
Establishing a Long or Short PositionWhen you buy a share, you are said to have a long position. Your
decision to buy means that you hope to profi t from an increase in
price in the future.
If you had no existing long position and you expect the market
to decline, you may wish to take a short position to profi t from
the expected decline. When you “short” a security, you are in fact
hoping and praying that the price of the security will go down so
that you can buy it back and replace the security at a lower price.
To you, bad news is good news.
How can you sell something you do not own? You can today with
the SGX Securities Borrowing and Lending (SBL) Programme
launched in January 2002.
To see how this works, suppose you short 1,000 ABC shares at
$10 a share.
If the short sale was for $10 a share and you buy the stock a
month later at $7 a share, you make a profi t of $3,000 ([$10-$7] x
1,000 shares). If, instead, ABC is bought back at a higher price of
$12 ($2 higher than the short-sale price), you will have a loss of
$2,000 ([$10-$12] x 1,000 shares).
Short selling is a very aggressive strategy since your upside
potential is fi xed (the price of the stock cannot go below zero), and
your downside potential is unlimited (the stock can go up and up).
Issuing Buy and Sell OrdersWhen you decide to buy a share, how exactly do you tell your broker
to establish a position? If you are not careful, you may end up paying
more than you expected. It is really important to understand how
orders are given and executed.
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93Th ere are three common types of orders:
1. Market orders
2. Limit orders
3. Stop orders
Market Orders
When you phone your broker and say, “Buy 1,000 shares of XYZ,” you
are placing a market order. A market order does not specify a price.
Some investors feel that market orders are risky because if the
market runs up suddenly, they may end up paying much more.
But market orders make sense for other investors. If they think a
stock is really hot and they do not want to miss getting the stock, a
market order at whatever the current price does the job.
Limit Orders
A limit order, on the other hand, specifi es the exact price at which
you want an order executed. For example, “Buy 1,000 shares of XYZ
at $10.00.” Th ere may be other buy orders in front of yours at more
than $10.00. Th ese investors will be serviced ahead of yours because
they are all willing to pay more than you are.
You can see that a limit order may never be executed so long as
there are orders ahead of yours in terms of price.
Stop Orders
If you want your order to go through no matter what, you can place a
stop order. A stop order guarantees that your order is fi lled by stating
the price at which a market order takes eff ect. A buy stop order is
placed above the current market price, while a sell stop order is
placed below the current market price.
For example, say you absolutely must own XYZ and it is currently
trading at $1.00. You can place a stop order to buy XYZ at $1.20. Th e
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94order becomes a market order to buy as soon as the market price
reaches $1.20. Th e order may not be fi lled exactly at $1.20 because
the closest price at which the stock trades may be $1.25. Th e exact
price specifi ed in the stop order is therefore not guaranteed.
A sell stop can be used to protect a profi t. Now suppose XYZ
has risen to $2.00. You want protection against a price decline, and
at the same time, you want to hang on to the share for extra gains.
To lock in most of the profi t, a sell stop order could be placed at
$1.80. When market price falls to $1.80 or below, a market order
to sell is triggered.
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Selecting and Managing Your
Individual Stock Investments
Th ere really is no secret to picking good stocks. Th e winning
techniques have been tested over and over. Th ey may not work all
the time, but they work often enough.
Because good stocks tend to stay good, take your time to fi nd the
right information. Do your homework, learn about the industries
your favourite stocks are in and do not rush into any purchase even
when the stock price is running away from you.
FUNDAMENTAL ANALYSISSo how do the pros sort out the good stocks from the bad? By looking
at a business at its most fundamental and fi nancial level. Th is type of
analysis examines key fi nancial ratios of a company, giving us an idea
of the company’s fi nancial health and the value of its stock.
Even if you do not plan to do thorough fundamental analyses
yourself, it will help you follow stocks more closely if you
understand these key terms and ratios.
IT IS ALL ABOUT EARNINGSTh e bottom line is what investors want to know. How much money is
the company making and how much is it going to make in the future?
Earnings are profi ts and that is what buying a company is about.
Increasing earnings generally lead to a higher stock price and,
in some cases, a regular dividend. And when earnings drop, the
market may knock the stock price down.
Suppose company A and company B are in the same industry.
Both companies made sales of $1,000 but company B earned more
as it incurred lower expenses. Which company would you buy?
08
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96 TABLE 8.1. EARNINGS OF COMPANIES A AND B
Company A Company B
Sales 1,000 1,000
- Expenses -700 -600
Earnings 300 400
Source: Authors’ own illustration
Company B for sure. Yet while earnings are important, by
themselves they do not tell you anything about the value of the
company’s stock.
Earnings Per Share (EPS)One of the challenges of evaluating stocks is making sure we make
apple-to-apple comparisons. Comparing the earnings of one company
with another really does not make any sense, if you think about it.
Suppose Adam’s family earned $300 and Adam is the only child, while
Betty’s family earned $400 and she’s got nine other siblings. Which
family has more earnings to go around?
Using raw numbers ignores the fact that two companies have a
diff erent number of outstanding shares. Let us look at earnings per
share (EPS). We calculate EPS by dividing earnings by the number
of outstanding shares:
EPS = Earnings / Outstanding shares
TABLE 8.2. EPS OF COMPANIES A AND B
Company A Company B
Earnings 300 400
Number of Shares 10 100
EPS $30 $4
Source: Authors’ own illustration
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97Now suppose company A has 10 shares outstanding, while
company B has 100 shares outstanding. Which company’s stock do
you want to own?
Should you buy Company A because its EPS of $30 is higher? We
are not quite there yet to answer that question, but we are close. We
still do not know how much we would pay for the stock of company
A and B. Before we move on, you should note that there are two
main types of EPS numbers:
1. Trailing EPS — last year’s actual numbers.
2. Forecast EPS — based on future numbers, which are projections.
Price-Earning Ratio (PER)If there is one number that people look at than more any other, it is
the Price-Earning Ratio (PER). It looks at the relationship between
the stock price and the company’s earnings. Th e PER is the most
popular tool for analysing a stock, although it should not be the only
one to consider.
You calculate PER by taking share price and dividing it by the
company’s EPS.
PER = Stock price / EPS
For example, if company A has a stock price of $300 and company
B’s price is $80, their PER are 10 times and 20 times respectively:
TABLE 8.3. PER OF COMPANIES A AND B
Company A Company B
EPS $30 $4
Stock Price $300 $80
PER 10 times 20 times
Source: Authors’ own illustration
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98What does PER tell us? Th e PER gives us an idea of what
the market is willing to pay for the company’s earnings. Th e
higher the PER, the more the market is willing to pay for the
company’s earnings.
A high PER can be read as an overpriced stock. While this may
be true, a high PER stock can also indicate that the market has high
hopes for the future prospects of this stock and has bid up the price.
Such a stock is called a growth stock. Th eir PERs can be quite high
and they can still be considered “cheap” by the market.
On the other hand, a low PER stock may indicate the market’s
lack of confi dence in the stock. Its future prospects are dim and the
market is depressing its stock price relative to its earnings. Or it
could be a value stock — an underpriced stock that the market has
overlooked. Investors can make fortunes by spotting these sleepers
before the rest of the market discovers their true worth.
Still, a company’s PER does not provide much of any buy and sell
clues until it is compared with:
• PER values of the same company over the past few years
If the PER of company A is currently 10 and its PER average over
the last 10 years is 15, we can say that the stock is cheap
compared with its past.
• PER values of other companies in the same business
If company A has a PER of 10 and is in the chemicals industry
that as a whole has a PER of 5, we can say that the stock is
expensive compared with its peers.
• PER values of stock indices representing the market as a whole
If company A has a PER of 10 and the STI stock index has a PER
of 20, we can say that the stock is cheap compared with the
entire market.
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99Using the PER to Value Stocks
Th e PERs we see on the stock pages in newspapers are trailing PERs.
It uses the current stock price divided by a historical earnings fi gure
from the company’s latest annual report.
A forecast PER on the other hand uses the current stock price
divided by the stock’s forecast EPS. Forecast earnings are found in
company research reports generated by analysts. You should use
these individual forecast PERs with care because they are based
on the earnings estimates made by a few individuals from one
brokerage house.
What is generally more reliable are earning forecasts taken by
averaging the estimates of several dozen analysts who follow the
stock. One example is Zacks consensus estimates (called Zacks
Rank) for the U.S. market. Are these consensus estimates reliable?
Th e best stocks picked by Zacks Rank have outperformed the S&P
500 for 15 out of the last 16 years.1
Forecasting Stock Price with PERs
PER is very commonly used by investors to forecast the future price
level of stocks and the market.
Forecast price = Trailing PER X Forecast EPS
EXAMPLE:
Stock A is trading at $15 and its trailing EPS is $1 based on its
latest annual report. Given a trailing PER of 15 ($15/$1), what is
the forecast price of stock A if its forecast EPS is $1.20? Note that
stock A has an historical PER of between 15 and 20 times in the
last 10 years.
Forecast price = 15/1 X $1.20
= $18
1www.zacks.com
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100Since the current price of stock A is $15, and assuming the
forecast proves accurate, one can expect stock A to increase in
price by $3. It is thus a good buy because this stock at $15 today
is an undervalued stock.
In order to make such a conclusion, one has to have certain
beliefs:
• Th at the stock’s eventual PER will reach a level of 15, which
is at the low end of the range for the last 10 years.
• Th at the forecast EPS of $1.20 is generally reliable.
• Th at forecast prices are estimated from assumptions about
company growth, the economy and other factors, and that
these assumptions can be proven wrong in the end. In other
words, we are taking calculated risks when we rely on
forecast numbers.
In the end, investors buy a stock not for what it can do for them
today, but for what they hope it will do for them tomorrow. If it does
not live up to expectations, they will probably bail out of the stock.
Th ere are countless other fi nancial terms and ratios you can learn
and use. We have highlighted the most popular — the PER.
TRACKING THE MARKET THROUGH INDICESWe track the market because it has an overall eff ect on the
performance of individual stocks. Th is is an established fact. Th e
Straits Times Index (STI) is the most widely quoted index for the
Singapore market. It consists of a basket of 30 stocks and measures
the average price level of the market.
Th e STI is plotted for the period between June 1995 and July
2010. If you had invested your money in the Singapore stock market
sometime during this period, you would either be very happy or very
upset, depending on which period of time you were in the market.
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101
Look at the self-explanatory volatility shown in Table 8.4 (STI
levels are rounded to the nearest 50):
TABLE 8.4. THE STI’S BIG JUMPS AND FALLS
Period STI Start STI End No. of months % change
Feb 96–Aug 98 2450 800 30 months -67%
Aug 98–Dec 99 800 2500 16 months 213%
Dec 99–Sep 01 2500 1250 21 months -50%
Sep 01–Mar 02 1250 1800 6 months 44%
Mar 02–Apr 03 1800 1200 13 months -33%
Apr 03–Oct 07 1200 3850 54 months 221%
Oct 07–Feb 09 3850 1600 16 months -58%
Source: Authors’ own compilation
FIGURE 8.1. STI PERFORMANCE BETWEEN JULY 1995 AND JULY 2010
(Source: www.sgx.com)
4000
3500
3000
2500
2000
1500
1000
500
0
Jul-
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Jul-
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Jul-
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Jul-
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Th at is why the experts harp so much on diversifi cation. By
putting your money into several baskets, you reduce both risk
and anxiety.
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102Components of the STIWhat makes the STI go up and down? Th e answer is this: When
its component stocks go up and down. Singtel, Wilmar, DBS, UOB,
Jardine Matheson Holdings and OCBC typically occupy the top six
positions in terms of weight.
Th e top six weighted companies constitute about 50 per cent of
the index. If these top six stocks collectively rise 10 per cent, the
impact on the STI is 5 per cent (50% X 10%). A higher weight
therefore means a greater infl uence on the index.
Using the STI as a YardstickStock indices provide a good yardstick against which investors can
compare their portfolios. If you own a unit trust that is broadly
invested in Singapore stocks, you could compare its performance
with that of the STI.
FIGURE 8.2. BENCHMARKING A SINGAPORE EQUITY FUND AGAINST THE STI
Source: www.aberdeen-asia.com
141.3
80.7
175
150
125
100
75
50
25
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-25
-501999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
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Percentage Growth Total Return, Changes Applied (31/08/99 – 30/06/10)
Aberdeen Singapore Equity SGD (MF) Singapore Straits Time TR (IN)
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103Figure 8.2. is an excerpt from a factsheet of the Aberdeen
Singapore Equity Fund, a unit trust invested broadly in Singapore
stocks. Th e bottom line chart is the STI rebased to 100 for the period
September 1999 to July 2010. Th e top chart is the Singapore equity
fund also rebased to 100 for comparison. It shows the Aberdeen
fund outperforming the STI benchmark over this period.2
International InvestingInvestors looking for ways to diversify their portfolio have a world of
opportunity through international investing. Buying stocks from an
overseas market can earn you returns in three ways. For example, if
you buy Microsoft (a U.S. stock), you gain when:
• Th e stock rises in price.
• Th e stock pays dividends.
• Th e U.S. dollar rises against the Singapore dollar (when you sell
the stock, each U.S. dollar converts to more Singapore dollars).
But there are other risks as well. Besides the stock price falling,
dividends getting cut and the foreign currency falling in value, you
will have to contend with:
• Confusing accounting rules that may cause earnings to be
under- or overstated.
• Inadequate disclosure requirements.
• Language barriers or complicated trading rules, and others.
2We rebase in order to compare apples with apples. To rebase any data series, we
take each data point and divide it by fi rst data point minus 1. If the fi rst data point
of STI is 1200 and the second is 1500, the chart would plot 0 (1200/1200 -1) and 25
per cent (1500/1200 -1).
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104
How to Invest InternationallyTh ere are several ways for you to buy international stocks:
• Local brokerages with access to overseas markets — for example,
DBS Vickers provides access to Hong Kong and Th ailand stocks.
• Some foreign companies list their stocks directly on Singapore
exchanges such as Noble Group (Hong Kong) and Total Access
(Th ailand).
• Open an account directly through a foreign brokerage such as
Ameritrade and E*Trade.
• Unit trusts that invest in international markets.
Keeping Track of International MarketsTh ere are hundreds of indices that measure the broad market or
specifi c parts of it. Table 8.5 on the following page lists some of the
most important indices used around the world.
CURRENCY RISK AND REWARDS
Currency movements can accentuate your gains as well as
losses. If your U.S. investment was purchased at US$1,000
when the conversion rate was S$1.8 : US$1.0, a major currency
move when you sell the stock can bring very happy — or
unpleasant — results.
Suppose you sell the stock after one year for US$1,000, a
breakeven position in terms of price. If the US$ rises to S$1.9,
you will receive S$1,900 — a S$100 profi t. But if the US$ falls
to S$1.6, you will only receive S$1,600 — a S$200 loss.
Exchange rate risk is a major added risk you need to
consider when you invest overseas.
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105TABLE 8.5. IMPORTANT INDICES AROUND THE WORLD
Country or Region Index
SingaporeTh e Straits Times Index (STI) is the most widely quoted stock index in Singapore with 30 large-cap, highly liquid stocks.
U.S.
Th e Dow Jones Industrial Average (DJIA) consists of 30 blue-chip stocks such as General Motors, IBM and McDonald’s. Despite being the most widely quoted stock index in the U.S., unit trust fund managers seldom refer to it as their benchmark.
U.S.
Th e Standard & Poor’s 500 (S&P 500) consists of 500 large-cap companies quoted on the New York Stock Exchange (NYSE). Th ese companies make up 80 per cent of the NYSE’s total value. Most U.S. funds use the S&P 500 as their benchmark because it is a broader measure of the market.
EuropeTh e MSCI Europe consists of over 500 European stocks from 16 developed markets.
AsiaTh e MSCI Asia ex-Japan index consists of more than 500 stocks in 13 countries.
JapanTh e Nikkei 225 is based on the 225 common stocks traded on the Tokyo Stock Exchange.
WorldTh e MSCI World Index consists of more than 1,500 stocks in 23 countries globally.
Source: Authors’ own compilation
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106PICKING A MARKETFund managers tend to analyse markets from a top-down perspective,
focusing on a region’s or a country’s economic environment fi rst and
then on individual companies. Among factors that make a country’s
stock attractive are the stability of the economy, exchange rate
movements and its interest rate environment. Th e best conditions
for an investor to fi nd in an overseas economy are that it is growing,
its currency is strengthening and its interest rates are low.
FIGURING OUT WHEN TO SELL A STOCKSelling a stock or bond often seems more diffi cult than buying one.
Th at is because every investor has sold a good investment too soon
or failed to get out of a bad one soon enough. Sounds familiar? Well,
it happens to the best of us, but you do not want to make a habit of
it. In the end, there really are not many clear-cut hard and fast rules.
Th at is why we begin watchfully with “Warning Signs”.
Warning SignsIf any of these warning signs appear, your stock is probably a good
sell candidate:
The Company is Embroiled in a Scandal
Th is is the most ominous of all warning signs. Do not wait around
expecting to see any silver lining or buying opportunity — sell
right away. Scandals are long-drawn aff airs. It may take many
months between the time the scandal is fi rst revealed, and when
investigations are complete and made known. Do not hang around
when the ship is sinking.
The Company is Not Doing Well
If your darling tech stock is showing negative or big drops in earnings
two years in a row and other tech stocks in the same industry are
registering record sales, something is probably very wrong with
your stock. You can be patient with a stock that does badly for one
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107year, but you should be impatient if it lags behind two years in a row
when the whole industry is doing fi ne.
You Made a Mistake
You bought a lemon from the start and you know it. You have a
strong sense of regret, but yet you are hanging on for a miracle. If
this happens to you, sell the stock right away.
You are Over-Exposed to One Stock in Your Portfolio
We know people who buy nothing but their company stock. Th ey say
it is plain loyalty and they are confi dent their company will prosper.
We say this is suicide. Remember to diversify. If any one stock grows
to occupy more than 20 per cent of your portfolio, you should start
thinking very carefully about how much risk you are taking on.
General Market ConditionsWhen economic indicators suggest that the economy is headed
towards a recession, then no matter how good your stock is, it is
probably going to decline as well. Here are some general guidelines for
predicting market declines, although, of course, the direction of the stock
market can never be reliably or consistently predicted. Th ese guidelines
are based on economic information that’s available in the newspaper.
Interest Rates are Rising to Historical Highs
When interest rates are high, companies face the prospect of high
borrowing costs and cut back on borrowing and business expansion.
Consumers cut back on spending as it gets too expensive to borrow.
Company stock prices fall as a result. Furthermore, bond returns
increase and become more attractive compared with stocks. High
interest rates are one of the worst enemies of any stock investor.
Stock Prices are Soaring and Economic Activity Does Not Seem to be
Picking Up
Strong economic activity justifi es strong stock market performance.
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108If economic activity is not robust, then it is diffi cult for any market
rally to sustain itself. For example, suppose the economy is coming out
of a recession and the stock market has raced ahead in anticipation
of increased economic activity. But you notice consistent poor news
— unemployment is high and is expected to increase, infl ation from
high commodity prices such as oil is pushing up the cost of doing
business, and consumers aren’t going out to spend money. Th is is
not good news for stocks.
SOME COMMON MISTAKES FOR NOT SELLINGIf you are still not convinced that the stock you own should be sold,
you probably own a good stock. Still, some of us may stubbornly
hang on even when there are obvious reasons for selling. Here are
some mistakes for not selling that you should avoid:
You are Emotionally Attached to the Company Maybe your grandparents worked there all their lives and left you
stock of the company. Th is and other sentimental reasons may be
valid reasons to hold and therefore not sell a stock. But you have to
accept that what you are doing makes little economic sense when the
stock is performing really badly.
You Hate to Take a Realised Loss Th is is classic. Your stock is trading at $7 and you bought it for $10.
You are making a 30 per cent paper loss. You have started to reject
fundamentals. Your good sense shifts to, “Let us wait until the price
rises back to the purchase price.”
MANAGING INDIVIDUAL STOCKS IN YOUR PORTFOLIOIndividual stocks are fl exible. If you plan to keep stocks for your
retirement portfolio, a selection of 5–10 blue-chip, high-quality
stocks across several industries should provide a good amount of
diversifi cation. Do not hold 20 or more stocks because it becomes
exceedingly diffi cult to follow your investments. Just so no stock has
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109a very heavy impact on the portfolio, each stock should constitute no
more than 20 per cent of the total stock portfolio.
You can also trade stocks speculatively. Just remember that you
should not have more than 20 per cent of your invested money in
individual stocks. Some investors are going to speculate and take
high risk anyway. Putting a cap on such investments is a sensible
way of taking high risk within a safe overall framework that should
not sabotage your retirement plans.
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110
Investing in Individual Bonds
Just about everyone knows that in the long run, stock returns do
better than bonds. Th en why would anyone invest in bonds? Bonds
have two main characteristics that stocks simply cannot match.
First, bonds return a known amount at the end of a stated period.
Unless the borrower goes bankrupt, a bond investor can almost be
certain that the capital originally invested will be returned. With
stocks, the loss of money is not only possible, but it can happen
quite frequently.
Secondly, bonds pay interest according to a fi xed schedule
(typically twice a year). Th is interest can provide valuable income
for retired individuals, or for those who want predictable cash fl ow.
Do you need bonds? You will need bonds if:
• You are a conservative investor and you cannot stomach the ups
and downs of the stock market.
• You have to set aside a fi xed sum of money, such as for your
child’s education, and you want the certainty of receiving known
and specifi c amounts in the future.
• You are retired and you want the certainty of income and your
capital protected from fl uctuation.
For example, suppose you invested in $100,000 worth of bonds
that pay eight per cent interest semi-annually and which mature in
10 years’ time. Th ese bonds would pay you $4,000 every six months
or $8,000 yearly, giving you money to live on or to invest elsewhere.
Finally at the end of 10 years, the principal sum of $100,000 is
returned to you.
As an investor, you are spoilt for choice because there are as many
types of bonds as there are ice-cream fl avours. Th ere are bonds that
09
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111pay regular interest, bonds that pay no interest, bonds that can
be called back by the issuer before maturity and even bonds that
convert to stock. Knowing what bonds to invest in and when to do
so can make a big diff erence to your bottom line.
BONDS ISSUERSBonds are issued by corporations and by the government.
Corporate BondsWhen corporate bonds are issued, they are normally sold at par,
usually in units of $1,000, and subsequently traded in the stock
THREE MAIN FEATURES OF A BOND
1. Face value
Th is is the original value of the bond that will be returned to the
investor upon maturity. Th e face value (also called par value) of
most bonds is $1,000.
2. Coupon
Th e coupon indicates the interest income that the bondholder
will receive over the life of the bond, usually payable in semi-annual
instalments. For example, an 8 per cent coupon bond with a par
value of $1,000 pays $80 annually or $40 semi-annually twice a year.
3. Maturity
Th e maturity indicates when the bond matures. At the time of
issue, the time to maturity is at least one year and can be as long as
30 or more years. At maturity, the issuer or borrower makes a fi nal
payment to the bondholder equal to the bond’s par value. In general,
the longer the maturity, the higher the interest rate to compensate
the investor for tying up his money for a longer time.
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112
TABLE 9.1. SAMPLE LIST OF BONDS TRADED ON SGX
Live Quotes from SGX Buy Sell
LTAn4.08%120521 10K 1.00 1.06
JTCn4.826%121024 10K 1.064 1.075
Source: : Extracted from www.sgx.com (29 July 2010)
exchange. Retail interest in corporate bonds is very low in Singapore
as investors prefer the stock market. Th ere are thus no more than
a handful of outstanding corporate bonds on SGX. Here are two
examples traded on SGX:
Th e LTA bond pays 4.08 percent coupon interest per year,
matures on 21 May 2012 and has a par value of $10,000.
Th e Buy price is the price being off ered for the bond, or what a
buyer is willing to pay. Th e highest price submitted was 1.00 or 100
percent of par value, that is, $10,000. Th e Sell price is the price at
which a seller wants to sell the bond. Th e best (lowest) selling price
was 1.06 or 106 percent of par value, that is, $10,600.
Government BondsGovernment bonds (called SGS or Singapore Government
Securities), on the other hand, are issued by MAS. SGS are not
listed on SGX, but are available through banks, fi nancial advisor
companies and Fundsupermart (an online distributor).
Governments are not profi t-making enterprises and do not issue
stock. Bonds are the primary way they raise money to fund daily
operations in running the country as well as capital improvements
such as building mass rapid transit systems and highways.
Th e Singapore government is the safest of all issuers because it
has taxing power, the ability to print more money if necessary, and
more importantly, has the highest credit quality assigned by the
major rating services (see Table 9.2.).
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113TABLE 9.2. CREDIT RATING OF SINGAPORE GOVERNMENT BONDS
Moody’s S&P Fitch
Rating Aaa AAA AAA
Source: www.sgs.gov.sg
MAKING MONEY WITH BONDSConservative investors use bonds to provide steady and predictable
income. Th ey buy a bond when it is issued and hold it till maturity.
Th ey expect to receive regular coupon payments during the term.
And at the end of the term, the principal is returned.
More aggressive investors may sometimes trade their bonds
before they mature, particularly when interest rates fall. When
bonds are issued at a high rate of interest, they become increasingly
valuable when interest rates fall.
For example, suppose you buy a bond for $1,000 when
interest rates are at 5 per cent. If interest rates fall to 3 per
cent, new bonds will offer 3 per cent interest. The older bond
which pays 5 per cent will become more valuable and hence
more expensive.
Th is means that an increase in the price of a bond, or capital
appreciation, can produce more profi ts for the investor than
holding the bond to maturity.
But you can lose money as well.
INVESTING IN BONDS IS NOT RISK-FREEInterest Rate RiskIf you sell the bond before maturity when interest rates have gone
up, the price of your bond will go down and you will incur a capital
loss. Th is is because buyers can buy new bonds that off er a higher
interest rate and the price of your bond off ering a lower interest will
have to go down to attract buying interest. Interest rate risk is one of
the three major risks bond investors face.
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114Inflation Risk Since the dollar amount you receive on a bond investment is fi xed,
the value of those dollars will be eroded by infl ation. At a rate of
infl ation of 2 per cent, $100 received in 10 years’ time is worth just
$82 today. Th at’s a loss of $18. In general, the longer the term of a
bond, the higher would be the interest rate off ered to make up for the
risk of tying money up for a longer period.
Default Risk Th is is the risk that the borrower fails to pay you interest and principal.
We will have more on this topic later.
WHAT IS A BOND WORTH?When you put $1,000 into a bond, the bond could be worth more or
less the very next day. While you know how much coupon interest
you will get in the future, your capital value or the current price of
the bond can fl uctuate.
Like everything else in life, bond prices too are driven by supply
and demand. When investors want to buy or sell, they consider two
main factors:
1. Interest rates in the economy.
2. Credit rating of the bond issuer.
Before we go on, we have to admit that investing in bonds can be
a daunting task for the new investor because of the mathematics.
Th ere are all sorts of calculations and terms to master, and many of
them seem diff erent from those of stocks. We urge you to devote
time and energy to learning the mathematics that drive bond prices
and returns. It will set you apart from most other investors.
Interest Rates in the EconomyWhen a bond is fi rst issued, the coupon rate is typically set to the
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115market rate of interest so that the issuer can receive an amount
equal to par value. For example, if the market interest rate is
6 per cent, the issuer sets the coupon rate at 6 per cent, making the
price of the bond on the day of issue exactly $1,000.
Market interest rates change as time passes by. As a result, bond
prices after the day of issue are seldom equal to par value. Interest
rates and bond prices move in opposite directions like two sides
of a see-saw. When interest rates fall, bond prices go up. And vice
versa. Let us go through an example:
Suppose KayOn Pte. Ltd. issues a new 10-year bond off ering
six per cent interest semi-annually. Lizzie buys a bond at the full
price or par value of $1,000.
Seller sells at par
Par value $1,000
Term 10 years
Coupon Interest 6 per cent
If Lizzie were to hold the bond to maturity, a period of 10 years,
she would receive 20 payments of $30 each every six months and
the return of $1,000 par value on maturity.
Buyer buys at par
Price $1,000
Holding period 10 years
Interest income 20 semi-annual payments of $30
At maturity $1,000
Her dollar return is $600 and her yield is 6%.
Return to buyer
Interest (20 x $30) $600
Par value $1,000
$1,600
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116 Less cost – $1,000
Return $600
Yield to buyer
Current yield $60 / $1,000 = 6%
Two years later, interest rates have gone up to 8 per cent. If new
bonds costing $1,000 are paying 8 per cent interest, no buyer will
pay you $1,000 for a bond paying 6 per cent. To sell her bond, Lizzie
would have to off er it at a discounted price that could wipe out the
interest she has earned so far.
Suppose Lizzie sells the bond for $840. She would incur a loss
of $40.
Seller sells at discount of $840
Market price $840
Interest received $120 (4 payments x $30)
$960
Less cost – $1,000
Loss -$40
Th e buyer pays $840 and if the bond is held to maturity, $1,000
will be repaid, or a capital gain of $160. Th e buyer can also expect
16 interest payments of $30 for the remaining eight years of the
bond’s life.
Buyer buys at $840
Price $840
Holding period 8 years
Interest income 16 semi-annual payments of $30
At maturity $1,000
Return to buyer
Interest (16 x $30) $480
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117 Par value $1,000
$1,480
Less cost – $840
Return $640
Yield to buyer
Current yield $60 / $840 = 7.14 per cent
Of course, the reverse can also happen. If, in two years’ time, new
bonds selling for $1,000 off er 4 per cent interest, Lizzie would be
able to sell her 6 per cent bond for more than what she paid. Buyers
would be willing to pay more for a bond that pays a higher rate of
interest than that prevailing in the economy.
If she sells the bond for $1,200, the premium (or capital gain) plus
interest received of $120 will make her a nice profi t of $320.
Seller sells at premium of $1,200
Market price $1,200
Interest received $120 (4 payments x $30)
$1,320
Less cost – $1,000
Profi t $320
Buyer buys at $1,200
Price $1,200
Holding period 8 years
Interest income 16 semi-annual payments of $30
At maturity $1,000
Return to buyer
Interest (16 x $30) $480
Par value $1,000
$1,480
Less cost – $1,200
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118 Return $280
Yield to buyer
Current yield $60 / $1,200 = 5%
MORE ON YIELDYield is what you actually earn. When interest rates fl uctuate and
cause bond prices to move, the investor’s yield changes as well.
When Lizzie buys the 10-year $1,000 bond paying 6 per cent
coupon and holds it to maturity, she earns $60 a year — an annual
current yield of 6 six per cent or the same as the interest rate.
Current yield remains the same throughout her ownership of
the bond.
Current yield = Coupon interest / Market price
= $60 / $1,000
= 6%
An investor who buys the same bond two years later in the
secondary market will be looking at a diff erent yield. Th at is because
the market price of the bond has changed. For example, if interest
rates had risen to 8 per cent:
Current yield = $60 / $840
= 7.14%
Th ere is an even more precise measure of a bond’s value called
Yield to Maturity (YTM). Compared with current yield, YTM
takes into consideration both coupon interest and capital gains/
losses. Th e investor of the $840 discount bond will earn $160
in capital gains at maturity, and this amount is not captured in
current yield.
YTM is the single most important calculation for a bond, but it
does have a complicated formula. But there is a simpler, albeit less
accurate, formula that helps to explain how YTM uses both capital
gains and interest income in its calculation.
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119Here it is. First, fi nd out the annual discount or premium over the
life of the bond. Th e KayOn bond has an annual premium of $20
($160 / 8 years).
Second, add the annual premium of $20 to the annual coupon
of $60 to get $80, which is the annual return from both the capital
gain and the income portions.
Th ird, divide the annual return of $80 by the average price of the
bond. Th e average price is obtained by adding the buying price of
$840 and the maturity price of $1,000 and dividing the result by 2.
From doing all this, the result is 8.7 per cent, which is slightly off
the actual result of 8.83 per cent:
YTM (approximate) = (160/8) + 60
(840 + 1000) /2
= 8.7%
You should know the actual YTM value when you invest,
although you need not kill brain cells to calculate it. It is best left
to a spreadsheet or your fi nancial adviser who is handy with a
fi nancial calculator.
BOND CREDIT RATINGS As a bond investor, you want reasonable assurance that you will get
your interest payments and principal back at maturity. It is impossible
for individuals to track the credit worthiness of individual bond
issues. Fortunately, rating services such as Moody’s Investors Service
(Moody’s) and Standard & Poor’s Corporation (S&P) provide this
valuable service.
Th ese rating services pore through voluminous fi nancial
statements and study the business prospects of bond issuers to
answer the question, “How likely is the issuer to default on its
payments on a particular bond issue?” Bonds that rank low in terms
of risk receive a higher quality rating.
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120
TABLE 9.3. RATINGS TABLE
Moody’s S&P Investment-Grade Bonds
Aaa AAAHighest credit rating, maximum safety
Aa AAHigh credit rating, investment-grade bonds
A AUpper-medium quality, investment-grade bonds
Baa BBBLower-medium quality, investment-grade bonds
Moody’s S&P Speculative Bonds
Ba BBLow credit quality, speculative-grade bonds
B BVery low credit quality, speculative- grade bonds
Moody’s S&P Junk Bonds
Caa CCCExtremely low credit quality, high-risk bonds
Ca CC Extremely speculative
C C Extremely poor investment
D D Bonds in default
Source: Authors’ own compilation from Moody’s and S&P
Bond ratings are assigned to a particular bond issue, not just to
the issuer of those bonds. For example, a secured bond issue gives
the investor a claim to specifi c assets in the event of default. Th is
gives a secured bond a higher credit rating than an unsecured bond
even when issued by the same corporation.
Th e top four grades (Aaa, Aa, A and Baa in the case of Moody’s)
are considered investment grades. All other grades are considered
high-yield or junk.
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121Ratings Influence YieldAs Figure 9.1. shows, credit ratings infl uence the interest rate an
issuer must pay to attract investors. Given the same maturity, the
higher a bond’s rating, the lower the interest it pays. On the other
hand, the lower a bond’s rating, the more an issuer must pay. Th at
is why the lowest-rated bonds are often described as high-yield
bonds.
In the next chapter, we will look at strategies for buying and
selling, and how you can manage your bond investments.
Source: Authors’ own illustration
RATING
YIE
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FIGURE 9.1. LOW QUALITY SPELLS HIGHER YIELD
AAA AA A BBB BB B CCC CC C D
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Selecting and Managing Your
Individual Bond Investments
Some investors think that bonds are conservative, even boring
investments. Th ink again. A $1,000, 4 per cent coupon bond, with
10 years to maturity, could rise $149 or fall $180 in response to a
2 per cent change in market interest rates. Knowing about bonds —
when to buy them and how to select among a multitude of choices
— can reap huge rewards.
THE MANY FLAVOURS OF BONDSBonds have many diff erent features, which make each bond unique.
As you learn about each feature, bear in mind whom the feature
benefi ts — the issuer or the investor. If a feature benefi ts the investor,
then the bond has lower risk, its yield should be lower, and its price
should be higher. So once you know who benefi ts from a feature, you
will have a good idea about whether to pay more or less for such a
bond. Here are some of the most common bonds you will fi nd.
Government BondsGovernment bonds (called SGS or Singapore Government Securities)
are issued by the Monetary Authority of Singapore (MAS). At the
time of issue, government bonds have maturities of between one and
15 years.
Corporate BondsCorporate bonds are issued by corporations. Th ey are bought
and sold mainly by institutions. Th ere is limited interest from
retail investors.
Secured BondsSecured bonds are backed by specifi ed assets such as mortgages
10
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123and accounts receivables. In general, bonds have to be backed by
something for investors to be convinced to part with their money.
For example, a mortgage-backed bond bundles mortgages, and then
sells investors the right to receive the payments that consumers make
on those mortgage loans.
Unsecured BondsUnsecured bonds (or debentures) are the most frequently issued
type of bond. Th ey are backed by the credit quality of the issuer.
In general, the higher the credit quality, the higher the chance the
borrower will pay you as promised. Although unsecured bonds sound
risky, they generally are not. Debentures are issued by high-quality
corporations, and they are often more highly rated than secured,
asset-backed bonds.
Floating-Rate BondsFloating-rate bonds (or fl oaters) periodically adjust the coupon
interest according to a formula based on current market interest
rates. When market interest rates are going up, fl oaters adjust their
coupon interest upwards.
Zero-Coupon BondsZero-coupon bonds do not pay coupon interest during the term of
the bond. Instead, the interest is built up and paid in a lump sum at
maturity. Zero-coupon bonds are sold at a discount. For example,
if you buy a zero-coupon bond for $900 and you collect $1,000 on
maturity, you would have earned $100 in interest.
Callable BondsCallable bonds give the issuer the right to call back the bond and
repay its debt before maturity. For this reason, callable bonds do not
always run their full term. Issuers tend to call a bond if interest rates
fall, in the hope of paying off the original loan and reissuing another
bond at a lower rate of interest.
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124If you think that is unfair, it is the same idea as you refi nancing
a mortgage to get a lower interest rate to make lower monthly
payments.
Callable bonds are less attractive for investors because an investor
whose bond has been called now faces a lower, reinvestment
environment. Callable bonds are riskier for investors and hence
off er a higher rate of return than non-callable bonds.
Convertible BondsConvertible bonds are hybrid investments because they possess
some qualities of a bond and some of a stock. Hybrids are normally
safer than either a bond or a stock.
If interest rates rise and the bond falls in value, the investor can
still benefi t if the stock price has risen. If the option to convert
is not exercised, the convertible remains in existence until the
bond’s maturity and you continue to receive interest income.
Th is fl exibility is especially appealing to conservative investors
who seek regular income and downside protection against falling
share prices.
Because convertible bonds have a little something extra — the
right to convert to common stock, they cost more than straight
bonds without conversion features. Convertible bonds are less
risky for investors and hence off er a lower rate of return than non-
convertible bonds.
High Yield BondsHigh yield bonds are lower-grade bonds that pay higher interest
rates. High yield bonds are not inferior bonds at all except that
they are riskier than investment-grade bonds. They are often
just a grade below investment grade and are issued by emerging
market economies and by good companies that have fallen on
bad times.
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125CHOOSING THE RIGHT TYPE OF BONDTh ere are so many types of bonds that it can be confusing trying to
pick one over another. Here are some rules of thumb, depending on
what you want:
• Maximum current income — Choose high-yield bonds.
• Protection from rising interest rates — Choose high-yield bonds
or short-term bonds. Th e prices of short-term bonds are less
volatile because they are closer to maturity.
• Protection from default risk — Choose investment grade bonds.
• Take advantage of falling interest rates — Choose long-term
bonds and zero-coupon bonds.
• A worry-free investment in a bond — Buy bonds and hold them
to maturity. Th e closer the bonds are to maturity, the less worrisome.
MAKING A BOND INVESTMENTTh ere are two main ways you can have a bond investment:
1. Purchase individual bonds.
2. Purchase bonds through a unit trust.
Instead of buying individual bonds, many investors fi nd it easier to
invest in bonds through unit trusts, which off er a diversifi ed portfolio
of bonds for as little as $1,000. Th e typical bond fund has 50 to 100
individual bonds of diff erent maturities, yields and credit ratings.
Th is allows investors to diversify risk easily and inexpensively across
a broad range of bonds. What is more, bond funds come with a fund
manager and an investment team — they provide expertise that most
individual investors do not have access to.
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126
TABLE 10.1. CHOOSING BETWEEN INDIVIDUAL BONDS AND BOND FUNDS
Invest in Individual Bond Invest in Bond Fund
Maturity Defi nite maturity date.
Bond funds never mature. As some bonds mature or are traded away, new bonds take their place.
Capital Preservation
Capital returned is predictable. It is at par at maturity, regardless of prevailing interest rates (unless issuer defaults).
Capital returned is unpredictable — based on the price of underlying bonds (Net Asset Value), which are aff ected by prevailing interest rates, among other things.
IncomeIndividual bonds send you interest income on fi xed dates.
Interest income is usually not paid out but reinvested.
Interest Rate Risk
Less aff ected by interest rate risk. In fact, the risk diminishes as bond reaches maturity.
Constant exposure to interest rate risk.
Default Risk
Th e impact of a default is greater, especially when few distinct bonds are owned. Conservative investors should seek mainly lower-risk, investment-grade bonds.
Default risk is minimised because a fund typically holds 50–100 distinct bonds.
Management
You are on your own when it comes to managing your bonds. When the bonds are repaid on maturity, you will have to think about what you are going to do with the cash.
Unit trusts off er management expertise on an ongoing basis.
Source: Authors’ own compilation
Here are some things to consider when making a decision about
whether to invest in individual bonds or in a bond fund.
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127BOND PICKING STRATEGIESAlong with your newfound knowledge of bonds, here are some
strategies on picking bonds that will help you become a successful
bond investor.
Buy Bonds When You Think Interest Rates are HighWhen you buy a bond, you are locking yourself into receiving a fi xed
amount of interest every year until the bond matures. If interest rates
are low, you should be fussier about what you buy. Look for short-
term bonds that mature in a few years and certainly give long-term
bonds a skip.
Buying when interest rates are high gives you two benefi ts. Th e
interest you receive on your bond will be higher. Second, if interest
rates are high, there is probably a good chance that interest rates
will fall and the price of your bond will go up.
Laddering MaturitiesLaddering means staggering the maturities in a bond portfolio.
Here is how it works. Suppose you have $20,000 to invest in a bond
portfolio. Buy 10 bonds each with $2,000 face value, maturing
annually for 10 consecutive years.
As time passes and the fi rst bond matures, invest in another
10-year bond. Continue this cycle, as long as you want to remain
in bonds. Th is approach means that you are never concentrated in
any one maturity. If there is a signifi cant change in interest rates,
you will have avoided putting a heavy portion of your money on a
single maturity. Laddering maturities reduces the eff ect of interest
rate risk on bonds.
Beware of Callable BondsCallable bonds can be called and retired by the issuer before
maturity. Th ey pay more interest because they are riskier than non-
callable bonds.
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128Be careful of callable bonds because bonds are often called when
interest rates have fallen. Calling a bond allows the issuer to reissue
the bonds at a lower interest rate. Th is does you no good because
you will reinvest your money in a lower interest rate environment.
What is more, callable bonds fi x the price that is paid to you. Just
when you think that lower interest rates point to higher bond prices,
you remember that callable bonds have a clause stating the maximum
price the issuer will compensate you in the event of a call. Th is price
is always lower than the price of a bond with no callable feature.
Buy Quality BondsBe careful about chasing after the highest yielding bonds. Such
bonds may be low quality and have a high chance of default. While
it is alright to allocate a small portion of your money to speculative
bonds, do not focus only on high yield bonds.
If you are buying individual bonds worth from about $10,000 to
$20,000, it is diffi cult to achieve a lot of diversifi cation. You should
therefore focus on high quality bonds.
Buy Bonds That You Expect to Hold till MaturityWhen you buy a bond and hold it till maturity, you will know the
rate of return because it can be calculated on the day you buy
your bond.
You may still hope to buy a bond and sell it for a nice profi t when
interest rates fall. But you have to ask yourself what you will do with
the proceeds of your sale. For example, you bought a bond when
interest rates were at 5 per cent, and which have now fallen to 3 per
cent. Sure, you can sell the bond and make a profi t (if you cash out
totally), but it would not make sense to use the proceeds then to
reinvest in another bond that pays only 3 per cent.
FIGURING OUT WHEN TO SELL A BONDSelling a bond before it matures is a big decision. We indicated in
the previous two chapters that one of the best reasons to buy a bond
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129is when you plan to hold it to maturity. Nevertheless, there may be
situations where selling makes sense:
1. Slipping of credit rating
While a drop in rating from AAA to AA is not such a big
problem, a bond falling into the junk or CCC and below
category is very risky and has a high chance of default.
2. You need the money
We hope you will never fi nd yourself in this sort of situation:
you have an emergency and your emergency funds are not
enough. Th e worst thing about forced selling is that it may be
the wrong time, especially when interest rates have risen and
bond prices have fallen.
3. Falling interest rates
Bond prices are rising as a result and you are now tempted to
cash in your profi ts. Th is is not a bad idea if you are thinking of
cashing out. But if it is to buy another bond, then realise that
other bonds are also paying lower returns. Th is defeats the
whole purpose of selling.
Still, there are two situations in which selling makes sense.
First, when interest rates fall, this is usually favourable to stocks.
You may move out of bonds when prices are high and move into
stocks as they benefi t from falling interest rates. But be careful that
you have really understood the fundamentals. It is easy to get the
signals wrong.
Second, falling interest rates is a good sign overall for the
whole economy as even shaky companies have a higher chance of
survival due to cheaper debt. Sophisticated investors do take such
opportunities to switch from safer bonds to higher-yielding bonds
of a lower quality in order to generate higher returns.
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130MANAGING INDIVIDUAL BONDS IN YOUR PORTFOLIOLike stocks, bonds are very fl exible investments. If you want
protection of capital and high liquidity, you can consider short-term
bonds, preferably of investment grade quality, that mature in one to
three years.
If you want to match a bond with your retirement, you can
consider a bond whose maturity closely matches your time of
retirement. For example, if you plan to retire in 10 years, then you
should go for investment-grade bonds that mature in 10 years.
Because the yield to maturity is known, this is a low risk strategy of
ensuring a certain return along with good protection of your money
as your retirement gets closer.
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3PART
INVESTING IN ALTERNATIVE ASSETSInvesting in traditional assets in Part 2 showed you how to build a portfolio of unit trusts for a long-term objective such as retirement. It also showed you how, after setting aside your funds for this most important objective, you could add individual stocks and bonds to your portfolio.
In this section, we go beyond traditional investments to include products such as gold and hedge funds. This is not to say that the traditional products are inadequate, but some of us would like to go a little further. Remember to stick to the 20 per cent rule — no more than 20 per cent of all your invested funds can be allocated to individual stocks and bonds and alternative products.
The chapters in this section are shorter than the other sections because they build on what you already know. For example, a capital guaranteed fund is made up of bonds and derivatives.
We suggest that you plan your retirement portfolio before putting a single dollar to alternative investments.
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Investing in Exchange Traded
Funds (ETFs) and Index Funds
An ETF is like a typical unit trust1 but it diff ers from it in two
fundamental ways:
• An ETF trades on a stock exchange such as SGX; and
• An ETF passively mimics an underlying index rather than
attempting to beat it actively.
Take the streetTRACKS STI Fund for example, which is listed on
SGX and passively mimics the Straits Times Index (STI). On the
other hand, a unit trust that focuses on Singapore stocks, such as
the Schroder Singapore Trust, looks actively for Singapore stocks
that together attempt not only to match, but beat, the performance
of the STI.
You probably have these questions:
• How is a portfolio of ETFs diff erent from a portfolio of actively
managed unit trust funds in terms of risk, performance and cost?
• Can you build a globally diversifi ed portfolio of ETFs where
each passively follows an index?
We’ll answer these questions about ETFs in this chapter and also
talk about how they are similar to index funds.
ETFsAn ETF trades like a stock on an exchange and so its price fl uctuates
during trading hours. By owning an ETF, you get the diversifi cation
1 What we mean by a typical unit trust here are those unit trusts whose objective is
to beat a specifi c underlying benchmark.
1 1
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133of an index as well as the fl exibility of trading it like a stock. Th is
means that you can sell short, buy on margin and purchase as few
as one share at a time. Your upfront cost of buying an ETF is the
brokerage fee, which is the same as that paid for stock trading. And
there is no 3 to 5 per cent front-end load, which is typical for a unit
trust.
Most ETFs fully replicate the underlying index by investing in
every stock in the index, weighted proportionately. It is because of
this passive approach to mimicking the index that ETFs are never
expected to beat or lose out to the underlying index in terms of
performance. If the STI goes south by 10 per cent, you can expect an
STI ETF to fall in the same direction by the same magnitude.
Its passive nature means the fund manager has to do far less
research and analysis to construct the ETF. As a result, ETFs have
lower expense ratios. In most cases, an ETF stays fully invested at all
TABLE 11.1. COMPARING ETFS AND UNIT TRUSTS
ETF Unit Trust
Objective
Passively tracks an index. Will not outperform or underperform the underlying index.
Actively attempts to outperform the underlying index.
Buying Charges
Based on what stock brokerages charge, typically measured by bid-off er spread.
1.5% to 5% of amount invested.
Recurring Fees
Typically between 0.75% and 1.5% per annum of amount invested.
Typically between 1% and 3% per annum of amount invested.
Trading Price
What you see on the trading screen is your paying or buying price.
Based on forward pricing. Investor will not know price paid or sold at usually till 1–2 days later.
Source: Authors’ own compilation
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134times while actively managed funds may keep a portion of investor
funds in cash depending on market conditions. Table 11.1 (page 133)
summarises the key diff erences between ETFs and unit trusts.
INDEX FUNDSIndex funds are unit trusts based on an index and mirror its
performance. Index funds came about before ETFs did. In the U.S.
where index funds were fi rst launched, there are 2.5 index funds for
every ETF.
Th e thinking behind index funds has strong academic backing.
For a long time, many academics have been saying that it is
impossible to beat the market consistently without raising your risk
level — a theory known as the Effi cient Market Hypothesis (EMH).
In 1975, John Bogle of investment management company Vanguard
took the position that if you can’t beat the index, create a fund to
mimic it. Th at’s when the fi rst low-cost mutual fund was created
mirroring the S&P 500 index.
Index funds have been a hit in the U.S. because many investors
are disillusioned by the returns of actively managed funds. In study
after study, data show that the majority of active mutual funds fail
to outperform the S&P 500 and other indices. So why pay a fund
manager to look actively for the best investment opportunities for
you, when more likely than not, the fund manager will not be able
to do better than the index?
One of the reasons this is true in the U.S. is that the fund industry
is very large and well followed. Th e stocks of the world’s largest
companies are tracked by hundreds of analysts. Th e amount of
information sharing and effi ciency is very high. Th ere is little that one
manager can know that is of material signifi cance to his portfolio that
other managers would not know about.
In Singapore and many parts of Asia, this phenomenon is less
pronounced. Our markets are smaller, are followed by far fewer
analysts, and have a lower degree of information effi ciency in
the sense that fund managers are able to extract information and
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135analysis that is not commonly known. In fact, studies show that
actively managed funds in Asia do at least as well as, if not better
than, passively managed ones.
BUILDING A PORTFOLIO OF ETFs AND INDEX FUNDSTh ere are diff erences, of course, between ETFs and index funds.
But overall, they are more similar than diff erent in that both are
passive investing styles that track indices in terms of composition
and performance.
In chapter 5, we showed you how to build your own globally
diversifi ed portfolio using actively managed unit trusts by allotting
your money in the following regions:
TABLE 11.2. RECOMMENDED ALLOCATION OF EQUITY FUNDS
Type of Equity Fund Recommended Allocation
US Equity Fund 30%
European Equity Fund 30%
Asia ex-Japan Equity Fund 30%
Japan Equity Fund 10%
TOTAL 100%
Source: Authors’ own recommendations
You can do the same with a combination of ETFs and index funds
that are available today. Table 11.3 shows a sample of such funds:
TABLE 11.3. SAMPLE OF ETFS AND INDEX FUNDS AVAILABLE IN SINGAPORE
Focus Index Tracked Example Fund
Global Funds
Global Equity MSCI World Index DBXT MS World
Regional Funds
U.S. Equity MSCI USA Index DBXT MS USA
European Equity MSCI Europe Index DBXT MS Europe
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136Focus Index Tracked Example Fund
Asia ex-Japan Equity
MSCI AC (All Country) Asia-Pacifi c Ex-Japan Index
Lyxor Asia
Japan Equity Tokyo Stock Price Index (TOPIX)
Lyxor Japan
Single-Country Funds
Singapore equity Straits Times Index STI ETF
Singapore bonds iBoxx ABF Singapore Bond Index
ABF SG Bond
Hong Kong equity
Hang Seng Index Lyxor Hang Seng
Korea equity MSCI Korea Index Lyxor Korea
China equity Hang Seng China Enterprises Index
Lyxor China
India equity MSCI India Index IS MSCI India
Sector Funds
Commodities RJ/CRB Index Lyxor Commodity
Gold Gold Spot Price SPDR Gold Shares
Technology DJ US Tech Sector Index IS DJ US Tech
Source: Authors’ own compilation
As indicated by Table 11.3, there’s enough out there for you to
create a globally diversifi ed portfolio as well as have some focused
investments in specifi c countries and sectors.
For example, if you had $10,000 to invest, you could build any one
of the following portfolios:
• Portfolio 1 — Put $10,000 all into one global stock ETF/index
fund for instant global diversifi cation.
• Portfolio 2 — Put $3,000 each into U.S., Europe and Asia ex-
Japan funds, and $1,000 into a Japan fund. Th is gives you instant
global diversifi cation, plus more control over the amount you
want in each region.
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137• Portfolio 3 — Put up to $2,000 into sector and single-country
funds, and the rest into a diversifi ed portfolio. Th is way you get
to have a long-term diversifi ed portfolio and are still be able to
have some fun and take more risk with more focused investments.
You may be wondering how come you don’t own such funds when
the cost of owning them is a lot lower. One reason is that you have
may not have been approached too persuasively to buy such funds.
ETFs do not earn fi nancial advisers any money and index funds are
less lucrative to sell compared with actively managed funds.
On the last point, lest you are fuming slightly, you must
understand that there is a cost to distribution. Th e bank and
fi nancial adviser who service and advise you need to earn their
keep too. Th ese investments work in the U.S. because the degree of
self investment there is higher — thanks to the much longer history
that U.S. investors have had with discount brokerages such as
Schwab and E*Trade. We in this region generally prefer to be helped
and advised.
Of course the other reason is, as we have mentioned, actively
managed funds in Singapore and the region do generally beat their
regional benchmarks.
In the end, you need to appreciate these diff erent dynamics
between a smaller market such as Singapore, and the U.S. market,
which is the largest in the world. ETFs and index funds will become
more important as the market expands, and you’ll have increasingly
more choices ahead.
Our advice is that if you are looking for a fund such as a Japan
fund, you need to challenge your fi nancial adviser by asking
whether an active or passive fund is better for you. And if your
interest is in the U.S. market, the question becomes even more
important because passive funds in the U.S. are the ones that
generally do better than active funds. Th ere are no straight answers,
of course, but it is important that you cover these angles when you
are buying.
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138
Investing in Real Estate
Once you own one home, as do most Singaporeans, the idea of
owning another home as an investment might pop into your head.
Whether you are looking at an investment property in Singapore,
Australia or Malaysia, pulling the trigger is something more and
more affl uent individuals are doing. In fact, according to the 2010
Merrill Lynch World Wealth Report, affl uent individuals have 18 per
cent of their investment portfolios in property.
Why is there such an age-old fascination with property? Th e most
obvious reason is that few things in life provide a greater sense of
security than having a roof over your head.
Th e second most attractive reason is that property prices rise over
the long term — as long as the underlying economy is growing.
Will Rogers once said, “Buy land. Th ey ain’t making any more of the
stuff .” How true especially if you live in Singapore. Look at Figure
FIGURE 12.1 PRIVATE RESIDENTIAL PROPERTY PRICES VERSUS GDP (1990 = 100)(
Source: “Residential Property Prices and National Income,” Economic Survey of Singapore, First Quarter 2001, pp 49
300
250
200
150
100
50
0
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REAL PPI
REAL GDP
1975 1978 1981 1984 1987 1990 1993 1996 1999
REAL PPIPIPI
REAL GDP
0
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13912.1,1 which shows a clear long-term correlation between property
prices and GDP from 1975 to 1999 (although there have been
periods of exuberance such as in 1981–84 and 1994–97).
Property costs hundreds of thousands of dollars and may be out
of the reach of some investors. Fortunately, buying directly into a
physical property isn’t the only way to invest. You can participate
in other ways including real estate investment trusts (REITs),
property funds and land banking. We start by looking at rental
properties.
INVESTING IN A RENTAL PROPERTYYou buy a property and rent it out to a tenant. As the landlord, you are
responsible for paying the mortgage, taxes and cost of maintaining
the property. Ideally, the rent paid to you will cover your monthly
expenses of that property. You can then sit tight till the mortgage
is paid off and you own the property exclusively, and then you can
enjoy the rent as profi t. Alternatively, you may sell the property when
its price has appreciated signifi cantly.
Th is all seems to make a rental property an ideal investment,
but landlords will tell you that there are always challenges. Unlike
a stock or a bond, a rental property requires you to devote time
to maintaining your investment. When the bath tub leaks or the
electricity gets cut in the middle of the night, it’s you who will get
the phone call.
You could also have trouble fi nding a tenant or end up with a bad
tenant who damages your property. You might receive poor rent
and have problems servicing your mortgage. It can get even worse
if the property’s valuation falls below your loan amount and you fall
into a negative equity position. Th at’s when the bank will demand
that you top up the diff erence.
1 http://app-stg.mti.gov.sg/data/article/21/doc/NWS_Property.pdf.
Also here: www.asiaone.com/print/Business/My%2BMoney/Property/Story/
A1Story20100426-212422.html
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140Some Strategies on a Recession-Proof Property InvestmentKnowing that property prices go hand in hand with economic growth,
how do you ensure that the price of your investment property does
not go south when the economic climate is rough?
Th ere are certain strategies you can employ to recession-
proof your investment. Since most homeowners will buy and sell
several times in their lives, you are likely to have a chance to use
these bulletproof principles the next time you buy. We will discuss
just two principles that we have found most critical in our own
experience.
Location, Location, Location You’ve probably heard it before, and it’s true: Location really matters.
Remember that homes are replaceable, but land is not. A mansion
in a poor location is a usually a worse off investment than a modest
apartment in a good location. If you’ve got a spot everyone wants,
your place will sell faster and for a better price than a similar house
elsewhere.
TABLE 12.1 GOOD PROPERTY LOCATIONS
City Good Property LocationsBangkok, Th ailand Sukhumvit, Lumpini, Silom
Hong Kong, China Happy Valley, Deep Water Bay, Mid-Levels
Jakarta, Indonesia Cilandak, Kebon Kacang, Pondok Indah
Kuala Lumpur, Malaysia Kenny Hills, Ampang, Bangsar
Singapore Bukit Timah, Orchard Road, Shenton Way
Sydney, Australia Chatswood, Rose Bay, Bondi
Tokyo, Japan Roppongi, Minato, Shibuya
Source: Authors’ own compilation
A location is considered good when it is close to good schools,
the central business district, the beach, popular shopping malls, the
airport and railway stations. A home in a remote, far away location
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141has far less potential for attractive price appreciation even when the
rest of the economy is doing well.
Holding Power
Can you hold on to your property even when prices are spiralling
downwards?
Property investment needs your long-term commitment and
holding power. If you have little savings in the bank, and servicing
your loan takes up most of your monthly income, you probably
have taken on a larger loan than you can manage. Th is means your
holding power is weak, and a sudden drop in home prices could
force you to liquidate your investment suddenly at a loss.
For instance, our friend Dawn bought a semi-detached home
in 1997 for $3.2 million. It was her sixth property. Every property
she had bought till then had produced huge profi ts. Th e bank was
happy to loan her more and more.
However, when property prices crashed, she found herself in a
negative equity position for most of her properties, and she had
to sell fi ve of her properties at fi re-sale prices. Th e semi-detached
home was sold for less than $2 million. She was left with one
property, her matrimonial home, and a debt of close to $5 million.
Home prices later recovered and it pained her to think, “if only I
could have hung on.” Th us consider your holding power before you
invest in property.
INVESTING IN REAL ESTATE INVESTMENT TRUSTS (REITS)If you have always wanted to own your favourite shopping centre
such as Tampines Mall or Junction 8, but you do not have $500
million in spare cash, do not fret. For as little as $1,000, you can
invest in a piece of commercial real estate to call your own.
When you invest in a Real Estate Investment Trust (REIT —
pronounced “reet”), a group of real estate professionals buys and
manages real estate on your behalf. REITs allow people to invest
in real estate without buying property directly. Th e properties
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142are then leased and rented out, and the income is passed on to
investors.
REITs mostly specialise and do not mix and match the types of
real estate they own. For example, some REITs may focus their
investments geographically (such as by country or city), or in
specifi c property types (such as shopping malls, industrial buildings
or residential apartments).
Th e fi rst Singapore REIT is Capital Mall Trust, which debuted in
July 2002. Over 20 REITs trade on SGX today. Table 12.2 shows a
sample of those REITs.
TABLE 12.2. REITS AND WHERE THEY ARE INVESTED
Name of REIT Invests Mainly In
AscendasIndT Commercial buildings in India
AscendasREIT Industrial parks
AscottREIT Service apartments in Asia
Cambridge Industrial buildings
CapitaComm Commercial buildings
CapitaMall Shopping malls
CapitaRChina Shopping malls in China
CDL HTrust Hotels
First REIT Healthcare real estate in Asia
Fortune REIT Shopping malls in Hong Kong
FrasersCT Shopping malls
K-REIT Commercial buildings
LippoMapletreeIndonesia Shopping malls in Indonesia
MapletreeLog Commercial buildings
Parkway Life Healthcare real estate in Asia-Pacifi c
Saizen REIT Residential real estate in Japan
SuntecREIT Shopping malls
Source: Authors’ own computations
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143Why Invest in REITs?Many investors turn to REITs as an alternative to savings and fi xed
deposit accounts. And why not? REITs off er two attractive benefi ts:
1. Liquidity
REITs are traded on stock exchanges and are liquid compared
with buying real estate directly. Try selling a house in a hurry
and you will fi nd that it’s not easy to liquidate.
2. High dividend yield
REITs typically off er two per cent above 10-year government
bond yields. So if 10-year government bond yields are three per
cent, REITs can be expected to yield fi ve per cent.
But REITs have risks too. In fact, you should take extra
precaution, especially in times when there are many dollars chasing
after REITs:
1. Management risk
Unit trusts invest in companies in which each company has a
diff erent management team. With REITs, it is just one
management team that makes decisions not only on buying and
selling, but also on managing and operating the REIT properties.
2. Interest rate risk
When interest rates rise, the income from REITs will become less
attractive relative to other investments. For example, government
bond yields will rise when interest rates rise. Th e situation
becomes worse if the economy is coming out of a low interest
rate environment, and the upside for interest rates is strong.
Capital values are likely to be vulnerable as well. Higher
interest rates mean that the cost of borrowing goes up and
REITs will suff er from larger interest payments on mortgages
and bonds.
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1443. Industry risk
While a REIT may be less risky than an investment in an
individual property, the fund has all the risks associated with
sector funds because of its exposure to real estate. Th eir values
will fall in an economic downturn while savings and fi xed
deposits are virtually immune to economic downturns.
4. Depreciation
Because of depreciation, the capital value of REIT properties
decreases over time. Th is is especially true for REITs that invest
in industrial property that sits on leasehold and not freehold
land. For example, if a landlord leases industrial land for 30
years at a time, the property is returned to the landlord when
the lease runs out.
S-REITs in Strong Position in AsiaTh e U.S. REIT market is the largest in the world with over 50 per cent
of total global market value. In Asia, the Singapore REIT (S-REIT)
market is the second largest after Japan. Th e future looks bright as
investors are attracted by the number of choices available today.
S-REITs are well diversifi ed with interests in retail, commercial,
industrial, hospitality and healthcare.
S-REITs are also well stocked with off shore assets as they have
interests in more than 10 countries, thus providing geographical
diversifi cation.
Managing REITs in Your PortfolioREITs behave like fi xed income securities and one can rely on REITs
for income. However, the capital value of REITs can rise and fall
along with cycles in the property market.
If you plan to keep a REIT for retirement, do a serious evaluation
of the property sector as a whole every three to fi ve years. Even if
dividend yields remain strong, the capital value of your investment
can go down. Remember that an investment in REITs is fi rst and
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145foremost an investment in real estate. And we all know how volatile
that is.
INVESTING IN PROPERTY FUNDSCompared with REITs, property funds are more diversifi ed in their
investments in terms of geography. As seen in Table 12.2. (page 142),
such funds are typically invested broadly across Asia, Europe or globally.
Th ese funds may invest in one or a combination of the following:
1. Funds that invest in REITs.
2. Funds that invest in investment companies (holding companies
that buy properties and receive rental income).
3. Funds that invest in property developers (companies engaged in
building and land development activity).
TABLE 12.3. EXAMPLES OF PROPERTY UNIT TRUSTS SOLD IN SINGAPORE
Name of Unit Trust Launch Date
Amundi Asian Real Estate Dividend Fund April 2005
DBS Global Property Securities Fund March 2005
First State Global Property Investment February 2005
Henderson Asia-Pacifi c Property Equities
Fund
March 2006
Henderson European Property Securities June 1999
Henderson Global Property Equity Fund March 2005
IOF-Asian Property Securities March 2008
United Global Real Estate Securities Fund March 2005
Source: Authors’ own compilation
If you would like to gain exposure to global and regional property
markets without having to buy physical property, such funds can
make a good addition to your portfolio.
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146INVESTING IN LAND BANKINGLand banking is the practice of purchasing raw land with the intent
to hold on to it until it is profi table to sell it. Th e intended increase in
value generally comes from the conversion of raw land to residential
or commercial use, or from the potential for extraction of natural
resources.
FIGURE 12.2. THE LAND BANKING PROCESS
Source: Authors’ own illustration
Important Trends to Consider
• Population Growth
• Economic Growth
• Government Policy
Land Acquisition
Conduct due diligence on
the area before acquisition.
Important Considerations
• Exit strategy
• Transparency
• Taxes
Land Exit
Land sold to developers
with concept plan already
approved by the authorities.
Important Considerations
• Zoning process
• Time horizon
• Growth requirements
Land Value Enhancement
Creating value by having
the concept plan approved
by the authorities.
Important Considerations
• Safety of investment
• Holding period
• Expected Returns
Land Syndication
Dividing the land in
smaller units and selling it
to investors collectively as
co-owners.
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147Th e most desirable parcels of land for land banking are those that
lie directly in the growth path of developing cities. Th e goal is to
identify such “virgin” parcels well in advance of developers and wait
for the value to be realised. Some of the best known land bankers
are people like Donald Trump and the Rockefellers in the US, Li-Ka
Shing in Hong Kong and the late Ng Teng Fong in Singapore.
Figure 12.2 shows an overview of the land banking process. One
important diff erence between Donald Trump and far less famous
investors like ourselves is that we are investing in undivided units of
land rather than whole big plots of land. Th rough land syndication,
big plots of land are chopped up into investible pieces for sale to
investors like yourselves.
Look Before You LeapInvestors like the concept of land banking as it is a tangible asset
as opposed to stocks and bonds. Based on the advertising that you
have probably seen, you might expect that this investment would
produce attractive returns with little risk. Of course, this is not
always the case.
In fact, land banking has been in the Singapore news recently
because of the failure of a land banking company to honour its
fi nancial obligations on a certain project. Does this mean we should
avoid land banking altogether or was the company’s failure a once-
off event?
Land banking is not regulated by the Monetary Authority of
Singapore (MAS). MoneySENSE, a national fi nancial literacy
program launched by the MAS, issued a consumer article on land
banking in June 2010.2 Th e article explains what land banking
is, highlights the key risks and important questions you should
consider before deciding whether to invest in land banking.
Th e key risks highlighted are:
2 See: www.moneysense.gov.sg/publications/quick_tips/Consumer_Portal_Land_
Banking.html
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148• It could turn out to be a scam.
• What if plans to develop the land are derailed?
• What if you need cash urgently?
• Foreign exchange risks.
Some key questions to ask yourself are:
• What do you know about the land you are purchasing?
• What do you know about the company you are dealing with?
• What do you know about the law of the country where you are
investing in?
As an added note of caution, if you were to perform an Internet
search on “land banking,” you would likely see a fair amount of
negative views on the investment.
Land Banking — Not All Bad NewsLand banking has been available in Singapore for over 15 years and
enjoys a good following amongst many investors. Th ere are many
land banking investors who have earned good double-digit returns
over the years.
Still, we’d like to leave you with more advice on its risks from
our experience with the product. We believe that if you heed more
advice than less, you too can become a successful land banking
investor.
A few more words of caution:
• Remember that there is no guarantee that a land banking
company will repeat its success even if it has had a proper track
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149 record of past performances and its projected returns on land
bank investment look promising.
• If you do invest in land banking, make sure that it is no more
than 5–10 per cent of your total investment portfolio.
• Some land banking fi rms may stress that all their projects
resulted in profi ts for their investors. In such cases, you might
like to check on the duration it took for the investors to exit.
Investors might have waited for a long time before the
development approval took place or the company may have
simply have bought back the project.
• Do your homework because most land banking projects are in
foreign countries and you need to be aware of the rules and laws
in those countries. Th is is not to be taken lightly as any legal dispute
is likely to adhere to the laws and regulations of that country.
• Profi ts are realised when the investors collectively exit from
the project upon approval of the development proposal which
was off ered. Investors should check with the land banking
fi rm on their plans should the proposal fail to get the expected
approvals.
CONCLUSIONInvesting in property is exciting and rewarding, although it can
be fraught with dangers from bubbles to recessions to scams.
Fortunately, there is one fact that always works in our favour: as long
as the underlying economy is growing (and it usually is), chances are
that your property investment will bring you bountiful rewards.
Once you decide that property would be a good addition to
your portfolio, you have many choices. You can invest in a rental
property, property unit trusts, REITs, a land banking project or
other choices you may come across.
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Socially Responsible Investing
Humanity is sitting on a ticking time bomb. If the vast majority of the
world’s scientists are right, we have just ten years to avert a major
catastrophe that could send our entire planet into a tail-spin of epic
destruction involving extreme weather, fl oods, droughts, epidemics and
killer heat waves beyond anything we have ever experienced.
~An introduction to the Oscar-winning documentary An Inconvenient
Truth by Al Gore (www.climatecrisis.net)
I don’t think any of you would want to retire a multimillionaire on a
planet where the air stinks with pollution, wars are going on across
continents, and the poor are not getting by with their most basic
food and medical needs. Is there another way?
Integrating your personal, social and environmental concerns
with your fi nancial considerations is called socially responsible
investing (SRI). SRI helps you meet your fi nancial goals while
ensuring that your investments have a positive impact on people
and the planet.
SRI describes an investment strategy that strives to maximise
both fi nancial returns and social good. Th is is also known as
having a “double bottom line”, because you are looking not only for
a profi table investment, but also for one that meets certain moral
criteria and lets you sleep well at night.
Th ere is a wide range of attitudes and values out there as SRI
investors screen companies and funds to check if they confl ict, or
are aligned with their beliefs. For instance, some will not invest in
those that pollute and damage the environment, use innocent mice
for research, or rely on cigarettes and alcohol to make a profi t.
Th ere are also investors who screen according to their religious
beliefs, such as Muslims who will not invest in the pork industry
and interest-bearing securities.
Various terms have been used to describe SRI. Some call it Ethical
13
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151Investing and Green Investing while others refer to the concept as
Environmental, Social and Governance (ESG) investing. Th ese
varying labels make it diffi cult to frame the market, but nevertheless
there are certain shared strategies that form the foundation of SRI.
HOW SRI CAME ABOUTSRI has been around for some time, and its beginnings can be
attributed to many people and places. Many believe social investing
began with the Quakers (a Christian religious denomination
founded in the seventeenth century) in the U.S. that in 1758 took
an offi cial stand against slavery. Religious institutions have been at
the forefront of social investing ever since.
Another early adopter of SRI was John Wesley (1703–1791), one
of the founders of the Methodist Church. A sermon of his, entitled
Th e Use of Money, outlined his principles on social investing that
included not harming your neighbour through your business
practices and avoiding industries such as chemical production that
could harm the health of workers.
Th e modern SRI movement probably began during the Vietnam
War. A photo in 1972 of a naked nine-year-old girl with her back
burning from napalm dropped on her village directed outrage
against Dow Chemical, the manufacturer of the napalm. Th is
prompted widespread protests across the U.S. against Dow
Chemical and other companies profi ting from the Vietnam War. In
the late 1970s, SRI activism turned its attention to nuclear power
and automobile emissions control.
Towards the end of the 1970s, an international outcry was raised
for South Africa to end apartheid, and some investors took their
money out of multinational companies that did business there.
Although economic sanctions against South Africa ended in 1993,
investors continued the practice by applying similar principles to
other companies.
Th e U.S. is the hotbed of SRI activity today. According to Th e
Social Investment Forum, a major national membership association
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152of social investment practitioners and institutions, SRI is growing
at a faster pace than the broader universe of all investment assets
under professional management. Roughly 11 per cent of assets
under professional management in the U.S. are now involved in
SRI. Between 2005 and 2007 alone, SRI assets increased more than
18 per cent while the broader universe of professionally managed
assets increased less than 3 per cent.
WHAT IS YOUR SRI PRIORITY?Before you put any money into SRI, decide what your socially-
oriented priorities are. Not all SRI investors agree on or have the
same priorities, and some issues are more popular than others. For
example, the top fi ve priorities of SRI investors are that they:
1. Reject companies that support the tobacco industry.
2. Reject companies that support the gambling industry.
3. Reject companies that support the alcohol industry.
4. Reject companies that support the defence industry.
5. Support companies that have a good environmental record.
On the lower-priority scale, SRI investors:
1. Support companies that demand human rights practices.
2. Support companies that support labour issues.
3. Support companies with a stance on abortion or birth control.
4. Support companies with a stance on animal rights.
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153Th ere are several approaches you can take to apply your second
bottom line, most of which relate to how strict you are about a
company’s “purity”. For example, how far along the supply chain
would you hold companies accountable? If the company you invest
in sells instant noodles to a casino, would you still invest in it, or
does the company have to be actively participating in the off ending
activity for you to screen it out?
Or you could take another more moderate approach and include
companies under certain conditions. One condition could be that
the company is the best in its industry for taking the most steps
to cut down on pollution, even though it still pollutes. As with
establishing your social issues, the standards to which you hold
companies are also completely up to you.
FINDING SRI OPPORTUNITIESHow do you go about fi nding appropriate SRI investments after
you’ve narrowed down your social priorities?
Th ere really are just two main strategies to consider —
exclusionary or inclusionary.
Exclusionary StrategyIn an exclusionary strategy, you create a list of companies that you
won’t invest in and exclude them from your portfolio. Th e only
thing you need to do with this style of investing is compile a list of
companies you want to avoid. Th is can be very time consuming and
expensive as you have to analyse whole groups of choices to fi nd the
social duds to avoid.
Exclusionary SRI can also become a slippery slope, where you
end up excluding an ever-growing number of companies from your
portfolio. For example, hotel chains are innocent enough, but they
sell alcohol in their cafés and many allow smoking in their rooms. If
you expand SRI investing too far, you could end up excluding large
segments of the economy.
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154When it comes down to the bottom line, few investors may be
willing to throw out traditional investment logic by sacrifi cing
investment opportunities in exchange for the satisfaction of doing
the right thing and sleeping well at night.
Inclusionary StrategyInclusionary investing, also called activist investing, is a more
proactive style. It involves either selectively investing in companies
that share your core beliefs, or purposely investing in companies that
violate them so you can become a shareholder and vote to change
company policy.
By investing in companies that meet your desired ethical values,
you are supporting their eff orts by increasing their stock price. A
good example is green tech companies that are working to provide
alternative energy sources, or fi rms that treat their workers well.
By investing in companies engaging in undesirable practices,
you establish yourself as a shareholder to which the company
management must answer. Th erefore, through activist investing, you
can use your shareholder rights to vote proxies in line with your goals
and attend shareholder meetings to propose appropriate changes.
It is impossible to have a completely “clean” company in the sense
that fi nding a company of any size that is 100 per cent in compliance
with every social and moral guideline all the time is unrealistic.
Nevertheless, the screening process is an honest attempt to fi nd the
truth and pick the best of the lot.
SACRIFICING PERFORMANCE FOR SOCIAL GOOD?As an investor, you cannot be completely philanthropic and expect
nothing in return for your investment other than that pure feeling of
having invested in a company that refl ects your own values.
How do you know if trusting your hard-earned dollars to a tree-
hugger or rainforest conservationist, no matter how earnest and
well intentioned, will actually do something positive for your net
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155worth? Th e reality is that there are no guarantees that your money
will even come back to you, let alone add to your net worth.
SRI advocates argue that screening helps eliminate companies
that have risks not generally recognised by traditional fi nancial
analysis. Critics take the stance that any approach that reduces
the universe of potential investments, will result in a sacrifi ce
in performance. No doubt the debate will continue, but there
are several reasons to be confi dent that investing in a socially
responsible manner does not equate to giving money away.
Here are some statistics to make you feel more at ease. Th e
record of the Domini 400 Social Index (DSI) is an indication that
socially responsible investors do not have to assume a sacrifi ce in
performance for sticking to their values. Created in 1990, the DSI
was the fi rst benchmark for equity portfolios subject to multiple
social screens. Th e DSI is modelled on the S&P 500 and has
outperformed that unscreened index on an annualised basis since
its inception.
Th e next question is, how does the performance of socially
responsible funds measure up to that of a regular portfolio?
Professor of Finance Meir Statman1 of Santa Clara University
reviewed 31 socially screened mutual funds and found that they
outperformed their unscreened peers, but not by a statistically
signifi cant margin. Th e bottom line appears to be that SRI funds do
not behave all that diff erently from regular funds and that investing
in a SRI fund does not negatively aff ect your returns compared with
choosing a conventional index fund.
INVESTING IN VICEIf investing in virtue off ers the possibility of superior returns,
should you focus on SRI and avoid “irresponsible” investments
altogether? In 2002, the Vice Fund was launched in the U.S. to
1“Socially Responsible Mutual Funds”, May/June 2000 issue of the Financial
Analysts Journal.
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156invest in companies that have signifi cant involvement in industries
such as tobacco, gaming, weapons and liquor. According to Daniel
Gross, a columnist for Newsweek who has been following the vice
versus virtue divide, both are eff ective investing strategies and have
handily beaten the S&P 500.2
Is it that investing in vice or virtue is a better investing discipline
than looking at P/E ratios, discounted cash fl ow and charts? Perhaps.
Th e folks managing such funds have clearly been good stock pickers.
As investors ourselves, we can safely say that SRI is a viable
investment strategy, and it’s not just fl uff and apple pie.
INVESTING IN SRIOnce you have established your second bottom line or social
priority, you have two main options: (a) invest in unit trusts or (b)
pick individual companies yourself.
Investing in unit trusts is a good way to begin as it is not easy
to screen companies on your own. Although there aren’t many SRI
funds in Singapore and those available don’t quite span the breadth
of SRI, there are more than a handful of attractive choices. We can
also look internationally for choices and to the future as well when
more choices become available in Singapore as it becomes a bigger
magnet for SRI.
Here are three funds you may consider:
1. Th e DWS Global Climate Change Fund by Deutsche Bank
invests mainly in companies that are active in energy-effi cient
technologies, renewable and alternative energies, and climate
protection. Between 35 and 40 per cent of its portfolio is
invested in the U.S. alone.
2. Th e DBS Mendaki Global Fund launched in September 1997
is one of the oldest SRI funds in Singapore. Th e fund invests in
2www.slate.com/id/2123644/
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157 listed equities anywhere in the world that harmonise with
Islamic philosophy and law.
3. Fortis L Green Future invests primarily in the shares of
companies whose technologies, products and services bring
solutions to environmental problems.
If you are a more active investor, do look at the individual
company investments that SRI unit trusts make. Th e DBS Mendaki
Global Fund, for example, has Apple Computer, BHP Billiton,
Hyfl ux and Keppel Corp among its top holdings (June 2010). If
these companies are already top performers in your books, then
you would be satisfying both your social and fi nancial bottom lines.
POPULAR SRI THEMESLet’s now turn our attention to some of the most popular themes
around today that you have probably been hearing about, such
as corporate social responsibility, green investing, biofuels, solar
energy, water and Islamic fi nance.
Corporate Social ResponsibilityCSR generally applies to company eff orts that go beyond what may
be required by regulators and involve incurring short-term costs
that do not provide immediate fi nancial benefi t to the company, but
instead promote positive social and environmental change.
Companies have a lot of power in the community and in the
economy. Th ey control a lot of assets, and may have billions of
dollars at their disposal for socially conscious investments and
programmes. Even smaller companies with a dozen staff can make
signifi cant contributions to the community in addition to expanding
their corporate bottom lines.
Many of America’s largest companies that had previously been
labelled polluters have adopted eco-friendly ways. Hewlett Packard
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158reports on its website that after 20 years, it has reached its long-
term goal of recycling one billion pounds of computer hardware
and supplies in 2007.
Singapore has its own CSR society called Th e Singapore
Compact. It is a non-profi t organisation whose membership
includes some of Singapore’s largest companies as well as SMEs
(small-medium enterprises). Th e Singapore Compact promotes
the idea that “Companies with positive CSR experiences that have
the support and respect of their stakeholders are more likely to
work better and be sustainable in the long run.” In October 2007,
it congratulated 26 winners of the “Inaugural CSR Recognition
Award for Good Corporate Citizens”.
Green Investing Th ere isn't a huge diff erence between SRI and green investing.
Green investing is actually a form of SRI and both terms refer to
investment philosophies that are backed by ethical guidelines. Th e
biggest diff erence is that green investing focuses on what’s good for
the environment.
Cleantech, or clean technology investing seeks to invest in
environmentally friendly technologies and includes six types of
industries: energy, water and waste water, advanced materials, energy
effi ciency and manufacturing, transportation, and agriculture.
Islamic FinanceLike green investing, Islamic fi nance is a subset of SRI. Islamic
fi nance is based on Islamic principles and jurisprudence (or
Shariah). Th e heart of Islamic fi nance lies in two defi ning principles:
Th e prohibition of riba (interest) and the sharing of profi t and loss.
Th ese principles help to ensure that funds are being channelled into
real business activities as opposed to speculative activities. Islamic
law also prohibits any participation in weapons, pork, gambling,
pornography and alcohol businesses.
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159It used to be that overcoming these prohibitions was very diffi cult
in the conventional fi nance system. Yet as the Islamic fi nance
industry progresses, many Islamic fi nancial institutions have
developed a vast range of products designed to serve the growing
market. Th ese products cater for housing and consumer fi nance,
business loans and project funding. Furthermore, these products are
increasingly providing both Shariah compliance and good returns.
Singaporeans have good access to Islamic fi nance products and
information. Th ere are over a dozen conferences on Islamic fi nance
in Singapore every year today. Singapore is a full member of the
Islamic Financial Services Board (IFSB), which was set up in 2002
to formulate international regulatory and prudential standards for
Islamic fi nance.
Singapore already has a well-developed capital markets
framework to allow our institutions to leverage its conventional
expertise to structure Shariah-compliant versions of their products
and services.
Looking at our neighbours, we have even more positive hope
that Islamic fi nance will reach mainstream channels. Malaysia is
one the world’s leaders in Islamic fi nance and of Islamic fi nance
education, all the way to PhD qualifi cations. And to the south,
Indonesia has the largest Muslim population in the world, who are
themselves actively growing their expertise and market in Islamic
fi nance.
KEEP A LEVEL HEAD BEFORE YOU INVESTIt is easy to let the green movement dictate your pocket book because
wanting good returns and promoting social good at the same time
is an ideal situation for any investor. Yet it is wise to maintain a
level head:
1. Get informed — Learn about socially responsible investing,
which funds qualify and where you can buy them.
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1602. Know your values — Everybody’s values are diff erent. Some
may feel strongly about environmental causes while others are
more concerned with social programmes. Rank your priorities.
3. Go beyond your values — Research the fundamentals and see
if you really feel comfortable. Ask tough questions — are some
of the green investments out there destroying the environment
that they are supposed to protect?
4. Diversify — Th ink of SRI as a focused investment that, together
with your other alternative investments, should occupy no
more than 20 per cent of your retirement portfolio.
Socially responsible investing suggests that you don’t have to
compromise your values to make money. If you approach socially
responsible investments like any other investment, you may be able
to put your money into something that both supports your values
and lines your pocketbook.
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Not so according to commodities guru Jim Rogers, a former
partner of George Soros, who says that commodity bull cycles have
historically lasted between 15 and 23 years, and predicted that “the
current bull market will probably last until 2020.”
Investing in Commodities
We are in the midst of the biggest commodities boom in three
decades. Look at how the prices on this commodities index chart are
going through the roof. You can see and feel the commodities boom all
around — record prices reached on oil, rice, copper, platinum.
With such a sharp and swift rise in prices, the obvious question
is, “Is the bull run over?”
FIGURE 14.1. THE COMMODITIES BULL RUN AS SEEN THROUGH THE
THOMSON REUTERS/JEFFERIES CRB INDEX
500
450
400
350
300
250
200
150
100
50
0
19
94
19
96
19
99
20
00
20
02
20
04
20
06
20
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20
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162WHY ARE COMMODITIES BOOMING?Many reasons. Let us cite three major ones.
The China EffectTh e China eff ect is real. Not only are there 1.3 billion people to
feed, but China has been growing at 9–10 per cent every year for
over 25 years and they now have a huge middle class of 100 million
people clamouring for all sorts of goods and services. Management
consulting fi rm McKinsey & Company expects 700 million Chinese
to have joined the consumer class by 2020.1 It’s not a revolution, it’s
a tidal wave.
Th ey are today the biggest users of mobile phones with 400
million subscribers. Th at’s only 30 per cent of the population. Th ink
of the growth ahead. Galanz, a Chinese company, is the largest
microwave oven maker in the world. It estimates that there are 200
million ovens in Chinese homes today and it is their dream to put
a microwave in every kitchen across China, just as Bill Gates had a
vision to put a computer on every desk and in every home.
China’s boom is also a refl ection of the Asian boom in general.
Forbes reported that the number of billionaires in Asia jumped
more than 30 per cent in 2007. In 2010, Forbes reported that a total
of 64 people from the China made the list of the world’s richest
billionaires, moving up to take second place behind the U.S. A lot of
the fortunes in Asia have been made in real estate and infrastructure
development. Global Property Guide reports that real estate price
increases in Asia-Pacifi c should continue to impress in the coming
years, while E.U. prices have moderated and the U.S. is mired in a
housing crisis.
Tight SuppliesTh ere are tight supplies across many commodity markets. Take oil
for example. Th ere have been no major oil discoveries in the last 40
1http://www.csmonitor.com/2007/0102/p01s02-woap.html
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163years according to Jim Rogers, while the reserves in Alaska, Mexico
and the North Sea continue to decline. Of the six top countries in the
world with the largest oil reserves, fi ve are in the Middle East, and
politically volatile Iran and Iraq are at numbers three and four, where
supply jolts can happen anytime and threaten production.
In 2006, the U.S. consumed more than twice as much oil as
did China, and we know that the gap can only decrease as China
becomes wealthier and more industrialised.
The Falling US$Th e falling U.S. dollar, combined with tight supplies across many
commodity markets, has fuelled the big run up in commodity prices.
If the dollar is falling, commodity prices have to go up just to keep
relative values the same. Th at’s because many non-U.S. commodity
producers still price their exports in dollars, and a weaker dollar
prompts them to seek higher prices.
Th e interest rate cuts by the Federal Reserve have also helped
push commodity prices higher. On the one hand, the cuts make a
recession less likely as companies would continue to borrow to fund
growth, thus bolstering demand for commodities. On the other
hand, the cuts have also further encouraged currency investors to
sell off dollars in the search for higher yield.
Well, enough of these present day trends for now. In the end, we
have to treat commodities as commodities whether the market is
going up or down. What we need to do is fi nd out if commodities
make a good addition to a long-term portfolio. So let’s get back to
some of the basics behind commodities.
WHAT IS A COMMODITY?A commodity is a basic, undiff erentiated good such as sugar or oil.
Whether a pound of sugar comes from a producer in the Philippines
or another producer in Brazil makes no diff erence in terms of
quality. A pound of sugar from anywhere in the world is pretty much
the same product, regardless of the producer. Th ey are generally
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164real assets with intrinsic value because they are consumed on a
regular basis.
Commodities are also often used as inputs in the production of
other goods or services. For example, sand, which Singapore buys
a lot of, is a major component of concrete, glass production, brick
manufacturing, landscaping and land reclamation.
Is a Mona Lisa painting a commodity? Not the original painting
by Leonardo da Vinci for sure. Th e reason is that the Mona Lisa is
unique and diff erentiated from all other paintings. Th e iPod whose
quality and features can be clearly diff erentiated from other MP3
products is also not a commodity.
Today’s Commodity MarketsTh ere are around 100 main commodities that are frequently traded
and they are generally classifi ed into three main groups:
A. Energy
B. Metals
• Base Metals
• Precious Metals
C. Agriculture
• Grains
• Softs
• Livestock
Energy encompasses a basketful of products used to provide
energy to heat and power homes and businesses. Th e most common
are petroleum and its byproducts: crude oil, heating oil, propane,
natural gas and coal.
Base metals refer to industrial non-ferrous metals, excluding
precious metals. Th ese include copper, aluminium, lead, nickel,
tin and zinc. Note: Ferrous metals contain iron while non-ferrous
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165metals do not. Ferrous metals are usually magnetic and rust.
Precious metals are rare and have high economic value. Th ey
include gold, silver, platinum and palladium. Chemically, they are
less reactive than most elements, have high lustre, are softer and
have higher melting points than other metals. Historically, precious
metals were important as currency, but are now regarded mainly as
investment and industrial commodities.
Grains or cereal crops are mostly grasses cultivated for their
edible grains or fruit seeds. Maize, wheat and rice account for
85 per cent of all grain production worldwide. Other grains that are
important in some places have little global production and do not
show up on exchanges. Th ese include durum (used to make pasta)
and wild rice.
Softs is a label for a set of commodities, usually including cocoa,
sugar, and coff ee, but also including cotton and orange juice.
Livestock refers to animals used for meat production, and
includes live cattle, pork bellies and lean hogs.
Non-Traditional CommoditiesMore recently, the defi nition of commodities has expanded to
include fi nancial products such as foreign currencies and indices.
Technological advances have also led to new types of commodities
such as carbon credits, weather and bandwidth.
THE TRADING OF COMMODITIES Th e trading of commodities is done mainly at commodity exchanges.
A commodity exchange is an entity, usually an incorporated non-
profi t set-up, that determines and enforces rules and procedures
for trading. It also refers to the physical centre where trading
takes place.
Th ree of the world’s top exchanges are:
1. New York Mercantile Exchange (NYMEX) —Founded in 1872,
NYMEX is the world’s largest physical commodity futures
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166 exchange for energy and precious metals. Th e prices quoted
for transactions on the exchange are the basis for prices that
people pay for physical commodities throughout the world.
2. Chicago Board of Trade (CBOT) — Established in 1848,
CBOT is the world’s oldest commodity exchange for trading
in futures and options. CBOT trades more than 50 diff erent
futures and options in agricultural commodities, fi nancial
derivatives based on U.S. Government bonds and notes,
mortgage-backed certifi cates, and more recently, South
American Ethanol futures.
3. Th e London Metal Exchange (LME) — Founded in 1877, LME
is the world’s largest market in cash and futures for non-ferrous
metals, including aluminium, copper, nickel, tin, zinc and lead.
COMMODITY INDICESCommodity indices provide investors with a reliable and publicly
available benchmark for investment performance in the commodity
markets, just as what the S&P 500 or MSCI Singapore indices do
for their respective markets. Several unit trusts and ETFs are
benchmarked against these indices.
Four of the most quoted commodity indices are:
1. Th e Dow Jones-UBS Commodity Indexes (DJ UBSCI) is
composed of futures contracts on physical commodities.
Nineteen commodities are included in the index representing
the following commodity sectors: energy, precious metals,
industrial metals, livestock and agriculture. Th e represented
commodities are traded on U.S. exchanges, with the exception
of three, which trade on the London Metal Exchange (LME).
None are based in Asia, which means that the index does not
include rice, a staple of a large percentage of the world’s
population.
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1672.Th e Reuters/Jeff eries CRB Index (TRJ/CRB) was launched
in 1957. Th e components of this index were, until 2005, equally
weighted. Th is resulted, for better or worse, in orange juice
having the same weight as crude oil. With the makeover,
component weights are assigned and rebalanced monthly. For
example, crude oil has a fi xed weighting of 23 per cent. If its
weight rises to 30 per cent because crude oil prices have gone
up relatively more than other commodities, the weight is
rebalanced back to 23 per cent.
3. Th e S&P GSCI Commodity Index (S&P GSCI) was created
in 1992 and is made up of 24 commodity components from
all commodity sectors: six energy products, fi ve industrial
metals, eight agricultural products, three livestock products and
two precious metals. Th is broad range of constituent
commodities provides the S&P GSCI with a high level of
diversifi cation, both across sub-sectors and within each sub-
sector. Th e goal of the GSCI is to measure commodities in a
way that refl ects their current importance in the global
economy. More weight is automatically allocated to
commodities that have risen in price.
4. Th e Rogers International Commodities Index (RICI) RICI
is the most diversifi ed commodities index available and tracks
35 commodities. Jim Rogers created the index in 1999 and
the index is weighted according to what he considers to be
each commodity’s importance to the global economy. Th e
index includes commodities that do not appear in other indices
such as: rice, rubber and lumber.
BUYING AND SELLING COMMODITIESSpot TradingBuying and selling commodities can be done on the spot through
“spot trading” where delivery takes place within a few business days.
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168Spot trading is not the main way in which commodities are bought
and sold. If you consider the fact that commodities are almost always
bought in large quantities, few buyers would want to take the risk
of accepting whatever the spot price is at the time of purchase, and
immediate delivery.
Futures TradingInstead, most commodities are traded on futures exchanges such as
NYMEX and CBOT. Th e prices of commodities are effi ciently and
transparently discovered through the participation of thousands of
buyers and sellers. Here are a sample of commodity contracts, where
they are traded and how they are quoted.
Not all contracts around the world are traded in US$ of course.
We are only showing you contracts traded on the main exchanges
we discussed earlier. At the Tokyo Grain Exchange, for example,
corn is traded in Yen while it is traded in US$ on CBOT.
TABLE 14.1. EXAMPLES OF COMMODITY CONTRACTS
Commodity Exchange Quote
Energy
Light Crude NYMEX US$ per barrel
Heating Oil NYMEX US$ per gallon
Natural Gas NYMEX US$ per mmBtu
Unleaded Gas NYMEX US$ per gallon
Metals
Gold COMEX US$ per troy oz
Silver COMEX US$ per troy oz
Platinum NYMEX US$ per troy oz
Copper LME US$ per tonne
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169
Trading StrategiesTh ose who participate in futures markets usually have two main
trading strategies. One may speculate by taking a position such as
buying a gold futures contract in the hope that gold would rise in
price.
Or one may hedge to mitigate the risk of a natural position in the
commodity. For example, a farmer can insure against a poor wheat
harvest by purchasing wheat futures contracts. If the wheat crop is
signifi cantly less due to bad weather, the farmer makes up for that
loss with a profi t in the futures contract, since the overall supply of
the crop is short everywhere that suff ered the same conditions.
For most investors, trading directly in commodities has a high
level of risk not only because of the volatility of commodity prices,
but also because it requires sophisticated skills and dedicated time
to follow a market that’s dominated by large commodity houses and
fi nancial institutions.
Commodity Index FundsFor investors looking to diversify their portfolios without wanting
to trade directly, commodity funds are a good choice. Some funds
specifi cally track commodity indices:
Commodity Exchange Quote
Agriculture
Lean Hogs CME US cents per lb
Pork Bellies CME US cents per lb
Live Cattle CME US cents per lb
Feeder Cattle CME US cents per lb
Corn CBOT US cents per bushel
Soybeans CBOT US cents per bushel
Source: Authors’ own compilation
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170• Th e Lyxor ETF Commodities CRB, which is available in
Singapore, tracks the RJ/CRB index. Th is exchange-traded fund
began trading on SGX in January 2007.
Commodity Unit TrustsIn Singapore, there are about a dozen unit trusts available for retail
investors. Th ese unit trusts are managed by fund management
companies such as ABN AMRO, Deutsche Bank, Schroder, First
State, Prudential, Lion Capital and UOB.
Th ese unit trusts generally invest broadly across the major
categories of commodities or they focus on specifi c sectors of the
commodities market, such as gold, energy and agriculture.
Commodity StocksFinally, the investor can buy stocks that are linked directly to
commodities such as palm oil, iron ore and energy. Singapore-
listed Wilmar is the world’s largest processor and merchandiser of
palm oil, and also the largest palm biodiesel manufacturer in the
world. Australian company BHP Billiton is one of the world’s largest
diversifi ed producer of diamonds, coal, iron ore, aluminium, oil and
natural gas.
COMMODITIES AS PART OF YOUR LONG-TERM PORTFOLIOTh ere’s no doubt in our minds that an investment in commodities
makes sense for our bottom line for several reasons:
1. Infl ation hedge potential — Commodities has recognised value
all over the world, and this value does not depend on any
nation’s economy or currency. Over time, most commodities
have held their values against infl ation very well because
anticipated trends in infl ation are priced into them. Th e
Consumer Price Index in Singapore, which is the key indicator
of retail infl ation, has been rising along with price increases in
rice, bus fares, petrol and food at food courts.
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1712. Participation in global growth — Demand for commodities
keeps growing in industrialising and emerging markets
such as China, India and the Middle East. As these regions
grow economically, so will their demand for commodities
sourced from all over the world.
3. Portfolio diversifi cation — Commodities have been found to
have a low correlation to stocks and bonds. In fact, commodities
tend to do well when stocks and bonds are down. According to
one U.S. study that looked at the correlation between
commodities and various asset classes, it was found that each
asset class had a negative correlation with commodities during
the period 1970 to 2003.2 Th is means that commodities are a
good addition to a portfolio as they reduce overall volatility.
Two words of caution though. Commodities are highly volatile,
even more so than stocks. If you cannot stomach huge, sudden
losses, commodities should never occupy a large portion of your
retirement portfolio.
Our last word of caution is that commodities are subject to long
up and down cycles. We are no doubt in the midst of a strong up
cycle. As an investor in commodities, you cannot just buy, hold and
sit back. You have to be more active in your monitoring. Just as up
cycles can last 20 years, down cycles have been known to last just
as long.
2Th e asset compared with commodities were U.S. stocks, international stocks, U.S.
government bonds, U.S. Treasury bills and small-cap companies. “Commodities as
an Asset Class”, www.investorsolutions.com.
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172
Investing in Gold
Th inking to get at once all the gold the goose could give, he killed it and
opened it only to fi nd — nothing.
~Aesop (620 b.c. – 560 b.c.), Th e Goose with the Golden Eggs
Man’s fascination with gold is timeless. Gold is beautiful and scarce.
It does not rust or tarnish. It is easily shaped and easily divisible.
Gold will always have a value.
Over the years, gold has been recognised and accepted by almost
everybody as an ideal medium of exchange and store of value.
Th e reasons for investing in gold have remained much the same
throughout history. Gold is a safe haven in times of economic and
fi nancial instability. It is a proven asset-diversifi er that, when included
in a portfolio, reduces the portfolio’s overall risk. Gold is also an
excellent hedge against infl ation over the long term. And gold is one
of the few assets that are negatively correlated with the U.S. dollar.
Besides being a highly reliable store of value, gold is widely used
as jewellery and coinage, and in industries.
Like other precious metals, gold is measured by troy weight
and by grams and when it is alloyed with other metals, the term
carat is used to indicate the amount of gold present, with 24 carats
being pure gold. Th e purity of a gold bar can also be expressed as a
decimal fi gure, known as the millesimal fi neness, such as 0.995.
Th e price of gold is determined on the open market, but a
procedure known as Gold Fixing in London, originating in 1919,
provides a twice-daily benchmark fi gure for the industry.
Gold prices have been on a bull run. Prices rose to over US$900
in April 2008 from average prices of below US$40 in the early 1970s
(see Figure 15.1.). Why have gold prices suddenly shot up in the last
three decades? To answer this and other questions, we begin with a
short history of gold.
15
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173
A SHORT HISTORY OF GOLDEgyptian hieroglyphs dating from 2600 b.c. have described gold as
being “common as dust.” Gold is mentioned several times in the Old
Testament. Exploitation is said to date from the time of Midas, and
this gold was important in the establishment of what is probably the
world’s earliest coinage in Lydia in 700 b.c.
Gold has thus long been considered one of the most precious
metals, and its value was used as the standard for many currencies
(known as the gold standard) in history. Th e gold standard is
defi ned as “a commitment by participating countries to fi x the
prices of their domestic currencies in terms of a specifi ed amount
of gold.” Money and near-money (bank deposits and notes) were
freely converted into gold at a fi xed price. A country under the
gold standard would set a price for gold, say $100 an ounce, and
would buy and sell gold at that price. Th is eff ectively sets a value
for the currency; in our example $1 would be worth 1/100th of
FIGURE 15.1. GOLD PRICE SINCE THE EARLY ‘70S
GOLD PRICE, $ PER OUNCE (LONDON PM FIX)
Jan 71 Jan 74 Jan 77 Jan 80 Jan 83 Jan 85 Jan 89 Jan 92 Jan 95 Jan 98 Jan 01 Jan 04 Jan 07 Jan 100
100
200
300
400
500
600
700
800
900
1000
1100
1200
1300
1400
Source: Global InsightSource: Global Insight
Source: Courtesy of World Gold Council, www.gold.org
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174an ounce of gold. Other precious metals could be used to set a
monetary standard; silver standards were common in the 1800s. A
combination of the gold and silver standard, known as bimetallism,
also existed.
During most of the 1800s, the U.S. had a bimetallic system of
money. A true gold standard came about in 1900 with the passage
of the Gold Standard Act. Th e gold standard eff ectively came to an
end in 1933 when President Th eodore Roosevelt outlawed private
gold ownership (except for the purposes of jewellery). Th e Bretton
Woods System, enacted in 1946, created a system of fi xed exchange
rates that allowed governments to sell their gold to the United
States treasury at the price of US$35 per ounce.
Th e Bretton Woods System ended on 15 August 1971, when
President Richard Nixon ended the trading of gold at the fi xed price
of US$35 per ounce. At that point, for the fi rst time in history, formal
links between the major world currencies and real commodities were
severed. Th e gold standard has not been used in any major economy
since that time. Almost every country, including the United States, is
on a system of fi at money, which is money that is intrinsically useless
and is used only as a medium of exchange.
THE CONTINUING IMPORTANCE OF GOLDGiven that gold no longer backs the U.S. dollar and other major
worldwide currencies, why is it still important today? Th e reason is
that while gold is no longer in the forefront of everyday transactions,
it is still important in the global economy. Central banks and other
fi nancial organisations hold approximately one-fi fth of the world’s
supply of above-ground gold. In addition, several central banks have
focused their eff orts on adding to their present gold reserves as their
currency reserves soar.
Compared with paper money, gold has successfully preserved
wealth throughout thousands of generations. Th e same cannot be
said about paper-denominated currencies because the value of a
dollar is constantly being eroded by infl ation. And when investors
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175realise that their money is losing value, especially when infl ation is
rising, they will start positioning their investments in a hard asset
that has traditionally maintained its value. Th e 1970s testify to this
as gold prices largely rose as a result of soaring infl ation.
Demand and SupplyTh e supply of gold is fairly constant from year to year although
production has been slowing down slightly during the past few years.
Source: www.goldsheetlinks.com
TABLE 15.1. WORLD’S TOP FIVE GOLD PRODUCERS
Year 1 2 3 4 5
1995 S Africa USA Australia Canada China
2000 S Africa USA Australia China Canada
2005 S Africa Australia USA China Peru
2006 S Africa USA Australia China Peru
2007 China S Africa USA Australia Indonesia
2008 China USA S Africa Australia Peru
Source: www.goldsheetlinks.com
ME
TR
IC T
ON
S
FIGURE 15.2. WORLD ANNUAL GOLD OUTPUT
1995 2000 2005 2006 2007
2444
2356
2518
2252
2008
2600
2500
2400
2300
2200
2100
2000
2469
2573
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176One reason for the drop in world output is South Africa’s falling
production in the past few years. As Table 15.1 shows, South Africa
was the top producer year after year for over 100 years till 2007 when
China overtook South Africa to become the world’s top producer.
Most of China’s gold output stays in the country where it’s
transformed into jewellery and industrial items. Along with China’s
demand, which makes it the largest consumer in the world, India is
the world’s number one importer as its increasingly wealthy middle
and upper classes continue to buy and adorn gold.
Gold’s role as a safe haven is indisputable as investors typically
run to it during times of political and economic uncertainty —
especially today amidst the subprime crisis, the falling U.S. dollar,
Middle East tensions and rising infl ation. During such times,
investors in the past who held on to gold were able to protect their
wealth successfully, and, in some cases, even use gold to escape
from the turmoil. Consequently, whenever there are news events
that hint at some type of uncertainty, investors will often buy gold
as a safe haven.
Th e cost to mine gold varies from US$150 to $400 per troy ounce,
with South African mines at the higher end (10,000 feet or more)
and Canadian mines at the lower end (1,000 feet or so). Added to
the high cost of mining are the hundreds of millions of dollars and
amount of time (three to fi ve years) it takes to start a new mine.
All these above factors help ensure that supply is unlikely to
increase any more than 1 to 2 per cent each year and that demand is
very likely to expand because of economic uncertainty and the rising
wealth in gold-hungry countries such as China and India.
HOW TO INVEST IN GOLDInvestors who wish to invest in gold can do so in fi ve ways:
1. Gold bullion bars and coins,
2. Gold certifi cates,
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1773. Gold mining shares,
4. Gold unit trusts and ETFs, and
5. Gold derivatives.
Prices for all these investment options are available daily from
banks and brokerages.
Gold Bullion Bars and Coins You can buy physical gold bars in a variety of weights ranging from
1 gram to the popular kilobar (32.15 troy ounces) to the international
“London Good Delivery” bar (400 troy ounces). Gold coins are
legal tender in the country of issuance and their gold content
is guaranteed.
Th e bullion coin bears a face value that is largely symbolic. Its
true value depends on its gold content and its numismatic value (or
collector’s value). An example is the Singapore Lion Gold Bullion
Coin, which ranges from one to 1/20 ounce.
One disadvantage of buying physical is that you’ll have to pay
GST, which is currently 7 per cent.
Gold CertificatesIf you do not want to hold gold physically, especially if you have a
large investment, you can invest in gold certifi cates, usually of one
kilobar each, up to a maximum of 30 kilobars. Th ere is no GST on
certifi cates. Th e gold is kept in the bank’s vault.
Th ese certifi cates can easily be exchanged for physical gold or
cash. However, the bank charges an annual administrative fee of
typically $30 per kilobar per annum, and $5 for each certifi cate.
Gold Savings Account You can buy and sell gold through a passbook at prevailing market
prices. UOB introduced the fi rst gold savings account in Singapore
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178in 1981. Gold savings accounts allow those who want to trade
frequently to buy and sell in 1g lots.
Gold Mining Shares Some investors may be comfortable accessing the gold market by
buying stock in gold mining fi rms. Th e capital appreciation potential
of a gold share is dependent not only on the future price of gold, but
also on the future prospects of the company, based on its management
and operating strengths. Where these companies make the most is
exploration, but that is also where one fi nds the highest risk.
Some of the most established gold mining companies in the world
are found on the NYSE. Denver-based Newmont Mining is one of the
world’s largest companies producing eight million ounces annually,
with a diversifi ed number of mines in several parts of the world,
including Nevada, South America, Australia, Russia and Indonesia.
Gold Unit Trusts and ETFsWith gold unit trusts, investors are buying general industry and
market risk instead of company-specifi c risk. Funds diversify their
holdings among dozens of companies. Th e United Gold and General
Fund is one such fund in Singapore. Th e United fund was launched
in 1995 and is globally diversifi ed across the industry. Not the entire
portfolio is in gold as about one-third of the fund is typically in base
metals (such as iron ore and copper) and about two-thirds are in
gold and precious metals.
Another way to invest in gold is through the SPDR Gold Shares
ETF listed on the Singapore Exchange, where your ETF shares
can be bought and sold at any time. Th e ETF is benchmarked to
spot gold, which means that it is as good as buying physical gold,
minus the fund’s expenses, and the transaction cost involved is
lower than the cost of buying and safekeeping physical gold.
Gold DerivativesGold futures and options are traded on established exchanges
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179around the world. At COMEX (New York Commodity Exchange,
the leading U.S. exchange for metals futures and options trading),
for example, each gold futures contract is for 100 troy ounces of
not less than .995 fi neness, and bears a serial number and the
identifying stamp of a refi ner approved and listed by the Exchange.
A similar contract is available through SGX-DT, but trading is not
very active.
THE RISK OF GOLD INVESTINGAs a tangible investment, gold is often held as part of a portfolio
because over the long term, gold has an extensive history of
maintaining its value. Still, gold, like all investments, involve risk.
Gold prices have historically seen strong fl uctuations that saw it hit
a 20-year low in 1999.
One reason for fl uctuating prices is that the value of a bullion coin
or a gold unit trust is directly aff ected by the current spot or market
price of bullion. Th is price fl uctuates daily and can be aff ected by a
multitude of factors, such as the perceived scarcity of gold, current
demand, market sentiment and economic factors. Th erefore, the
price of your gold investment can go down as well as up in value.
Second, like all prices, the gold price refl ects not only the
inherent value of gold, but also the relative strength of the currency
in which it is quoted. For example, the dollar price of gold may
increase more in percentage terms than the sterling price, to the
extent that the change in price is a refl ection of dollar weakness
(in this case, against the sterling), rather than an intrinsic change
in gold market fundamentals. So if you purchase a gold investment
in U.S. dollars and the U.S. dollar has increased 20 per cent by the
time you sell it 12 months later, your investment would have fallen
in value by 20 per cent — regardless of any change in gold market
fundamentals.
Th e strength of the U.S. dollar in the two decades between 1980
and 2000 was an important reason for gold prices not performing
well during those years. It was in part the rapid rise in the dollar
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180that hurt the dollar gold price. Another reason for gold’s poor
performance between 1980 and 2000 was the success of the world’s
central bankers in fi ghting infl ation. Gold’s role as a hedge against
infl ation is one of the main reasons people buy it.
MANAGING GOLD IN YOUR PORTFOLIODespite the volatility of gold prices and its sensitivity to fundamental
factors, the diversifi cation benefi ts of gold in a portfolio are backed
by strong evidence. Ibbotson Associates, a leading authority on
asset allocation, performed a study with respect to the portfolio
diversifi cation benefi ts of gold, silver and platinum bullion,
covering a 33-year period from February 1971 to December 2004.
Ibbotson determined that of the seven types of assets covered
in the study, the precious metals asset class is the only one with
a negative correlation to other asset classes. What this means is
that precious metals perform best during the years that traditional
asset classes, such as stocks and bonds, had negative returns.
Ibbotson determined that investors can potentially improve their
portfolio risk-reward performance by including precious metals
with allocations of between 7.1 and 15.7 per cent for conservative
to aggressive portfolios respectively.
Historically, gold has produced excellent long-term gains during
up cycles; however, it may not be suitable for everyone. You should
acquire a good understanding of gold products before you invest
in them. Since all investments, including gold, can decline in value,
you should have adequate cash reserves and disposable income
before considering a precious metals investment.
In the end, speculating in gold should be avoided at all cost by
conservative investors. Speculating involves short-term trading
and the early withdrawal from accounts or securities can result in
substantial penalties or fees — in addition to any decrease in gold
prices due to fundamental factors.
MYMWFY (3rd Edition) 4 Jan.indd 180 1/25/11 8:14:15 AM
Investing in Hedge Funds
How would you like to invest in a fund that makes money in a bear
market as well as in a bull market? Hedge funds aim to do just that, and
as consistently as possible, regardless of market conditions. What’s
more, hedge funds can be very good for your portfolio. Th ey can
reduce overall risk and quite often, they can also increase returns.
Look at Figure 16.1 (below), which compares three major indices.
While the S&P 500 and Dow Jones World Index went on major
roller coaster rides between Dec 1993 and Dec 2000, the Credit
Suisse Hedge Fund Index (indicated by the arrow) chugged along
very smoothly throughout the 17-year period. Compared with both
indexes, the hedge fund index was not only less volatile, but it also
provided higher returns, at lower risk.
FIGURE 16.1. COMPARING PERFORMANCE OF THE S&P 500, DOW JONES
WORLD INDEX AND CREDIT SUISSE HEDGE FUND INDEX
Th is is the stellar reputation of hedge funds that many of you
may have heard about. In this chapter, we will help you examine
whether hedge funds are right for you, and how they can fi t into
your portfolio.
Copyright 2010, Credit Suisse Hedge Index LLC. All rights reservedC ii htght 20201010 CC didit St S ii H dH dg I dI d LLCLLC AAllll iightht dd
350%
300%
250%
200%
150%
100%
50%
0%
-50%
12
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182WHAT ARE HEDGE FUNDS?To most investors, hedge funds are shrouded in mystery. When
considering if a fund is a hedge fund, MAS looks at whether:
• Non-traditional investment strategies such as leverage, short
selling and arbitrage are used; or
• Investments are in non-mainstream asset classes, that is,
investments other than listed equities, bonds and cash.
Leverage Leverage is used to increase risk. It refers to the degree to which the
fund is using borrowed money to invest. If a fund is leveraged 100
per cent, it means that it has borrowed $1 for every $1 that it actually
has. Profi ts as well as losses are magnifi ed 100 per cent as a result.
Short Selling Th is is an aggressive strategy of sell-high, buy-low rather than the
traditional strategy used by unit trusts of buy-low, sell-high (called
a long strategy).
Short selling has unlimited risk. Here is an example that will
help you understand how short selling works. Suppose you enter a
contract to deliver a Toyota you do not own for $50,000. In other
words, you are short-selling the Toyota. What you hope will happen
is that Toyota prices will drop and you can buy a Toyota for a lower
price of say, $40,000, and deliver the car to make a $10,000 profi t.
However, what happens if the price of the car goes up instead?
Technically, prices could go up to $60,000, or $80,000 or beyond.
You see, price, in theory has no ceiling, and that is why short selling
is an unlimited risk strategy.
Arbitrage Hedge funds use arbitrage to exploit mispricings between related
securities. For example, one can take a long position in Company
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183A’s convertible bonds and short its stock. An example would help.
Suppose Sri Lankan crabs are selling at $50 a kilogramme at the Pasir
Panjang Wholesale Centre. Over at the Telok Blangah wet market,
the crabs are going for $80 a kilogramme. If you are able to buy crabs
from Pasir Panjang and sell them at Telok Blangah, you would have,
in essence, made a profi t by exploiting a mispricing situation.
Th is suggests that hedge funds are not for everyone. A retail investor
who is just starting out to invest, or a retiree wishing to protect her
income, should not be placing money in hedge funds. Th ese funds
employ aggressive strategies and are exempt from many of the rules
and regulations governing unit trusts. Individuals who buy hedge
funds are usually deemed “sophisticated” and they usually have to
pay high minimum investment amounts.
In the U.S., an investment fund can be exempt from direct
regulation if it is open to accredited investors only, and only
a limited number of investors can belong to it. Because of an
exemption from the types of regulation that apply to mutual
funds, hedge funds can invest in more complex and more risky
investments than a retail fund might.
HEDGE FUND STRATEGIESA wide range of investment styles and strategies are available to
hedge funds. Table 16.1 lists some of the most popular.
What makes hedge funds diff erent is their diversity. Th e variety
of hedge fund strategies far exceeds anything off ered by traditional
unit trusts.
TABLE 16.1. POPULAR HEDGE FUND STRATEGIES
Strategy Objective
Convertible ArbitrageExploit price ineffi ciencies between convertible securities and stock.
Dedicated Short BiasEquity and derivatives portfolios with net short, “bearish” focus.
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184
Classifying Hedge FundsSome funds employ only one strategy; others may use several. Some
funds are more speculative and comb the world for opportunities;
others are less risky and off er protection for your invested capital.
We can hence classify hedge funds in a broader way:
1. Single strategy funds,
2. Fund of funds, or multi-strategy, and
3. Capital guaranteed and protected hedge funds.
Single Strategy Funds
If a hedge fund adopts one main strategy, it is called a single strategy
Strategy Objective
Emerging MarketsEquity and fi xed-income investments in emerging markets worldwide.
Equity Market-NeutralOff setting long and short equity positions that are beta-neutral, currency neutral, or both.
Event DrivenCorporate strategies focused on distressed securities, high-yield debt, and risk arbitrage.
Fixed-Income ArbitrageExploiting price ineffi ciencies between related debt securities.
Global Macro Directional macroeconomic strategies.
Long-Short EquityDirectional equity and equity derivative strategies.
Managed FuturesListed futures strategies often driven by technical or market analysis.
Multi Strategy Multiple strategies.
Source: www.hedgeindex.com
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185hedge fund. Single strategy funds clearly come with higher risk
because if the strategy fails, the entire fund loses money.
Fund of funds
A fund of funds invests in other hedge funds as a means of
diversifying strategies and managers. Th e risk for such funds is
generally lower than that of single strategy funds. For these funds
to succeed, the manager’s ability to choose good funds is more
important than his ability to execute any single strategy.
Fund of funds do have some disadvantages. For one, investors
have to pay two layers of fees — one for the individual funds and
another for the fund of funds manager.
Guaranteed Hedge Funds
Th ese funds work like their retail cousins. Th ey invest a high
proportion of their assets (say 70 per cent) in bonds that mature
to provide 100 per cent of the capital guarantee and the rest of the
money (30 per cent) is invested in other hedge funds, derivatives and
other speculative securities to provide the upside kicker in returns.
Guaranteed hedge funds have a fi xed maturity of typically fi ve
to 10 years. If you invest in one of these funds, be prepared to stay
the course. Asking for your money back after two years will cost
you in terms of likely capital losses and redemption fees.
Th ey diff er from retail guaranteed funds in two ways. Th e
bonds invested in tend to be higher-yielding and are often not of
investment-grade quality. While retail funds may have 90 per cent
in bonds, guaranteed hedge funds may have 80 per cent or less
because of higher yields.
Th e second diff erence is that guaranteed hedge funds tend to
make use of leverage. For example, a guaranteed hedge fund that
has borrowed 40 per cent can be invested at 140 per cent of its
capital: 80 per cent into bonds and 60 per cent into derivatives.
Retail guaranteed funds in comparison would only have the
remaining 20 per cent to invest in derivatives.
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186Should You Invest in Hedge Funds?Investors are drawn to hedge funds for many reasons, but are
hedge funds right for you? Your decision should take into account
these factors:
1. Diversifi cation
At the most basic level, hedge funds can be thought of as just
another investment alternative, as are bond funds and REITs.
For investors with the means and appetite, hedge funds can
certainly help diversify a portfolio.1
Th ose strongly in favour of hedge funds often cite statistics
that show hedge funds not only reduce portfolio risk, but also
increase portfolio returns because of spectacular performance.
Th ose who are fearful about hedge funds cite fudged statistics
and underhand tactics.
2. Th e best talents are drawn to hedge funds
Th e compensation of hedge fund managers is mostly tied to
the fund’s performance. Th is attracts the best talents. Also,
hedge fund managers themselves are usually one of the key
investors in the fund. Th ese are two very strong incentives for
fund managers to perform. Unit trust managers, on the other
hand, make money whether the fund goes up or down in price.
Investing in Hedge Funds in SingaporeInvestors can choose between domestic hedge funds and off shore
hedge funds. Domestic hedge funds are organised within Singapore.
Investors are protected by Singapore regulations.
MAS has set guidelines for the minimum subscription amounts
for hedge funds:
1Th e CSFB/Tremont Hedge Fund Index has a 0.47 correlation with the MSCI
World Index. Source: www.hedgeindex.com.
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187• Single strategy funds — $100,000
• Fund of funds —$20,000
• Capital protected and capital guaranteed funds — no minimum
subscription where certain criteria are met
MAS in April 2010 announced that new regulations will require
hedge-fund fi rms in Singapore that manage more than S$250
million to be licensed. Hedge-fund fi rms were previously exempt
from holding a license provided they manage funds on behalf of
no more than 30 qualifi ed investors.2 Th ose that manage less than
S$250 million would not need a license although they will have to
maintain a base capital of at least S$250,000.
Off shore hedge funds are structured under foreign law and are
available only for accredited investors and not for retail investors.
Since such funds are managed outside Singapore, they are regulated
under foreign laws. While this does not mean no recourse for the
investor should fraud or scandals occur, it does make things a lot
more diffi cult for investors should something go wrong.
DIFFERENCES BETWEEN HEDGE FUNDS AND UNIT TRUSTSIn considering whether hedge funds are right for you, there are a few
important diff erences between them and unit trusts that you should
be aware of (see summary in Table 16.2. on page 168):
1. Absolute performance
Unit trusts are mainly measured on relative performance based
on a relevant benchmark such as the S&P 500 index. Hedge
2A “qualifi ed investor” is an accredited investor, or a fund whose underlying investors
are all “accredited investors”. An accredited investor is defi ned under the Securities
and Futures Act as one earning at least $300,000 for the last 12 months or one
who owns at least $2 million in net assets, or her aggregate consideration for the
acquisition is not less than $200,000 for each transaction. An accredited investor may
also be a corporation with net assets exceeding $10 million in value.
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188 funds on the other hand are expected to deliver absolute returns
— they attempt to make profi ts in diff erent market conditions,
even when the relative indices are down.
2. Hedging risk in a downturn
Hedge funds can protect against declining markets by using
hedging strategies such as shorting. Unit trusts are not able to
protect portfolios eff ectively against declining markets.
3. Performance-based remuneration
Hedge fund managers are rewarded with performance-related
incentive fees as well as fi xed fees. Unit trust managers are
generally rewarded based on the size of the assets under their
management.
HOW MUCH DO TOP HEDGE FUND MANAGERS MAKE?
Hedge fund managers can make a scary amount of money.
John Paulson, founder of New York based Paulson & Co,
was paid an estimated US$3.7 billion in 2007, according to
Institutional Investor’s Alpha magazine.
Th e average compensation for the top 25 fund managers
was US$892 million in 2007. Th e “poorest” fund manager in
the top 50 made US$210 million.
TABLE 16.2. SUMMARY OF DIFFERENCES BETWEEN HEDGE FUNDS AND
UNIT TRUSTS
Unit Trust Hedge Funds
Performance measurement Relative Absolute
Asset classes permittedCash, bonds and stocks
Unrestricted
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189Unit Trust Hedge Funds
Regulations Highly regulated Less regulated
Investment strategy Buy and sell only Unrestricted
Performance fee Usually none Very likely
Liquidity (ability to sell easily) Daily Usually monthly
Target investors Retail High-net-worth
Expenses ratio Lower Higher
Leverage Prohibited Allowed
BE CAREFUL WHEN YOU INVEST IN HEDGE FUNDSTh e assets under management of a hedge fund can run into many
billions of dollars, and this is usually magnifi ed by leverage. Th eir
infl uence over the markets and even entire economies, whether they
succeed or fail, can be substantial and there is an ongoing debate
about how much they should be regulated or unregulated.
When hedge funds fall, they fall hard and often take others along
with them. Take the collapse of the U.S. hedge fund Long-Term
Capital Management (LTCM) in 1998 for example. LTCM made a
huge and wrong bet on interest rates in the form of Russian debt
and caused the U.S. Federal Reserve to step in to negotiate a US$3.6
billion bailout plan.
Investors should also be wary of potentially infl ated returns.
According to a study by Burton Malkiel, a Princeton University
professor, hedge fund returns are infl ated because failed funds that
have been liquidated are often not included in key fund indices.
Th is “survivor bias” means that dead funds such as LTCM are not
refl ected in the major indices. Th e study estimates that fund results
are overestimated by an average of 3.74 per cent.
For these and other reasons, investing in hedge fund can be tricky
and here are a few guidelines you should follow to protect yourself:
Source: Authors' own compilation
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190• Remind yourself that although the rewards can be tremendous,
you take on substantial risk when you invest in hedge funds.
Your due diligence and monitoring must be top-notch. Never
place a major portion of your investment funds into hedge
funds. Up to 20 per cent is about right.
• When examining hedge fund returns using an index, make sure
the index includes dead funds. If the index includes dead funds,
subtract 3.74 per cent (based on Professor Malkiel’s study) from
the illustrated returns to compensate for any potential infl ation
of returns.
• Look for funds with at least 10 years of return information. Do
not trust slick brochures that show only recent performance.
• Seek a knowledgeable fi nancial adviser to give you advice. Ask
your adviser how he is compensated by the hedge fund
managers he is recommending.
MANAGING HEDGE FUNDS IN YOUR PORTFOLIOIf you want to invest in a hedge fund for retirement, look for lesser-
risk fund of funds and capital guaranteed funds. Avoid single strategy
funds. Make sure that hedge funds comprise no more than 20 per
cent of your overall portfolio.
If you wish to enhance risk in your overall portfolio, any type of
hedge fund will do. We recommend you consider single strategy
funds only if your total invested assets equal $500,000 or more
(since one single strategy fund priced at $100,000 amounts to
20 per cent of a $500,000 portfolio).
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Investing in Art and Collectibles
We hear more and more these days about art and collectibles
being auctioned for hundreds of thousands of dollars, or someone
discovering that grandma’s stamp collection in the storeroom is
worth a fortune.
Whether you have a passion for Coca Cola bottles, vintage
cars or Picasso paintings, you do need specialized knowledge to
determine the value of a specifi c collectible. It is easy to pay too
much for a collectible if you do not have the needed experience and
knowledge.
Unlike a stock exchange where thousands of buyers and sellers
congregate electronically to provide the latest transacted prices, the
collectibles market is informal, is illiquid (not easily convertible to
cash) and has high transaction costs. Th ere is no updated price list
or regulatory authority to ensure that transactions are carried out
in an orderly way. Many collectibles are bought and sold in auctions
in which the prices for similar items can vary widely.
Ultimately, when a collectible (even for something as seemingly
mundane as a toy or a comic book) is highly desirable, splurging
is not uncommon. Hello Kitty celebrated its 35th anniversary in
2009 with a limited edition platinum doll that sold for around USD
170,000 each. Th e fi rst issues of Superman and Batman have sold
for over USD 1 million each in 2010.
In this chapter, we look at the glamorous pursuit of collecting
paintings followed by some sensible rules on buying and selling
collectibles.
PAINTINGS — GOING, GOING, GONEExpensive paintings seem to always take the spotlight when compared
with other collectibles. It is understandable if you look at the highest
prices paid at auctions (see Table 17.1. on page 192):
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192TABLE 17.1 LIST OF 10 HIGHEST PRICES PAID AT AUCTIONS1
Painting Artist Year Painted
Year of Sale
Original price (in millions)
Adjusted price (in millions)
No. 5, 1948 Jackson Pollock
1948 2006 $140 $151.2
Woman III Willem de Kooning
1953 2006 $137.5 $148.5
Portrait of Adele Bloch-Bauer I
Gustav Klimt
1907 2006 $135 $144.8
Portrait of Dr. Gachet
Vincent van Gogh
1890 1990 $82.5 $139.0
Bal du moulin de la Galette
Pierre-Auguste Renoir
1876 1990 $78.1 $131.6
Garçon à la pipe
Pablo Picasso
1905 2004 $104.2 $119.9
Nude, Green Leaves and Bust
Pablo Picasso
1932 2010 $106.5 $106.5
Portrait of Joseph Roulin
Vincent van Gogh
1889 1989 $58 plus exchange of works
$101.3
Dora Maar au Chat
Pablo Picasso
1941 2006 $95.2 $102.3
Irises Vincent van Gogh
1889 1987 $53.9 $101.6
1 Th is list, which is adapted from Wikipedia, is infl ation-adjusted in US dollars. A
list in another currency may be in a slightly diff erent order due to exchange rate
diff erences. Paintings are only listed once, for the highest price sold.
Irises by Vincent van Gogh is tenth in the list valued at an
astonishing USD 101.6 million. To give you an idea how prices
have risen the last few years, consider that just fi ve years ago,
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193the “cheapest” painting on the top-10 list was just a little over
USD 50 million. Prices of the top-10 paintings have doubled in the
last fi ve years.
Table 17.1 is a list of the highest prices paid for paintings. Very
valuable paintings, if sold, are usually not sold at auctions. Most of
the world’s most famous paintings are owned by museums, which
very rarely sell them. As such, they are quite literally priceless. If
a painting like the Mona Lisa were to become available, it would
almost certainly sell for much more than any of the paintings listed.
Long ago in 1962, the painting was already assessed at US$100
million.
IF YOU CANNOT OWN ONE, STEAL ONESome art thieves may have been inspired by Pierce Brosnan in the
movie Th e Th omas Crown Aff air where he orchestrates an elaborate
New York museum heist to steal a Monet painting. Although
Brosnan’s character does it for the thrill of it, most art thefts are
performed for monetary gain.
Which is the most expensive art theft in history? According
to the Art Loss Register, a fi rm that maintains the world’s largest
database of stolen and missing art, that may be the 1911 theft of the
Mona Lisa.
A more recent and embarrassing theft occurred in May 2010
when fi ve paintings were stolen from the Paris Museum of Modern
Art. Th e stolen pieces included ones by Henri Matisse and Picasso.
It was embarrassing because it was a one-man heist. Dressed in
black and wearing a mask, the thief merely cut a padlock on the
gate, smashed a window to get inside and then carried off a stunning
haul worth hundreds of millions of euros. While the thief ’s image
was captured on CCTV, the museum’s security system had failed
terribly as the break-in triggered no alarm. Th e guards were alerted
only when they noticed the smashed window.
While this may make art robbery seem like a good career
choice for some people, art thieves rarely make big money off
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194their crimes. Th at’s because the stolen pieces of art are easily
recognisable, and diffi cult to offl oad at their actual value on the
open market.
ART AND COLLECTIBLES CAN BE RISKY INVESTMENTSUnlike an investment in stocks, an investment in collectibles cannot
be measured by time. In fact, the variables that govern price can be
very unpredictable and volatile. One factor that can drive up the
value of art is the artist. General interest caused by an exhibition,
conference, the publishing of a book, or even the production of
a major fi lm (as in the case of Mexican painter Frida Kahlo and
Amedeo Modigliani who was a struggling rival of Picasso), will
bring with it a new wave of people wanting to know more about
the particular artist and the necessary demand can cause a hike in
price.
It’s often said that if the artist is alive, her new fame might allow
the artist to become more prolifi c by satisfying the demand while
keeping the price at the same level. But when an artist dies, there is
a tendency to see a sharp increase in price for works of her creation
due to the publicity generated by the death of the artist, as well as
what we might call the close of her artistic production.
In the months immediately following Andy Warhol’s death, a
frenzy developed for anything Warhol. Even his personal property
was bid into the stratosphere at the famed 1987 Sotheby’s auction
where his vintage cookie jars sold for thousands of dollars. But
this posthumous popularity is not always the case. Some artists
have a huge following only during their lifetimes because of their
big personalities. Th e paintings of Pascal Cucaro, a colorful San
Francisco artist for example, sold for around US$50,000 while he
was at his peak in the 1950s. Today, those same paintings may sell
for no more than US$1,000.2
2 www.artbusiness.com
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195What we often do not hear is that collectibles are risky
investments and may be diffi cult and expensive to liquidate.
Investing in arts and collectibles is rife with risk and, for most
investors, doesn’t off er the returns aff orded in the equities or
traditional markets. Th e value of art rises and falls sharply with the
economy and what’s considered valuable to one collector could be
worth far less on the open market. If growth is an investor’s sole
motivation, she will likely do much better investing in stocks or
bonds than buying paintings, phone cards or antiques. Here are
three other challenges investors may encounter:
1. Low price transparency — Buying securities usually occur at
fair market value in large market places. But when buying a
piece of art, it is much more diffi cult to confi rm that a fair
price is being paid.
2. Security — Investors are responsible for the safekeeping
of the collectible. If the piece gets damaged or lost, its value is
compromised.
3. Liquidity — Securities can be sold much more easily than
art and collectibles because securities are traded more readily
on organized networks and exchanges.
MAKING SENSIBLE INVESTMENTS IN ART AND COLLECTIBLES Most authorities agree that we should buy art and collectibles
primarily because we like them. Th eir profi t potential should be a
secondary consideration. Here are a few sensible strategies to bear
in mind when investing:
1. Buy from reputable dealers — Find a reputable dealer who has
been in the business for many years, long enough to know
about quality, market trends and pricing practices in the type
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196 of art and collectibles to be collected or invested. Th e dealer
should also provide a written appraisal or certifi cate attesting
to the quality and authenticity of the item.
2. Buy quality — Like buying homes in good locations, buying
top-quality items while expensive, provide price protection
even in poorer market times.
3. Maintain the item — provide appropriate environmental
conditions and regular maintenance as well as insure the item
adequately.
4. Limit the amount invested — Avoid putting more than 10 to 15
per cent of an investment portfolio into art and collectibles.
Collecting things is a very satisfying pastime when you are
passionate about the things you collect. But collecting for the sake
of profi t is seldom a productive activity unless you have pockets
deep enough to invest in the rarest collectibles. So for many people,
the collectibles they acquire may never provide much profi t at all or
are likely to decrease in value over time.
Between ourselves, we collect coins, stamps, photos and books.
Some cost us a few thousand dollars while most cost just a couple
of dollars. In the end, we subscribe to what television producer
Norman Lear said, “Life is made up of small pleasures. Happiness
is made up of those tiny successes. Th e big ones come too
infrequently. And if you don’t collect all these tiny successes, the big
ones don’t really mean anything.”
Happy collecting!
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197
Understanding Basic Derivatives
Over 92 per cent of the world’s largest 500 companies use
derivatives to manage their corporate risk, according to a survey
by the International Swaps and Derivatives Association (ISDA) in
2003. Th e percentage is probably even higher today. Derivatives are
widely used today and this is why it is important that you have a
good understanding of them and how each of the main derivative
products diff ers.
If you’ve ever owned a capital guaranteed product or just a unit
trust, chances are that you too own or have owned derivative
instruments although you may have done so indirectly. Th at’s
because guaranteed products have a sizeable portion of their
structure made up of derivatives, and unit trusts use derivatives to
manage risks such as currency fl uctuations.
Th ese days there are many new products that just a few years
ago didn’t exist — such as protected funds, contracts for diff erence
(CFD), currency-linked notes and call warrants. Why has there
been such an increase in the use of derivatives and structured
products by both companies and individuals? You guessed it. It’s all
about risk and return.
WHY DERIVATIVES ARE EVER SO IMPORTANT FOR YOU TO KNOW TODAYThe markets are very volatile these days. You saw in Chapter 8
how the STI tripled in value from 800 to 2500 in the 16 months
between August 1998 and December 1999, then lost half its value
in the next 21 months. You saw in Chapter 15 how gold went
from US$270 in 2001 to over US$1,200 per ounce in 2010. You’ve
seen the subprime crisis bring about shocking losses for many of
the world’s largest banks, some of which have lost tens of billions
of dollars. Now imagine you are two years from retirement and
you have a portfolio of Singapore stocks worth $300,000 that you
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198plan to use for travelling and cruises. Bad economic news and a
likely recession then destroy over 50 per cent of your portfolio’s
value.
Volatility can bring about returns that can be very good for your
portfolio — or very bad. Th e problem is that you’ll never know for
sure which direction the market is headed.
In this chapter, we will to bring you through some of the most
common derivatives and structured products around today so
you’ll know that there are many more options available for you to
consider when managing your portfolio. We will go over some of
the foundation topics on derivatives that we covered in Chapter
2, but we will do so at a very conceptual level. We will not look
too much under the hood of these very technically demanding
instruments. Our advice is that you should leave those daunting
details to your fi nancial adviser and just focus on how these
instruments may be important for your fi nancial future.
IT ALL STARTED WITH FORWARDS 5,000 YEARS AGOIf you had lived 5,000 years ago in Sumeria, which was situated in
modern day Iraq and western Iran, you might have had the honour
of participating in one of the fi rst derivative transactions known to
mankind called a forward. Let’s suppose that you did.
Suppose it is June and you are a goat farmer hoping to sell one
of your goats in three months’ time in September. While goats are
selling at 100 gold coins today, and you would be happy with that
price, your goat is not quite mature yet. You have what is called a
natural position — you own a goat — which exposes you to risk
because the price of goats could fall sharply by September.
Now suppose there is also a shish kebab maker who wants to
buy a goat for a village feast taking place in September. Like you,
he doesn’t mind the price of a goat at 100 gold coins today, but he
doesn’t want to look after a goat for three months. Like you, he is
also exposed to price risk, but on the opposite side. He is worried
that the price of goats will rise in three months’ time.
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199What you and the shish kebab seller can do is to have a forward
agreement with these terms:
I, goat farmer, agree to sell one of my goats to shish kebab maker
for 100 gold coins in three months’ time.
I, shish kebab maker, agree to buy a goat from goat farmer for
100 gold coins in three months’ time.
In three months’ time, if the market price of goats rises to 140
gold pieces, you are obligated by the contract to sell the goat for
100 gold coins. You would, of course, be upset for letting the goat
go so cheaply at 100 gold coins when you could have sold it at 140
if you had not gone into the forward contract. But then, the market
price of goats could just as easily have fallen to 50 gold pieces, in
which case you would be happy because the shish kebab maker is
obligated to buy it from you for 100 gold coins.
Th e point of the forward contract is that you and the shish kebab
maker are able to lock in a price three months ahead of time. By
doing so, both of you have removed your price risk. As you have
seen, removing your price risk also removes any chance of taking
advantage of price movements that would have been in your favour
had you not agreed to lock in a price.
Forward contracts have three key features:
1. Th ey can be customised since it is usually between one buyer
and one seller, a special type of goat, a specifi c weight or colour
can be specifi ed.
2. Both buyer and seller are obligated to buy and sell at the
specifi ed price.
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2003. Forward contracts are traded over-the-counter (OTC) rather
than on a formal exchange such as SGX.
Th ese features of forward contracts do point to some
challenges. Because forward contracts are agreements between
two parties, counterparty risk can be high. If the market price
of goats rises to 200 gold coins, the goat farmer may decide to
scupper the agreement in order to sell it in the marketplace for
200 gold coins. Second, it is hard to guarantee the quality of the
goat. It may arrive with a disease or one leg missing. And third,
what if either the buyer or seller decides to get out of the contract
for legitimate reasons? For example, the designated goat dies one
month before delivery.
FUTURES CONTRACTS Futures markets began as a response to some of these challenges
experienced with forward contracts. In a futures market, there
are thousands of buyers and thousands of sellers who converge
their interests into one marketplace (see Figure 18.1). As a result,
the trading of futures contracts is diff erent from that of forward
contracts in the following ways:
Th ousands
of Buyers
Th ousands
of SellersClearing House
FIGURE 18.1. A FUTURES EXCHANGE
Source: Authors’ own illustration
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201Futures contracts have standardised terms to facilitate trading. A
corn futures contract would have specifi c details of contract size,
origin of the corn, delivery times and acceptable moisture quality.
Forward contracts do not have standardised terms and that is why
they are diffi cult to get out of as it requires another buyer or seller
who is willing to accept customised terms.
Second, a clearing house sits between the buyers and the sellers.
Th e role of the clearing house is to guarantee the trades that come
through. If a buyer puts in a buy order and it is accepted, the
clearing house guarantees that the order will be fi lled. Th is gets rid
of counterparty risk, which is the risk that accepted orders are not
fi lled for one reason or another.
Like a forward contract, a futures contract obligates the buyer
and seller to buy and sell. However, one diff erence is that because
the contract terms are standardized and the exchange is open to
thousands of buyers and sellers, it is very easy for someone to get
out of a position before the contract matures. In fact, over 95 per
cent of all futures contracts are “unravelled” in this manner.
Futures in Your PortfolioWe often hear about the high risk nature of derivatives (especially
futures). China Aviation Oil in 2004 ran up US$550 million in losses
from oil futures. Nick Leeson’s trading of Japanese futures made
his employer Barings Bank bankrupt in 1995 with losses of US$1.4
billion. But this occurred when futures were used for speculating
with huge bets on the direction of the market.
When used for hedging an existing physical position, they do a
wonderful job of reducing, not increasing, risk. Take the case of the
shish kebab maker who hedged against price rising in the future by
agreeing to a price today.
Now suppose you have $300,000 invested in ten Singapore
stocks that you have held for many years. It is January, and you are
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202concerned about a market decline over the next two months. You
do not wish to liquidate your portfolio but you don’t want to suff er
losses either should the market decline.
What you can do is sell2 a number of STI futures contract so
that if the market does fall, your profi ts from your futures position
would off set your losses from your actual portfolio. (Note that the
operational details of trading futures can be easily obtained from
www.sgx.com and from other exchanges, and we are not focusing
on those details here. What we are focusing on is the important
concept that you can hedge (or protect your portfolio) with the use
of futures.)
Let us return to our example. Th e March STI futures contract is
trading at 3,000 points. With a multiplier of $10 per point, the price
of one March contract is:
Price per contract = 3,000 X $10
= $30,000
To protect the portfolio against a market decline, the number of
futures contracts to sell is:
Number of contracts = $300,000 / $30,000
= 10 contracts
By hedging, you have greatly reduced or even eliminated the
possibility of a loss from a decline in your Singapore portfolio. If the
market indeed falls, the losses from your stock portfolio would be
off set by the gains from the futures contracts. For example, if the STI
index falls 50 points, your gain from your futures position would be:
2 Selling or shorting is useful when you have a pessimistic view of the market. For
example, you agree to sell a car to John for $20,000 today to be delivered a week
from today. Assuming you don’t already have the car, you hope to buy a car in a
week’s time at a price lower than $20,000 in order to make a profi t.
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203 Gain = 50 points X 10 contracts X $10 per point
= $5,000
However, you would have also eliminated the possibility of a gain
from a price increase. Th at’s because if the market went up instead,
the gains from the market would be off set by the losses from your
futures position.
Finally, there are details on the STI futures contract that we have
intentionally skimmed in order to focus on the concept of hedging.
However if you are new to the STI futures contract, here are a few
things to note:
• Futures contracts generally have specifi ed future expiry dates
often going into 12 months or more into the future. For the
STI contract, we chose the March contract because it still has
two months remaining before expiry.
• Futures contracts have to be “monetized.” Because the
underlying asset is the STI with a points value, a $10 per point
multiplier is used to give the contract a monetary value.
TRADITIONAL OPTIONS CONTRACTSBoth forwards and futures obligate the buyer and seller to buy and
sell. If you buy an options contract, you have a choice. Th is is the
most important diff erence between options and futures/forwards.
We’ve already discussed in Chapter 2 what call and put options
are. To review, if the goat farmer and shish kebab maker were to
agree to an options contract, it might look something like this:
I, shish kebab maker, pay goat farmer two gold coins for the
right to buy a goat from goat farmer for 100 gold coins anytime
in the next three months.
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204I, goat farmer, accept two gold coins from shish kebab maker
and give him the right to buy my goat for 100 gold coins anytime
in the next three months. If shish kebab maker exercises his
right to buy, I must sell. If he does not, I keep the two gold
coins.
You can see that the option to buy the goat is valuable, and for
that, a price has to be paid. Th is is called the option premium, the
calculation of which won its creators the Nobel Prize in Economics.
It’s that sophisticated.
We need to get more specifi c about the type of options that we
are talking about because there is actually quite a variety of them.
Th e options that we discuss here are traditional exchange-traded
options. Th ey give you the option to buy or sell a number of shares
at a specifi ed price (called the exercise price) within a period of
usually three to nine months. Th ey are issued by third parties such
as a bank, rather than by the company itself. Th is means that if an
option to buy is exercised, the third party delivers the shares to you
from its own inventory of shares. New stock is not issued by the
company. In fact, the company whose shares are being bought and
sold is usually not at all involved in such transactions.
Traditional stock options are popular in the U.S. and Australia,
but they are not popular in Singapore. Stock options have been
created on a few blue-chip companies in the past, but the options
have been dormant because of lack of interest.
Th e short-datedness of the option does have an impact on the
exercise price in that it shouldn’t be too far away from today’s
market price at the time of issue. To understand what this means,
suppose we have the following:
Today’s price of XYZ shares = $10
Strike price of call option = $16
Price of call option = $0.20
Expiration = 3 months
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205Does this make sense? Would you pay 20 cents for an option to
buy XYZ for $16 when its price is trading at $10 today? If you buy
the option, it means that you have very gigantic hopes that XYZ
would rise at least 60 per cent during the next three months.
Despite whatever optimism you have about XYZ, you can see
that the strike price of $16 is not reasonable. So, the exercise price
should be closer to, rather than farther away from, today’s price.
TRADITIONAL WARRANTSContinuing with the last example, we now ask what if the expiration
is fi ve years and not three months? Does a strike price of $16 seem
more reasonable to you if you had fi ve years to wait this out? Th e
answer should be yes, and this is one of the main diff erences between
traditional options and warrants.
At the time of issue, warrants have a lifespan of up to fi ve years.
Warrants are in fact often called “long-dated options” for this
reason. Th e exercise price is usually far away from today’s share
price at time of issue.2
One other diff erence with traditional options is that traditional
warrants are issued by the company itself. When such company-
issued warrants are exercised, new shares are released.
Th ere are two diff erent types of warrants: call warrants and
put warrants. Like a call option, a call warrant is what we just
described. It gives its holder the right to purchase a number of
shares from the issuer at a specifi c price, on or before a certain
date. A put warrant represents a certain amount of equity that
can be sold back to the issuer at a specifi ed price, on or before a
stated date.
Warrants issued by companies entitle the holder to buy a
specifi c number of shares in that company at a specifi c price at a
specifi c time in the future. For example, AsiaWater Tech W110818
2Th is is true more so when the company’s share price is considered low.
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206is an SGX-listed warrant issued by Asia Water itself. It listed on 23
February 2010 and expires on 18 August 2011. It had the following
details in July 2010:
Price of warrant = 3 cents
Exercise price = 4.5 cents
Underlying Stock Price = 6.5 cents
Conversion Ratio = 1 share: 1 warrant
Analysing this is not diffi cult at all. To own Asia Water, you have
a choice of buying it directly at 6.5 cents or you can pay 3 cents
for the warrant and exercise it by paying another 4.5 cents for a
total of 7.5 cents. Th e conversion ratio of 1:1 means that it takes
one warrant to purchase one share.
Is this a good deal? First, by buying the warrant and exercising
it, you’re paying 7.5 cents, which is 1 cent more than buying the
stock directly. Why in the world would you want to do that?
A good reason is that you’re paying a premium of 1 cent to be
able to sit tight for over one year and hope that the underlying
stock price shoots sky high. For example, if you buy the warrant
at 3 cents and Asia Water stock rises to 10 cents in a year, you can
cash in for a nice profi t of 2.5 cents per share (10 minus 7.5 cents).
And what if the underlying stock price falls to 1.5 cents or even
lower? Th en your maximum loss will always be limited to just the
initial investment of 3 cents per warrant.
Warrants Compared with OptionsWarrants are similar to long-term options where they off er the
opportunity for capital gain, which makes them interesting for
speculative investing. Th e price movement of warrants tends to
refl ect the price changes in the underlying equity — but in an
exaggerated fashion. For example, if the price of a share increases
10 per cent, the price of an associated warrant may increase 30 per
cent. Th at is the bottom-line attraction for speculators.
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207But warrants are not exactly like options; there are a few
diff erences, which are summarised in Table 18.1 for call warrants
and call options.
TABLE 18.1. DIFFERENCES BETWEEN WARRANTS AND OPTIONS
Warrants Options
How long they last
Long dated. Usually issued with a 3-5 year life.
Short dated. Ranges from 1 month to 12 months.
Issuer
Issued by the company itself with a promise to issue new shares if the warrant is exercised.
Usually not issued by the company itself. A promise is made to deliver existing shares if the option is exercised.
Dilution
New shares are issued by the company when warrants are exercised. Th is results in earnings dilution for shareholders.
When an option is exercised, existing shares are delivered. Th is does not cause earnings to dilute.
Where they are traded
On an exchange. On an exchange.
Source: Authors’ own compilation
The Lure of WarrantsBecause warrants exaggerate the movements of the underlying
equity, they tend to be more volatile than shares, which is why
speculators love them. Warrants thus off er the opportunity for
greater price gains than do the associated shares.
Th is feature of warrants is called gearing and this is found
commonly in fi nancial markets. An example of gearing is if you
borrow money from the bank and invest the money in the stock
market, you are said to be “gearing up” your exposure to stocks.
Similarly, if you arrange a mortgage from a bank to buy a house,
you are gearing up your exposure to the property market.
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208Th e major attraction of warrants is this feature of gearing —
they track, and magnify, share price movements. In bull markets,
speculators will often fl ow into warrants, instead of shares, to gain
from the turbo-charged performance of warrants.
Hence, in bull markets, warrants will easily outperform most
shares, and have the greatest price increases among securities.
Th e advantages of gearing can also be its greatest danger, as
gearing works both ways. While warrants can rise spectacularly
fast, they can plummet just as quickly.
Warrants are very speculative, capital gain plays. Warrant-holders
get no dividends or any other type of income. Th ey are therefore
not appropriate for investors who are interested in income.
Structured WarrantsStructured warrants and company warrants have many similar
features. Th eir values are linked to an underlying asset. In the case
of company warrants, the underlying asset is the company’s shares.
Structured warrants are more fl exible as their underlying asset is
usually either a stock or an index. Both types of warrants are listed
on an exchange and off er leveraged trading.
Compared with company warrants that are issued by the company
itself, structured warrants are issued by third-party fi nancial
institutions. Th is and other diff erences are summarised in Table 18.2.
(page 209).
Here’s an example of how a structured warrant is listed on the
stock exchange and what each term means:
STI 3,700 ABC e CW 120328
STI 3,700 ABC e CW 120328
STI is the underlying asset Straits Times Index
3,700 is the Strike Price*
ABC is the name of the issuer
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209E refers to a European maturity which means that the warrant can
only be exercised on the day the warrant matures**
CW means Call Warrant while PW means Put Warrant
120328 is the maturity date — that is, 28 March 2012
* Strike price is the price at which the warrant holder is entitled to buy
(for calls) or to sell (for puts) the underlying asset at maturity.
** Warrants with American maturity can be exercised at any time
before maturity.
TABLE 18.2. DIFFERENCES BETWEEN STRUCTURED WARRANTS AND
COMPANY WARRANTS
Structured Warrants Company Warrant
Warrant issuer Issued by third parties such as fi nancial institutions.
Issued by the company itself.
Underlying asset Any index or company shares that are not related to the fi nancial institution.
Shares of the listed company.
On exercise Does not result in dilution of the underlying shares.
Company will issue new shares, which results in share dilution.
Maturity period Short term, likely to be 12 months or shorter.
Long term, can be as long as 5 years.
Source: Adapted from http://sg.warrants.com
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Understanding Structured
Products and Other Derivatives
CFDs, structured deposits and equity-linked notes — these are just
some of the names of securities that you might have heard of in the
news, and have no doubt been intrigued, confused and enlightened
by all at the same time. Th at’s probably because derivatives are such
highly fl exible instruments.
Th ey can stand on their own as a leveraged investment for
speculators. Th ey can be structured to mimic the behaviour of
another asset. Th ey can be added to your portfolio to provide
temporary protection from an anticipated market downturn. And
as you will see in this chapter, they can be attached to traditional
investment assets such as bonds to become structured products.
In fact, the number of combinations is limitless and like in the
previous chapter, we will focus on some very technically challenging
investment products at a conceptual level without digging too much
into the details.
In this chapter, we will touch on some of the most popular
products in the market:
• Contracts for Diff erence (CFDs).
• Structured products such as guaranteed funds, structured
deposits and equity-linked notes.
In the end, your conceptual understanding will allow you to
diff erentiate one product from another, and hopefully we will
help you not only make informed decisions, but also ask the right
questions to enhance and protect your bottom line.
19
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211CONTRACTS FOR DIFFERENCE (CFDS) If you love BreadTalk and can’t seem to get enough of their buns and
pastries, you might want to think about a CFD. A CFD allows you
to take a leveraged position on a security such as equities or indices.
Th is means that by taking a leveraged CFD position on a stock such
as Breadtalk, and putting down $1,000 with a broker such as Phillip
Securities1 you are able to hold a $5,000 position.
CFDs are a very simple type of derivative that off ers all the
benefi ts of trading shares without actually having to own them.
A CFD mirrors exactly the performance of the underlying stock
where the profi t or loss is determined by the diff erence between the
purchase price and the selling price.
A CFD is an over-the-counter (OTC) derivative that represents
an agreement between two parties (you and the broker) to exchange
at the close of the contract the diff erence between the closing and
opening prices of the contract. A CFD thus allows you to trade on the
outcome, or performance, of Breadtalk and other securities without
owning the stock or security. You would not have voting rights or
ownership entitlements such as warrant issues and rights issues.
Because CFDs are leveraged, you trade on margin like what you
would do with futures contracts. Margin trading gives you the
ability to purchase, or gain an exposure to, a stock without putting
up the full principal value. Th is lets you multiply your profi ts if the
price moves in your favour. Th e opposite is true as well. If price
moves against you, your losses are multiplied as a result.
Margin is made up of two parts. Th e fi rst is the initial margin,
which is the initial amount required to open the position. In
Singapore, the initial margin level is typically 20 per cent, which
means a leverage of fi ve times — every dollar you put down allows
you to hold fi ve dollars of assets. If the price of the stock moves in
your favour, no additional margin will be required, but if the balance
1Phillip Securities is one of the top CFD brokers in Singapore, providing hundreds
of CFDs in several markets, including Singapore, Malaysia, Hong Kong and even
the U.S.
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212goes below a maintenance margin (for simplicity, let’s assume it is
also 20 per cent), then you will get a margin call to top up so your
balance returns to at least the 20 per cent level.
Th is principle is no diff erent from buying a home with a loan.
When you buy a home, you put down a deposit (for example, 20 per
cent) and you borrow the rest (80 per cent). If the property market
goes up in your favour, your profi ts are multiplied a few times
relative to your initial deposit. Or if it goes against you, you can lose
more than what you put down. CFDs can be risky and speculative,
and you should know what you’re doing.
Let’s look at a simplifi ed example in Table 19.1 of a long trade
in which you open a CFD position in XYZ stock which is trading
TABLE 19.1. SAMPLE CFD POSITION IN XYZ STOCK
Opening Position:
Price of XYZ $10.00
Number of shares $5,000
Value of shares $50,000
Margin Required (20%) $10,000
Commission (0.30%) $150.00 (GST excluded)
Total Value of Transaction $10,150 (margin plus commission)
Closing Position (5 days later)
Price of XYZ $10.50
Number of shares 5,000
Value of shares $52,500
Commission (0.30%) $157.50
Financing (5 days) $50.00
Profi t ($)$2,142.50 ($52,500 minus commissions and fi nance charges)
Profi t (%) 21.1% ($2,142.50 / $10,150)
Source: Authors’ own illustration
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213at $10.00 per share. You put down an initial margin of $10,000
for a $50,000 position. Five days later, when XYZ has gone up to
$10.50, you close out your position for a profi t of $2,142.50 after
subtracting commissions and other expenses.
Since CFDs are margined instruments, any positions held overnight
are subject to fi nancing. Th is is to take into account that your broker
is actually lending money to a client or borrowing money from him.
Long CFD positions are required to pay fi nancing since you are
eff ectively borrowing 80 per cent of the total position like in a home
mortgage. To simplify the example, we assume this is $50 for fi ve days.
Th e above example shows a 21.1 per cent return on the initial
investment, given a fi ve per cent move in XYZ’s stock price. Bear in
mind again that as profi ts are magnifi ed, so too will your losses be,
if the price goes in the opposite direction instead.
CFDs in Your PortfolioTh ere are two main ways you can use CFDs:
• You can speculate — if you are convinced about the direction of
a stock’s price, you could speculate by longing (you are bullish)
or shorting (you are bearish) the CFD.
• You can hedge — Suppose you own actual shares of XYZ that
you don’t want to sell because your grandmother gave them
to you. Even if you expect its value to decrease from a market
downturn, you can maintain your fi lial duty by opening up a
short position using a CFD on the individual share. If, in fact, the
stock goes down from $10 to $9, you can compensate for the
losses from your actual shares by the profi t made with the short
CFD position.
CFDs are bad for your nerves if you are a risk-averse investor. If
you can’t even stomach a 10 per cent drop in your favourite stock,
imagine a 50 per cent drop as a result of the leverage feature.
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214CFDs aren’t very good for long-term investing either unless you
are one of those investors who can stay on the roller coaster for six
hours at a time without a break. Because of leverage, your returns
can swing very wildly.
STRUCTURED PRODUCTSSuppose you have $1,000 to invest. You buy a high-quality AAA-
rated zero-coupon bond for $864. Th e bond matures in three years’
time whereupon you will receive $1,000. Since your capital has been
“guaranteed”, you now venture to take a huge risk with the remaining
$136 or 13.6 per cent of your investment money. You invest the
entire $136 on stock options that are tied to the performance of a
technology index.
In three years, if the technology index does poorly, you walk away
with $1,000. Your return is zero per cent. Still, you are comforted
by the fact that you did not lose any money.
If the technology index does really well and your stock options go
up 30 per cent, you earn a return of 4.1 per cent:
Return =13.6% x 30%
= 4.1%
Congratulations! You have just created your own technology
capital guaranteed fund, a type of structured product. Structured
products are very popular with retail investors, and we will look at
three — capital guaranteed funds, structured deposits and equity-
linked notes.
The Appeal of Guaranteed FundsA basic structured product such as a guaranteed fund has a very
simple structure:
Capital Guaranteed Fund = Bonds + Higher-risk Investments
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215You can create a similar structure on your own. Now imagine
if you had to pay a commission to someone to create the above
structure. Would you ever buy a capital guaranteed fund?
It is understandable if your answer is “no” since theoretically you
can just do this yourself. However, the cost and transaction volume
requirements of many derivatives are beyond most individual
investors.
As such, structured products were created to meet specifi c needs
that cannot be met from traditional fi nancial instruments. Structured
products can be used as an alternative to direct investment, as a way
to reduce portfolio risk, or to exploit a current market trend.
In Singapore, billions of dollars have been invested in capital
guaranteed funds. Th ey were the rage when the fi rst funds appeared
at the end of 2000. At the time, the STI was in a slump. It fell from
2500 in December 1999 to lower than 1300 points 21 months later
in September 2001. Hungry investors seized what was a great
investment, an investment in which capital is guaranteed (net
of commissions) and there was the potential of an upside tied to
markets recovering in three to fi ve years’ time.
Defining Structured ProductsTh e term “structured products” in the market is somewhat unclear
and frequently refers to the packaging of derivative products with
traditional ones. A good defi nition comes from Michael Fraikin,
Director of the Global Structured Products Group at INVESCO,
who defi ned a structured product as “a systematic way of investing
rather than one that centres on the use of derivatives”. In other words,
structured products express an investment strategy.
A guaranteed fund, for example, is an investment strategy that
provides the investor with protection from a downturn, yet gives
the potential of profi ts should the market go up. Th is is appealing to
not only a risk-averse investor, but also one who has the view that
while the market could weaken, there is hope of an upturn.
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216Structured DepositsTh e most serious risk associated with many structured products
is that many investors buy them when they don’t quite understand
their risk-return characteristics. Take structured deposits for
example. Th ey appeared around end-2001 and work just like capital
guaranteed funds in that capital is often guaranteed and there is
also the potential kicker in returns from risky investments. What is
diff erent is that structured deposits were sold as alternatives to fi xed
deposits. While capital guaranteed funds appeal more to investors,
the appeal of structured deposits lies with depositors.
Billions of dollars too have poured into structured deposits. It is
easy to see why when we look at how low fi xed deposit and savings
rates have fallen over the years (see Figure 19.1).
At the start of 2002, 12-month fi xed deposit rates were around
2.46 per cent. Around mid-2010, the rate was 0.14 per cent. Th is is
a very depressing rate for depositors.
FIGURE 19.1. BANK FIXED DEPOSIT AND SAVINGS RATE (1995 TO 2010)
Jan
95
Jan
96
Jan
97
Jan
98
Jan
99
Jan
00
Jan
01
Jan
02
Jan
03
Jan
04
Jan
05
Jan
06
Jan
07
Jan
08
Jan
09
Jan
10
6
5
4
3
2
1
0
Bank 12Month FixedDeposit RateP
erce
nt
(%)
Bank 12Bank 12Month FixedDeposit Rate
BankSavings
Rate
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217What many structured deposits off er are high early payouts. For
example, a structured deposit may off er 8 per cent returns in eight
months. If you are thinking that this is a great deal, so are thousands
of depositors. Here are a few characteristics about structured
deposits that you should know about:
• Th ere is often a high early payout (the earliest versions off ered
lower, regular payouts)
Whatever the amount or the regularity, remember that this is
just the income portion.
• Th e capital is usually protected
Capital protection is a little diff erent from capital guarantee.
A capital guarantee is a guarantee that you will get your capital
REMINDER — TWO BASIC TRUTHS ABOUT INVESTING
First, the most sacred investment truth of all — the lower the
risk, the lower the returns. And the higher the risk, the higher
the returns. If an investment makes guarantees, it does so by
off ering lower returns.
Second, returns consist of two components:
Return = Income + Capital Gains
So, if you are getting a lot of “returns” upfront, for example
8 per cent or $80 for every $1,000 invested, do not be too
happy yet. Th at is just the income portion of your returns.
Please ask the salesperson about the capital gains portion.
Chances are that if the income portion is guaranteed, the
capital gains portion is not. And very often, you could even
suff er capital losses.
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218 back. If the bank buys a bond and the issuer defaults, the bank
will pay you your money. With the guarantee, the bank takes
on the risk. With protection, the bank passes the risk to you if the
issuer defaults. So while capital protection is still low risk to you
(the bonds purchased are usually good quality), it is not risk-free.
Th e next time you read a product brochure and you
are confused, think about it this way. If the income portion is
guaranteed, the capital portion is probably not guaranteed. Or,
if the capital portion is guaranteed, the income portion is
probably not. If they are both guaranteed, which is unlikely, you
can't then expect the returns to be great.
• Long lock-in period
Some funds lock you in for up to 10 years and there is a penalty
for early withdrawal. Th e worst that can happen is when you get a
high early payout and get locked in for 10 years. And then at the
end of the period, you fi nd out that you would not be getting any
extra returns because the options and other higher risk
investments failed to perform.
Th ere have been plenty of complaints by investors about structured
deposits and how they were being sold. Some investors complained
that they were lured by the high early payouts. But when they learned
that they needed cash and wanted to liquidate, they got upset by the
penalties for early withdrawal.
Th ere were also complaints that banks were selling structured
deposits as if they were simple deposit products. Th ey are not. MAS
has issued a notice that “Unlike traditional deposits, structured
deposits have an investment element and returns may vary.”2
Equity-Linked NotesAn equity-linked note (ELN) is a structured product. It starts
with a debt instrument, usually a bond. It is diff erent from a bond,
2MAS Guidelines on Structured Deposits, www.mas.gov.sg, 7 October 2004.
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219however, in that the fi nal payout is typically based on the return of
an underlying equity instrument, which can be a basket of stocks or
an equity index. A typical ELN is capital-protected, which you now
know, is diff erent from being capital-guaranteed.
A common feature is that the fi nal payout is the amount invested,
times the gain in the underlying stock basket, or index times a
participation rate, which can be more or less than 100 per cent.
For example, if the underlying basket gains 50 per cent during
the investment period and the participation rate is 60 per cent,
the investor receives 1.30 dollars for each dollar invested. If the
underlying basket remains unchanged or declines, the investor still
receives one dollar per dollar invested as long as the issuer does not
default. You can see that this payoff is no diff erent from that of a
capital-guaranteed fund.
MANAGING STRUCTURED PRODUCTS IN YOUR PORTFOLIOStructured products may be suitable for you if you have suffi cient
cash elsewhere so that the possibility of an early withdrawal is
remote. If you want to enhance returns on your fi xed deposit, which
you have set aside for emergency funds, you can consider putting up
to 30 per cent of your emergency funds in structured products that
mature in no more than three years’ time.
Capital guaranteed/protected investments are generally low risk
and should not really occupy a large proportion of your retirement
portfolio. However, if you strongly believe in a market recovery,
but you still want some returns from income payouts, you might
consider such funds. Invest no more than 20 per cent of your
retirement portfolio in such funds.
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Figure 20.1 shows that in 2002, US$1 exchanged for S$1.85. In
mid-2010, the exchange rate had gone down to less than S$1.40, a
drop of over 25 per cent for the US$.
INCREASING INTEREST IN CURRENCY INVESTINGInvesting in currencies is becoming quite popular these days.
Everyone from housewives to doctors seem to have a view of where
Understanding Currency
Currency movements seem to be favouring Singaporeans these days.
Th e US$ is weak. Th e SGD is strong. Suddenly, we hear many of our
friends wanting to visit, eat and shop in the U.S. It’s a great time, but
that’s true only if you’re buying and shopping, and bad if you own
U.S. assets or you are selling goods to the U.S. (you may be forced to
raise prices which would make your customers unhappy).
If you hold lots of U.S. assets or US$-denominated assets such
as real estate and unit trusts, your investment would have gone
down 25 per cent between 2002 and 2010 from just the currency
movement itself.
FIGURE 20.1. USD VS SGD MOVEMENTS BETWEEN 1994 AND 2010
1.9
1.8
1.7
1.6
1.5
1.4
1.3
1.2
Jan
94
Jul
95
Jan
97
Jul
98
Jan
00
Jul
01
Jan
03
Jul
04
Jan
05
Jul
07
Jan
09
Jul
10
Ex
cha
ng
e ra
te
4
USD / SGD
20
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221the S$ or US$ is headed, and every other person we know seems
to have traded currencies or bought currency-related investments.
Currencies can be considered an alternative investment because
their returns are not well correlated to stocks and bonds, but they
can be very risky investments too; hence they should fi t into your
supplementary bucket.
Each country has its own currency. Singapore’s offi cial currency
is the Singapore dollar. Switzerland’s offi cial currency is the Swiss
franc, and Japan’s offi cial currency is the yen. An exception would
be the euro, which is the currency for several European countries.
In this chapter, we will look at several ways in which we
commonly deal with currencies, whether to invest, speculate or
simply exchange on the spot for a vacation.
CHANGING ON THE SPOTWe Singaporeans are quite seasoned when it comes to exchanging
Sing dollars for a foreign currency. Many of us love to travel and
we can take off from Changi airport and land almost anywhere in
the world.
If you are going to the U.S. in a few days’ time and you want
US$10,000 exchanged to spend on luxurious spa treatments, the
money changer would quote you a “spot exchange rate”, so called
because the exchange is made on the spot for immediate delivery.
Th e price you pay to buy US$ is the US$/S$ rate or “the price of
US$ based on S$”. For example, if the US$/S$ rate is 1.5, then you
would pay S$15,000 for US$10,000.
Now suppose you are going to the U.S. in one year’s time instead.
As you know, exchange rates change all the time and are actually
quite volatile. Which would work more in your favour — a stronger
or weaker US$ when you need to exchange your S$ for US$ in a
year’s time? Th e answer is that you would want a weaker US$
because it means US$ are cheaper to buy using S$. For example, if
the US$/S$ rate goes down to 1.3, then you would pay S$13,000 for
US$10,000 — a savings of S$2,000.
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222Of course, the exchange rate could work against you too. If the
rate goes up to 1.7, then it means you’ll have to pay S$17,000 for
US$10,000. You may be asking whether or not it is possible to “fi x”
the rate you pay one year ahead of time? By doing so, you will know
ahead of time what rate you will pay exactly, thus removing the
uncertainty of rates moving against you.
Fixing Rates Ahead of Time Th ere are a few common ways to fi x rates ahead of time. One way
is to open a 12-month foreign currency time deposit by accepting
the spot exchange rate that the bank is off ering today. Of course,
you would opt for this only when you are comfortable with today’s
exchange rate and you don’t mind locking this in today.
So if the US$/S$ exchange rate is 1.5 today, you would pay
S$15,000 for a US$10,000 time deposit that pays interest in US$. In
12 months’ time when you need the money for your holiday, there
will be no surprises — whether positive or negative. You will get
exactly US$10,000 plus interest.
If you did not fi x the rate, then you would face the risk of the US$/
S$ going against you in the next 12 months to 1.7 or even higher,
which means you would have to fork out more S$ for US$.
Banks typically off er time deposits based on maturities of between
one week and 12 months. If you need a more fl exible time frame, you
may consider a customised contract called a forward contract where
you and the bank can agree to a schedule of fi xed exchange rates,
even for several periods into the future. Of course, the amount that
you are dealing with should be big enough to interest the bank and
you are also willing to accept whatever rates the bank is off ering.
For example, if you have a recently deceased wealthy relative
from Australia who left you A$5 million and her will instructs that
A$500,000 be transferred to you every six months for a total of
10 payments, then this might be a good situation in which to
approach the bank to structure a forward contract to lock in a series
of 10 exchange rates.
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223What we just discussed is called hedging your currency risk,
where you manage your risk by locking in an exchange rate today to
buy or sell a currency in the future.
WHAT AFFECTS EXCHANGE RATES?
Th e most fundamental factor that aff ects exchange rates is
demand for the currency. If the demand for a currency is high,
then the currency tends to be strong. So when you are trying
to fi gure out whether the US$ is going to strengthen in the
next 12 months, you need to fi nd out if demand for the US$ is
going to be strong or weak.
Here are some rules of thumb on what cause currency
rates to rise and fall. Bear in mind that rules of thumb work
and make sense in general, but not all the time. We will use
Singapore as a reference point:
1. Interest rates — If interest rates in Singapore go up, the
demand for Singapore bonds, especially from overseas
investors, would go up as well. Th is increases demand for
S$ as overseas investors sell their currencies to buy S$ in
order to invest.
2. Trade balance — If Singapore experiences a trade
surplus, it means that it is selling (exporting) more goods
and services than it is buying (importing). A trade surplus
causes a strengthening of the currency as S$ is bought up
in order to buy Singapore exports.
3. Commodity prices — Major commodities such as oil
have a strong infl uence on currencies. A rise in the price
of oil will positively aff ect the currency of an oil-exporting
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224
SPECULATING IN FOREIGN CURRENCYIf instead you want to speculate and take on risk because you have a
certain view about where a currency is headed, then you may wish
to open a currency trading account. But do be very careful because
currency trading institutions such as banks and brokerages are
usually very happy not only to accept your application (typically if
you have at least US$50,000 to start), but also to grant you a trading
line that is fi ve, 10 or more times what you deposit.
For example, suppose your bank off ers you a currency trading
account with a trading line of up to 10 times the size of your initial
investment deposit of a minimum of US$50,000. Th is means that
you will receive a US$500,000 trading line. Such accounts are called
leveraged accounts because you are able to trade using “borrowed”
money. Th e risk of leveraged accounts is that they magnify your
gains as well as your losses by the amount of leverage. If you obtain
a trading line with a leverage of 10 times, then your losses and gains
can be magnifi ed 10 times.
To see how this works, suppose you have a trading account with
an initial deposit of US$50,000 and a leverage of 10 times. On
country such as Saudi Arabia and Canada, and negatively
aff ect oil-importing countries such as the U.S. High
global demand for non-oil commodities such as iron ore
and wheat has also benefi ted major commodity exporters
such as Australia.
4. Stock market performance — Th e overall direction in
stock prices has an impact on currencies as money fl ows
into countries with rising stock markets. Th is makes sense
as a rising stock market is an indication that the country’s
economic prospects are positive, and hence the greater
the demand for the country’s assets and currency.
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2251 June, you have the view that US$ will weaken against the Japanese
Yen. You decide to buy Yen against US$500,000 based on a rate of
JPY 100 = US$1 to be settled one month later on 1 July.
On 19 March, you commit to buy US$ 500,000 and sell YEN for
settlement on 19 April (1 month forward).
Exchange Rate Buy Sell
JPY 100 / US$1 JPY 50,000,000 US$500,000
Two possible outcomes can happen:
Outcome 1: US$ Strengthens — You lose money
On 1 July, the US$ strengthens to JPY 110. US$1 now buys more
JPY or said another way, more JPY are now needed to buy US$1.
Exchange Rate Buy Sell
JPY 110 / US$1 US$454,545.45 JPY50,000,000
Your loss is US$45,454.55 (US$500,000 minus US$454,545.45).
Th is represents a loss of 91 per cent on your initial deposit of
US$50,000. Had your account not been leveraged, your loss would
be 10 times less or 9.1 per cent.
Outcome 2: US$ Weakens — You make a profi t
On 1 July , the US$ weakens to JPY 95. US$1 now buys fewer JPY
or put another way, fewer JPY are now needed to buy US$1.
Exchange Rate Buy Sell
JPY 95 / US$1 US$526,315.79 JPY50,000,000
Your gain is US$26,315.79 (US$526,315.79 minus US$500,000).
Th is represents a return of 53 per cent on your initial deposit of
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226US$50,000. Had your account not been leveraged, your profi t would
be 10 times less or 5.3 per cent.
Your potential losses and profi ts in foreign currency trading can be
substantial because of the volatility of exchange rates and the leverage
off ered on trading accounts. And in certain cases, the losses can be
extreme, a case in point being the foreign currency trading losses
of SembCorp of US$248 million, which came about from just one
individual. Not only were there exchange losses but also, its mother
SembMarine shares, fell more than 15 per cent when the news broke.
CURRENCY UNIT TRUSTSIf you still want to take on risk and benefi t from currency movements,
you can consider unit trusts that take positions on currencies. Th ese
funds are managed by currency specialists who follow the market
very closely with research and analysis. Th ey generate absolute
returns in the sense that their returns are not correlated with stock
market returns because currency movements can be independent
of stock market movements. So, whether the stock market is headed
up or down, currency funds are able to generate positive returns.
DUAL CURRENCY INVESTMENTSSuppose for the last few years, you’ve travelled to Hong Kong
several times a year to shop, and each time you go, you visit the
money changer to get HK$ for whatever the spot HK$/S$ rate is.
Th e actual dates on which you travel are not known ahead of time
and you’ve travelled on short notice a few times. You’ve set aside
S$50,000 in your savings account for this purpose, separate from
your other monies.
You’re fi ne with this arrangement except that you get a very low
return on your savings account. Also, you have to accept whatever
the exchange rate is at the time you travel and the risk each time is
that if the S$ falls in value, the HK$ becomes costlier to buy.
Th e relationship manager (RM) at the bank calls you one day
about a dual currency investment (DCI). From what she described,
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227the DCI seems to fi t your needs. First of all, it provides an attractive
return of 4.8 per cent, which is far higher than what you are getting
from your savings account. Th e interest earned based on a S$50,000
investment would be:
S$50,000 X 4.8% X 1/12 = S$200
You next invest by choosing two currencies, one as the base
currency (in this case, S$), and the other as the alternate currency
(the HK$). You then select a suitable maturity date, ranging from a
few weeks to up to six months; you choose one month.
On maturity, you get paid in either the base or alternate currency,
depending on which is the weaker currency when measured against
a pre-determined exchange rate (called the strike price). To see how
this works, say you invest S$50,000 at a strike price of HK$/S$ = 0.20.
Note that this strike price is a value that you agree with the bank, and
one that you are comfortable with if you had to exchange S$ for HK$.
On maturity, suppose the S$ weakens or strengthens as follows:
TABLE 20.1. S$ SCENARIOS
Scenario 1 Scenario 2
Rate on maturity date S$ weakens to 0.25S$ strengthens to 0.15
Payout currencyPrincipal & interest to be paid in S$
Principal & interest to be paid in HK$
Principal + interest received
S$50,200HK$251,000(S$50,200 / 0.20)
Source: Authors’ own illustration
In sum, if the S$ weakens against the HK$ as in Scenario 1, you
would get an attractive S$200 worth of interest, which is far more
than you would have achieved leaving it in your savings account.
If the S$ strengthens as in Scenario 2, you get HK$251,000, based
on an exchange rate of 0.20, which was an exchange rate you were
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228comfortable with at the start. And if you want to take advantage of
the fact that the HK$ is now cheaper, you could buy more at S$0.15.
Note that if you had not gone into the investment, you could have
exchanged your S$ at a more attractive rate of 0.15. Based on an
amount of S$50,200, you would have obtained HK$313,750 rather
than HK$251,000, a huge diff erence of HK$62,750.
With Scenario 2, you can actually lose quite a lot of money if you
decide to convert the HK$ back to S$:
HK$251,000 x 0.15 = S$ 37,650
Th is translates to a loss of S$12,350 or nearly 25 per cent. But
again, since you do plan to have HK$ anyway, converting the HK$
back to S$ is not a consideration for you.
Some fi nancial commentators have written against DCI, calling
them attractive investments that are without much bite. While the
high interest rate is attractive, the rest of the deal is not attractive. If
your foreign currency goes down (the HK$ weakens as in Scenario
2), you must take all the losses — but of course, only if you choose
to convert the HK$ back to S$. But if the S$ weakens (the HK$
strengthens as in Scenario 1), you don’t get all the profi ts except a
higher-than-market yield, 4.8 per cent in our example.
So the bottom line is that if you are planning to speculate because
you have a view on a pair of currencies, you would get limited
profi ts with unlimited losses. But if you are comfortable holding
money in either currency, and wish to earn an attractive return on
your principal, then DCI may be suitable for you.
FINAL WORDAs you have seen from the examples above, currency investing
can be mind-boggling. But if you are a maturing and increasingly
sophisticated investor, understanding currency products is a must.
Having a globally diversifi ed portfolio means that most of your money
is invested outside, not inside Singapore. Th e reason you may not see
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229this is that, if you are a unit trust investor, the currency translations
and movements are hidden away from you for convenience.
Singaporeans are becoming more interested in direct investments
in other countries and alternative investments such as real estate
and wine. As you make more of such investments, you will need to
deal with foreign currencies. Having a good understanding of what
makes foreign currencies move is absolutely necessary.
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SPECIAL TOPICSWe have covered a fair bit of ground in the first three parts, from basic investment concepts to investing in traditional and alternative products.
In this last section, we turn our attention to special topics such as investing for kids, during retirement, your rights as an investor, and whether or not you should get professional financial advice.
In the final chapter, we discuss what we can do to protect our portfolios more actively whether the market is in an upturn or downturn.
4PART
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Investing for Kids
If you have young children like we do, you have probably already
tried to get a sense of how much it will cost to send them to
university. Unfortunately, by the time our children are ready for
university, it is usually about the time we retire. Th ere will be a
tussle for money — should you provide for your kids fi rst or for
your own retirement?
Parents have this perpetual set of worries:
• How to pay for their kids’ university education?
• How to teach kids about money and investment? We want to
teach them to be fi nancially responsible so that we won’t have to
support them in our old age.
GOLDEN RULE OF INVESTING FOR KIDSBack to the question above — in the tussle for your money, who will
win? Your kids, or yourself? Most of the time, you will give in to your
kids and that will mean less for your retirement.
Many people often go the distance for family members and
forget to take care of themselves. When you are faced with the
monumental task of saving for your child’s university education,
it is easy to forget about saving for your own retirement. Th at is a
big mistake. Saving for retirement always comes fi rst. Your child’s
education comes second.
You and your child can fi gure out ways of getting him through
school when the time comes, whether this be through loans,
co-payment or some other means. What you want to avoid is
fi nd yourself broke after having taken care of all your children’s
educational needs, thereby placing yourself in a position of
dependency. So when putting together a strategy for your child’s
education, consider these three steps:
21
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2321. Set a goal to save for up to two years of university expenses,
and no more.
2. Every month, set aside the minimum needed for education
funding and no more.
3. Th e rest of your savings should go into your retirement account.
Remember: Do not give them everything. Make them work
for part of it. By teaching them fi nancial responsibility, you
will be doing them a favour. So set them up for some personal
accountability and let them learn how to fend for themselves.
HOW MUCH IS NEEDED? Whenever the newspapers report on how much it will cost to
educate our kids, we get depressed. As far we can see, it will cost
the equivalent of half a three-room HDB fl at to educate one child in
Singapore today, and one entire four-room fl at if your child furthers
his/her studies overseas. If you have two or more children, it will
require putting aside more money than you could possibly aff ord.
Tertiary expenses include tuition, books, travel and
accommodation. How much does a basic four-year science degree
cost all-in? Based on our compilation,1 the cost of a four-year
science degree from a Singapore university was S$140,000 dollars
in the 2010 academic year. Going to Canada, the cheapest overseas
location popular with students, would cost $185,000.
If we project an education infl ation rate of six per cent, the cost of
educating your child in Singapore starting in 2020 is $250,000. To
send your children overseas, you’ll have to be a millionaire probably
a few times over.
1 Basic cost information was taken from the 13 April 2010 Straits Times article “Fee
hike unlikely to deter foreign students,” and then projections were made.
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233It’s not possible to project what it will cost exactly. But you can
at least use the fi gures in Table 21.1 to obtain an idea of what your
children’s education would cost, and it is hoped this will stir you
into action.
TABLE 21.1 COST OF FOUR-YEAR SCIENCE DEGREE
Country 2010 2020
Singapore $140,000.00 $250,000.00
Canada $185,000.00 $330,000.00
Britain $220,000.00 $400,000.00
Australia $230,000.00 $410,000.00
USA $320,000.00 $570,000.00
Source: Authors’ own compilation.
Note: Figures are rounded to nearest fi ve thousand and includes cost of living expenses.
Investing for UniversityHow you invest depends on when the money is needed. Assuming the
university going age is 18, the nearer your child is to university, the
less risk you can aff ord to take. Let us assume traditional investments
such as unit trusts and bonds are used in the following examples:
1. Investing for pre-teens
If your child is under 13, invest your money aggressively with
as much stock funds as your risk tolerance allows.
2. Investing for teenagers
By this time, you would have begun to switch gradually out of
stocks and into bonds. You do not want to have too much
money to stay in stocks in case there is a market tumble just
before the money is needed.
Table 21.2. (page 234) shows a framework for managing your
asset allocation as time moves forward.
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234 TABLE 21.2. ASSET ALLOCATION IN RELATION TO CHILD'S AGE
CHILD'S AGE <9 9 10 11 12 13 14 15 16 17 18
Stock funds %
80 80 70 70 60 50 40 30 20 10 0
Bond funds %
20 20 30 30 40 40 30 20 10
Short-term bonds %
10 20 30 50 70 70
Cash % 10 20 20 20 30
TOTAL 100 100 100 100 100 100 100 100 100 100 100
Source: Authors’ own calculations
Table 21.2. shows:
• Th e exposure to stock funds gets lower and lower as time passes.
• Bond funds fi ll the diff erence initially, but start to be drawn
down as short-term bonds and cash increase as time passes.
• We suggest short-term individual bonds that are held to
maturity. Holding bonds to maturity off er a known yield and
certain cash when the money is needed.
SOME OTHER MATTERS TO CONSIDERHere are some other options and matters to consider:
Borrow From Your CPF (Ordinary Account) Your child can borrow against your CPF, and pay it back as soon as
he starts working. Th e scheme only covers full-time courses off ered
locally. What if your child decides not to pay up? Well, the CPF
Board will actually take action to recover the money borrowed, plus
interest. Th ere are many conditions to satisfy, however, so please do
your homework, or get fi nancial advice.
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235Investments to AvoidCash value life insurance serves a great purpose in providing
protection for the whole of your life. But as a savings tool, it just
does not generate suffi cient returns. Real estate is too risky for
such a near-term objective. If you take a large loan and the market
collapses, you may not even have money to cover the fi rst year of your
child's education.
Teaching Your Kids about Investing In the old days, parents used to be able to rely on their children to
support them in their old age. Th ings have changed. Because we
marry later and have children later, it is entirely possible that by the
time we retire, we will still be supporting our kids. We fi gure that
the more fi nancially literate our children are, the better off everyone
will be.
YoungstersWe have a friend Ken, who bought his eight-year-old daughter
Sarah a piggy bank. Ken told Sarah that her university tuition cost
is going to be shared 50-50, so she should start saving up part of
her allowance. To give Sarah the incentive to save, Ken deposited
twice what Sarah managed to save each day. So if Sarah saved $1,
Ken would put in $2.
When the piggy bank was full, Ken opened a POSB account. With
the interest from POSB, Sarah learned that money that is wisely put
away can grow. Th is was an important lesson. It took Sarah some
time to get used to the new habit, but very soon, she was fi lling the
piggy bank happily, jiggling it ever so often to hear if it was full.
Th ink how absolutely thrilling it is for children to be able to watch
their money grow!
TeenagersMost teenagers, if they have been exposed to the mechanics of
saving, will sooner or later show an interest in investing. If your son
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236has $2,000 in the bank, try signing up for a joint benefi ciary account
with one of the online fund distributors and buy a unit trust or two.
Better still, let him choose which fund to buy and ask him why. Do
not discourage him. Investment, like any other skill, is best learnt
while young.
You will soon see them going to the newspapers for the latest
prices. Even if the chosen fund bombed out, they would have
learned one of the most important rules in investing: that even the
best investments may hit a snag.
ONE LAST THOUGHTWhether your child is fi ve, 15 or 30, always discuss family investments
in their presence. You don’t need a huge portfolio, but regular
discussions will show the next generation that fi nancial planning is
fun and should be part of everyday life.
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Investing During Retirement
Contrary to what many people think, retirees need not make major
changes to the way they invest. As they move towards retirement,
they will have started to adjust their portfolios along the way by
switching to bonds and withdrawing from riskier instruments.
What is really important now is to fi nd ways to satisfy their need
for both income and growth, in order to meet their near-term
and long-term needs. It is a balancing act. How is one to achieve
growth, which is essential to meet rising future income needs,
without taking too much risk?
Th ere are three main questions on their minds:
• How much money can I safely withdraw?
• How can I make my nest egg last forever?
• How can I hedge my portfolio against infl ation?
HOW INFLATION CAN CREATE AN UNHAPPY RETIREMENTWhen I hear retirees talk about how their portfolios consist mainly
of fi xed deposits, we cringe. Why? Because we know infl ation will
cause them to end up with less money to spend. Looking at history,
we know that infl ation has frequently been higher than fi xed
deposit rates.
Th e fact is that while retirees need income and safety from their
investments, they also need growth. Take a look at Table 22.1. (page
238) which shows how much living costs can increase over a long
retirement, based on an infl ation rate of 2 per cent. If you are not
growing your money during retirement, how will you have enough
to last you through your retirement years?
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238 TABLE 22.1. LIVING EXPENSES DURING RETIREMENT ADJUSTED FOR INFLATION
Age Annual Living Expenses Adjusted for 2% Infl ation
60 20,000 30,000 40,000 50,000 60,000 70,000 80,000
65 22,082 33,122 44,163 55,204 66,245 77,286 88,326
70 24,380 36,570 48,760 60,950 73,140 85,330 97,520 75 26,917 40,376 53,835 67,293 80,752 94,211 107,669
80 29,719 44,578 59,438 74,297 89,157 104,016 118,876
85 32,812 49,218 65,624 82,030 98,436 114,842 131,248 90 36,227 54,341 72,454 90,568 108,682 126,795 144,909
95 39,998 59,997 79,996 99,994 119,993 139,992 159,991
100 44,161 66,241 88,322 110,402 132,482 154,563 176,643
Source: Authors’ own computations
Let us go through an example. Suppose Daniel, aged 59, is getting
ready to retire and he estimates that his living expenses in his fi rst
year of retirement will be $40,000. By age 80, Daniel will need
$59,438 a year or 50 per cent more than he started out with. While
infl ation in Singapore has been low, it can quickly add up over a
long retirement.
HOW LONG WILL YOUR MONEY LAST?Th is is the big question. Let us consider Table 22.2. (page 239) which
shows the number of years money will last at a given rate of return,
and a withdrawal rate.
Table 22.2 shows that if your retirement dollars can earn 5 per
cent a year and you withdraw 10 per cent of your money each
year, your money will last 13 years. If you have $300,000 in your
retirement fund, you can withdraw $30,000 per year for 13 years.
Now suppose your buddy Joe invests his money at 8 per cent. He
could withdraw 12 per cent or $36,000 per year for 13 years. Th at
is $500 more per month. Keeping most of your money in a fi xed
deposit is not a good long-term retirement plan.
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239TABLE 22.2. HOW LONG WILL YOUR MONEY LAST?
Rate of Capital Withdrawal (% per year)
6 7 8 9 10 11 12 13 14 15 16
5% 35 24 19 15 13 11 10 9 8 8 7
6 32 22 17 14 12 11 10 9 8 7
7 30 20 16 14 12 10 9 8 8
8 27 19 15 13 11 10 9 8
9 25 18 15 12 11 10 9
10 24 17 14 12 10 9
11 22 16 13 11 10
12 20 15 13 11
Source: Authors' own computations
SHOULD YOUR PORTFOLIO HAVE ZERO EQUITIES?Bonds are less risky than stocks. But that does not mean the retiree
should invest 100 per cent in bonds. In fact, studies show that retirees
should have a healthy amount of stocks in their portfolios, or about
20 per cent.
While bonds are less volatile, they are not totally immune to
volatility. A sudden rise in interest rates near the time you need the
money can ruin your retirement party. By adding equities to your
portfolio, you obtain:
1. Lower overall portfolio risk
Th is sounds weird, but it is true. When you add riskier
investments such as equities to your bond portfolio, you can
reduce your portfolio’s overall risk. Th e reason is that equity
and bond prices do not move together. Th e volatility of equities
balances out the volatility of bonds. Together, they usually lead
to a reduction of overall portfolio risk.
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240
2. Higher overall portfolio returns
Equities will off er you the growth to counter infl ation as well as
increase your income for a nice, long retirement.
BEGIN YOUR RETIREMENT PLAN TODAYNow that you have some idea about what it means to retire, let us
formulate a plan of action.
First, begin by stating your number of retirement years. You
obviously would not know how many years of life you have after 60.
To be safe, expect to live till 90. So if you plan to retire at 60, you
will have 30 years of retirement.
Second, what lump sum will you have at retirement? Let us
suppose you expect to have one million dollars. Th is amount
invested at 6 per cent will last 30 years if you withdraw 7 per cent
or $70,000 annually.
FIGURE 22.1. HOW EQUITIES AND BONDS TOGETHER REDUCE PORTFOLIO RISK
Source: Authors’ own illustration
Portfolio becomes
less volatile
Bonds
Equities
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241Th ird, save and invest like crazy. None of us wants a scaled-down
lifestyle during retirement. Stash the money aside today so that you
can live it up during your retirement.
IF YOU HAVE NOT INVESTED MUCH — HOW TO CATCH UPYou had wanted to start investing for retirement years ago. But
monthly bills, unexpected expenses and your children’s education
got in the way of a regular savings plan.
Or maybe you are counting on your CPF money. But you now
know that your CPF funds are not going to be enough to support
you comfortably through 30 years of retirement. If you are now in
your 40s or 50s and have yet to start building a retirement nest egg,
you cannot aff ord to wait any longer.
Avoid “Get Rich” TrapsTh e newspapers and internet are fi lled with get-rich, low-risk
schemes. We have seen more than a few of our middle-age friends
get hoodwinked by these schemes. Even when you are anxious, do
not dispose of your common sense.
With only 10 to 15 years till retirement, you need to choose
investments that will provide growth potential as well as security.
A balanced portfolio of 40 per cent in equities and 60 per cent in
bonds would be a good start. If you are on a late start, don’t further
endanger your future.
Consider Getting Professional AdviceIf choosing investments that strike the right balance between growth
and protection seems too daunting for you at this time, you could
benefi t from the advice of a fi nancial adviser. A fi nancial adviser can
help you choose funds, stocks and bonds, and help determine the
most appropriate asset allocation to meet your retirement goals.
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242Finding the MoneyFinding the money to invest is a big challenge because you do not
have the luxury of time. Most likely, you would have to cut back on
your current spending to fi nd money to invest.
Make a commitment to live more frugally. You do not have to
go hungry, but you can go to fewer expensive restaurants, go for
cheaper holidays and look out for bargains when you shop.
If one of your challenges is funding your children’s university,
consider getting them to take a loan instead. Th ey will have
a long time to pay it off , while you have a short time to prepare
for retirement.
If cutting your expenses is not fi nding you enough money,
consider selling your car. It is one of the most fi nancially draining
things to own. You could also consider a second job. Th e income
from a second job for a few years could get you back on track. And
fi nally, consider postponing your retirement by fi ve years. Working
past your 65th birthday is nothing to dread when you need money.
It can be fun especially when you have a job you enjoy.
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Protecting Your Wealth
with Insurance
You might be asking why we are talking about insurance in an
investment book. Well the reason is simple. You have worked hard
to build wealth and put your fi nances in order, and you don’t want
to leave your fi nancial security to chance. Saving, investing and
planning for the future won’t mean much if an unforeseen event such
as an accident or business failure leaves you fi nancially devastated.
Th is is where protection is needed.
Like most people, you probably already have a fair amount of
insurance to protect your home, income, health and life. You
understand that while insurance may seem like an added expense
in your budget, it’s necessary to your fi nancial plan.
You can insure almost anything under the sun, but certain
things absolutely need to be properly insured. Th ese include your
life, health, car and home as indicated by the bottom layer of the
pyramid shown below (see Figure 23.1.) We will assume that you
have already taken proper care of those basic insurance needs.
FIGURE 23.1 INSURANCE: THE FOUNDATION OF FINANCIAL SECURITY
SPE
CU
LA
TIO
NIN
VE
STIN
G
SAV
ING
S
INSU
RA
NC
E
Principal not guaranteed
Diversify your Investments
Principal is safe
Save 6 months’ salary for emergencies
Foundation of your Financial Security
Protect your life, health and wealth
Higher
possibility of
loss
23
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244Th e type of insurance we are discussing in this chapter deals with
protecting wealth that you already have acquired. Th at’s right. We
are assuming that you are affl uent with a fair amount of wealth
accumulated or you are steadily on the way to becoming fi nancially
comfortable. In fact, even if you are still busy building wealth for
your fi nancial security, the insurance concepts in this chapter will
be useful to you too.
CAN YOU IDENTIFY WITH SALLY?Sally has spent years taking risks and attaining wealth, and now at
age 50, she is looking for ways to preserving her wealth while earning
a good return without incurring major losses.
Affl uent individuals can easily identify with Sally’s situation.
After achieving success in their careers and businesses, they
begin to have this increasing desire to protect what they have
accumulated. Th e reasons for protection usually range from
wanting to pass on as much wealth as they can to their families to
funding a charity. Th ey want to meet these goals without causing
a huge drain in their wealth or aff ecting their ability to continue
their present lifestyles.
For these reasons, affl uent individuals like Sally should consider
life insurance; a vital component of their long-term planning.
INTRODUCING UNIVERSAL LIFE Th ese days, affl uent individuals have an insurance tool called
Universal Life (UL) insurance. One of the best ways to understand
UL policies is to compare it to Term and Whole Life (WL) policies,
which you are likely to be familiar with — see Table 23.1 (on page
245) for a summary of diff erences.
Universal life insurance is a form of “interest sensitive” type of
WL that off ers a death benefi t, and because of its fl exible premium
feature, it provides the opportunity to build cash values that the
policy holder can borrow from or withdraw. Th e policy cash values
earn interest at a declared rate, which may change over time. Most
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245UL plans guarantee a minimum interest crediting rate. Within
certain limits the policy holder can choose the amount, method
and timing of the premium, payments.
Th ere are three areas where UL diff ers from WL. Firstly, UL
insurance off ers a more transparent fee structure. Th at means you
will be make known of the cost and how much you are paying. It
also allows you to know how much you will be earning from the
policy. Secondly, the policy can be surrendered at any time and
access to cash values that grow at competitive interest rates. Th irdly,
UL policies have sums assured typically in the millions of dollars.
For families of the affl uent, the only thing more challenging than
attaining wealth is protecting it, keeping it for a lifetime and for
the next generation. Th is is where UL can help you by providing a
solid tool in preserving your wealth. UL is a relatively predictable
asset since the amount of death benefi t is usually guaranteed. It also
serves as form of diversifi cation to other investment assets. Th is
means that despite the occasional declines in the stock and bond
market the value held in a UL policy may remain unaff ected.
TABLE 23.1. SOME DIFFERENCES BETWEEN TERM, WHOLE LIFE AND
UNIVERSAL LIFE INSURANCE
Term Insurance Whole Life Universal Life
Duration Fixed such as 10 or 20 years.
Permanent, all of life.
Permanent, all of life.
Premium Usually fi xed. Guaranteed fi xed.
Flexible.
Cash Value
None. Projected cash value.
Guarantee minimum interest crediting rate.
Suitable for Whom
For those who seek pure protection for a fi xed period and because it’s aff ordable.
For those who are conservative savers and want protection all of life.
For those who want a large amount of protection and access to cash values that grow at competitive interest rates.
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246Let’s now turn to two situations in which affl uent individuals
can use UL insurance to protect their wealth. We look at Kim,
a business owner, and John, who wants to leave a donation to his
favorite charity when he passes away.
Kim the Business Owner
Kim left her IT job when she was 35 years old to strike out on her own.
She set up SoftTech to sell IT services to multinational companies.
Fifteen years later, Kim’s company has an annual turnover of $50
million and a healthy looking balance sheet with $15 million in net
assets.
TABLE 23.2. SOFTTECH’S BALANCE SHEET
ASSETS (in Millions) LIABILITIES (in Millions)
Cash 5 Accounts payable 5
Accounts receivables 10 Property loan 20
Commercial property 25
TOTAL ASSETS 40 TOTAL LIABILITIES 25
NET ASSETS 15
SoftTech has total assets of $40 million of which $5 million
is in cash and $10 million is owed by customers. Kim bought a
commercial property worth $25 million a year ago. It has a $20
million loan outstanding against it. SoftTech owes its suppliers $5
million. Overall, the company has net assets of $15 million.
With such a glowing set of fi nancials, Kim felt at ease since
$15 million would surely take care of her family, employees and
the business should something happen to her. What’s more, she
exercised regularly, ate well and was very healthy.
One day while driving to work, Kim became physically disabled
from an accident. Her mental abilities deteriorated and she was
unable to run the company like before, and subsequently died from
the accident. She had not appointed or trained a successor. Th e
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247company’s creditors and customers lost confi dence in the company.
Suppliers demanded to be paid. Th e commercial property market
sank, and the property’s valuation fell below the loan amount — the
bank called for $5 million to be topped up.
In this situation, there may be little choice but to sell the
company’s assets very quickly at fi re-sale prices in order to generate
liquidity to pay off creditors.
Business owners like Kim really do need to have business
continuation plans in place from day one, and life insurance is one
of the most cost-eff ective ways of funding such plans. Yet business
owners often shy away from insurance.
When Kim fi rst took out a loan to buy the commercial property,
her fi nancial adviser recommended life insurance to pay off the loan
in case she passed away or became disabled before the loan was paid
off . Kim not only felt she had enough money, but that life insurance
was expensive and an unnecessary cost to incur. She believed that
should she pass away, her family could sell or liquidate the business
to cover the loans and provide fi nancial security for them.
In reality, this rarely happens. When the family is forced to sell
the business quickly, they may have to sell at a discount or may
experience poor market conditions that make the business less
attractive. In most cases, the business is worth very little without
the founding owner around.
Individual life insurance can protect your family by providing
funds to cover debts, ongoing living expenses, and future plans in
the event that something happens to you. Insurance can also protect
the business by helping to make up for lost sales and earnings, and
to cover the cost of fi nding and training a replacement.
John Leaves a Legacy to His Favorite Charity
Affl uent people are some of the most generous givers to charitable
causes. To them, giving back can be one of the most fulfi lling
experiences of their lives, but they want to do so without wrecking
their retirement plans. Th is is where life insurance can help.
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248Suppose John wants to give away a sum of $1 million to his
university but does not have the liquidity to do so today. He can
buy a life insurance policy and make his university the benefi ciary
of his policy.
Th e price of a $1 million UL policy for a 40-year-old male non-
smoker would typically cost a one-time premium of around
$250,000. In other words, John’s university will receive his desired
donation of $1 million upon his death and he need only fund his
donation with about 25 cents to the dollar today.
CONCLUSIONUL policies have a place in your portfolio even when you are affl uent.
But before you buy a UL policy, there are a few questions you should
keep in mind.
1. Do you need such a policy? Go through a thorough fact fi nd
with your fi nancial adviser to examine your fi nancial situation
and life goals.
2. What happens to your policy if market conditions become
extremely poor? Are there guaranteed returns or might you be
expected to pay higher premiums?
3. Where is the policy is administered? Is it onshore in Singapore
or off shore in another country? Some people prefer UL policies
administered in Singapore so that they are subject to the
rigorous regulations of the Monetary Authority of Singapore
regarding the arrangement of life insurance policies. If
your policy is administered off shore, you need to be aware
of any jurisdictional risks found in that country. You also have
to consider the proximity to after-sales services. Remember
that it’s a permanent policy and you will probably use the
fl exibility of UL policies to make adjustments as your
circumstances change.
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1 Visit MoneySENSE at www.mas.gov.sg
When Things Go Wrong
You went to the bank to deposit money into your savings account.
While there, a relationship manager tried to interest you in an Asian
unit trust. Despite being new to investing, you were won over by
the relationship manager’s convincing presentation. You decided
to invest the money that was meant for your savings account. One
month later, the price of the unit trust falls 30 per cent. You’re very
upset. You feel you should not have bought the unit trust. You think
the relationship manager pressured you into buying.
Th is is a common story — investors losing money from investments
that have gone sour. What can you do when things go wrong?
While there will always be cases of unscrupulous salespersons
who take advantage of unwary consumers, the fact is that many of
us are capable of making appropriate investment decisions. Th ere
are countless opportunities to pick up investment tips, including
the many educational programmes and seminars sponsored by the
government as well as investment companies. You can learn more
from consumer guides, TV programmes, newspaper articles, web
tools and other seminars.1
Fortunately for consumers, most fi nancial services companies —
banks, fi nancial advisers, insurance companies and stock brokerages
— are fair and even-handed in their dealings with the investing
public. Constant scrutiny by the media and regulatory watchdogs
such as MAS have contributed to this practice of fair dealing.
In this chapter, we will discuss your rights as an investor and what
you can do when things go wrong.
24
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250YOUR RIGHTS AS A SHAREHOLDERAs a shareholder, whether you own 1,000 shares or 10,000 shares, you
have certain rights. You own part of the company and the company’s
management board is answerable to you.
The Right to InformationOne of your most important rights is that the management keeps
you informed about the progress of, and the material developments
that aff ect the company as it is required by law to do. Of course, the
law has to strike a balance. You should understand that disclosure
aims to put you on equal footing with every other investor, big or
small, and that even the most transparent disclosure provides no
guarantee against loss.
The Annual General Meeting (AGM)Th e annual general meeting (AGM) is an important occasion for
shareholders, especially minority ones, to meet and ask questions.
Attending the AGM is something few investors do although it is
one of the basic rights that come with stock ownership in a public
company. Every investor should attempt to attend annual meetings
as they give a clearer insight into how the aff airs of companies
are conducted.
Looking at the glossy pages in an annual report or the numbers
in the fi nancial statement seldom gives a clear understanding of the
management’s style and objectives. If you are investing a large sum
of money in a company, it makes sense to meet the management
team face-to-face for they are the ones who will ultimately
determine the returns on your investment.
The Proxy StatementTh e proxy statement is a document that a company is required by
law to provide to shareholders containing information that will be
brought up at the AGM.
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251Th ere is usually a section on the voting of resolutions, which may
include issues such as approval for fi nancial statements, declaration
of dividends, proposals for additions to the board of directors and
remuneration for auditors.
In essence, a proxy statement is a ballot sent to a company’s
shareholders whereby the company requests that shareholders vote
in favour of its offi cers and directors continuing in their positions. A
proxy also provides for a negative vote. As a shareholder, you can vote
against re-electing the present management. It is generally diffi cult
for individual shareholders to get rid of the existing management
unless it has openly performed fl agrant acts such as fraud. Hence,
it is not uncommon for a law-abiding, but mediocre management
to continue running a public company for a number of years,
particularly if ownership of the company’s shares is fragmented.
So unless you own a substantial amount of shares (5 per cent or
more), your best option, if you feel a company’s management is
doing a poor job, is to walk away by selling your shares.
WHEN SOMETHING GOES WRONGMost problems investors face fall into one of two categories. Th e fi rst
consists of outright criminal activity such as stealing and cheating
of money through some sort of scam or phony transaction. If
the investment was related to securities, you should contact MAS
or the police.
Th e second and more common category of problems encountered
by individual investors has to do with the execution of a trade, or
the way an account was handled. For example, you may be surprised
to receive a confi rmation via e-mail about a stock you have sold,
although you never gave such an order. Or you may be surprised at
the price at which your unit trust was sold when you had told your
fi nancial adviser to transact at a distinctly higher price.
Most fi nancial advisers and institutions are honest and fair in
their dealings with investors. Errors that occur are simply errors
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252and there is rarely an intention to cheat. Such errors are generally
corrected as soon as they are brought to the attention of the
company representative who sold you the investment.
Where to Turn for HelpShould you still feel that you have been unfairly treated, there are
several ways to seek redress. You can submit an offi cial letter of
complaint to the fi nancial institution. If this does not resolve your
problem, you can consider a dispute resolution scheme.2
Th e Financial Industry Disputes Resolution Centre Ltd. (FIDReC)
is an independent institution specialising in the resolution of
disputes between fi nancial institutions and consumers. FIDReC
was created from the merger of the Consumer Mediation Unit
(CMU) of the Association of Banks in Singapore and the Insurance
Disputes Resolution Organisation (IDRO) to streamline the dispute
resolution processes across the entire fi nancial sector of Singapore.
FIDReC provides an aff ordable and accessible one-stop avenue
for consumers to resolve their disputes with fi nancial institutions
without having to go to court, which is a costlier and more time-
consuming option. For example, consumers can go to FIDReC in
the following situations:
1. For claims between insured consumers and insurance companies:
up to S$100,000.
2. For disputes between banks and consumers, capital market
disputes and all other disputes (including third party claims
and market conduct claims): up to S$50,000.
At present, FIDReC’s services are available to all consumers
who are individuals or sole-proprietors. Consumers pay a
2For a more detailed explanation on dispute resolution, please see “Getting it
Right: How to Resolve a Problem with your Financial Institution”, a MoneySENSE
Consumer Guide at www.mas.gov.sg.
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253nominal administrative fee of S$50 when their cases proceed for
adjudication, and the fi nancial institution pays S$500.
You may even go one step further by seeking the help of a panel
of mediators appointed by FIDReC. Th e panel will give you access
to a pool of industry experts and professionals. Th e panel has the
authority to order the fi nancial institution to do certain things, such
as perform their contractual obligations or make monetary awards.
Its rulings are binding on the fi nancial institution, but not on you.
If you do not accept the panel’s ruling, you can choose to pursue
legal action or approach the Consumers Association of Singapore
(CASE), the Singapore Mediation Centre (SMC) or the Small
Claims Tribunal (SCT). Th ese organisations handle disputes across
all types of products and services, and not just those on fi nancial
matters. In general, taking legal action should be the last resort as it
is usually time-consuming and costly.
If you have a problem with your remisier, you can approach
Securities Investors Association of Singapore (SIAS) Disputes between
retail investors are handled by the Dispute Resolution Committee
whose members meet from time to time when complaints are
received. Not every complaint is heard by the committee. If the
complaint is justifi ed, the committee will seek a cordial settlement
with the broking house concerned. If the complaint is serious and it
contravenes the bye-laws of SGX, the matter is referred to SGX. As
with FIDReC, legal action is avoided.3
3For more information, please visit these websites: www.mas.gov.sg; www.case.org.
sg; www.sias.org.sg; www. sgx.com; and www.fi drec.com.sg
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As the market rose, people started to liken the market to a money-
making machine. In such an euphoric environment, according to a
survey, investors felt that fi nancial advisers were unlikely to be able
to add further value.
Getting Financial Advice
Are you a DIY (do-it-yourself ) investor? Or do you prefer to work
with a fi nancial adviser and let him help with the analysis?
As it turns out, your answer could very well depend on market
conditions. If you were invested in the U.S. market between 1995
and 2000, your answer would have been “no”. Th at is because during
that time, the S&P 500 tripled in value, from 500 to 1500 points,
off ering a very nice return of 25 per cent annually over fi ve years.
FIGURE 25.1. S&P 500 BETWEEN 1985 AND 2010
2000
1500
1000
500
0
1985 1990 1995 2000 2005 2010
Source: Standard & Poor’s
25
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255By 2003, when the S&P fell 50 per cent, many investors lost
large fortunes. A second survey done by the same company then
found that over 90 per cent expressed interest in working with a
fi nancial adviser.
DO YOU NEED A FINANCIAL ADVISER?Before deciding whether you need a fi nancial adviser, answer these
two questions:
1. Are you worried about how to handle market volatility? Markets
will sometimes go crazy. Have you a game plan when that
happens?
2. How much time are you willing to spend constructing and
monitoring your portfolio, as well as following the market and
reading up on new products?
If these questions make you feel uneasy, or suggest that you could
use some help, a fi nancial adviser can be a great ally. Working with
a fi nancial adviser off ers three important benefi ts:
1. Time
Investing on your own takes time. Th is is time that is taken
away from your family, your work and hobbies. Some of the
smartest people around have fi nancial advisers. Daniel
Kahneman, who shared the Nobel Prize in Economics with
Vernon L. Smith in 2002, admits that he gets advice from his
fi nancial adviser.
2. Discipline
Financial advisers use a structured process to manage your
investments. Every six months, or at some fi xed interval, your
adviser will meet you to update you on your portfolio and the
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256 market. If your adviser is worth his salt, he will also consistently
nag you to invest smartly to keep you on track.
3. Expertise
Financial advisers have the expertise that most investors may
not have to do an eff ective job. Th is is not to say that investors
are not capable of attaining this expertise. We have spent
chapters of this book saying you can. But the fact is that
fi nancial advisers have made the commitment to attain a level
of expertise that most investors are not willing to make.
Financial advisers go through rigorous exams to get licensed.
Some fi nancial advisers even take professional exams to get
more expertise. As a result, they have the latest knowledge of
the markets, products and solutions to help you.
ARE ALL CERTIFICATIONS CREATED EQUAL?
If you have trouble sifting through the alphabet soup to tell the
diff erence between a CFA, ChFC and CFPCM, here is some help.
Below is a list of fi ve popular designations and what each one does:
Chartered Financial Analyst (CFA)
Th is is the Rolls-Royce designation for investment
professionals. A CFA holder is a specialist and he has to
demonstrate competence by passing exams on accounting,
economics, money management and security analysis.
CFAs tend to work with institutions rather than directly
with individuals.
Certifi ed Financial Planner (CFPCM)
A CFPCM holder has overall expertise in personal fi nancial
planning in these areas — risk management, insurance, tax,
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How Meaningful are These Letters?Certifi cations are a mark of professionalism. A professional has
gone the distance to acquire expertise. He conforms to a strict code
of ethics to provide advice for your benefi t rather than his own.
Certifi cations are conferred on individuals with a certain number
of years of relevant work experience. Th is ensures that the ChFC or
CFP sitting across the table is not fresh out of school.
While certifi cations are not everything, you should give credit
to an adviser who has any of these designations. Many of these
certifi cations require many hours of study to meet high standards.
WHERE DO FINANCIAL ADVISERS COME FROM?Th ere are some 13,000 fi nancial advisers in Singapore and they come
from two main sources:
estate planning, investments and retirement planning. Unlike
a CFA holder, a CFPCM holder has not obtained the knowledge
to be a specialist in any one area.
Chartered Financial Consultant (ChFC)
Th e ChFC is similar to the CFPCM. Th e ChFC holder has
also not demonstrated specialist knowledge in any one area.
Where they diff er is that the ChFC requires the candidate
to pass two more exams compared with the six the CFPCM
candidate has to take. Th e two exams deal with planning for
business owners and wealth management.
Chartered Life Underwriter (CLU)
Th is designation is for a specialist in insurance.
Certifi ed Public Accountant (CPA)
CPAs are specialists in tax and accounting. Th eir title does not
indicate training in other areas of fi nancial planning.
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2581. Financial advisers who are “tied” to a specifi c company and its
products
Tied advisers such as those from Prudential and AIA can only
sell fi nancial products created or distributed by their
companies. If you are looking for an investment product,
your AIA adviser can sell you only products that AIA
distributes. Tied advisers usually come from four large
companies — besides Prudential and AIA, there is also Great
Eastern and NTUC Income. Th ere are about 12,000 tied
advisers in Singapore.
2. Financial advisers who are not tied to a specifi c company and
its products
Th ese untied fi nancial advisers can advise and sell you products
from several product manufacturers. So if you are looking for
an investment product, an untied FA will have access to many of
the fund management houses in Singapore. Th ere are around 30
untied companies in Singapore with about 1,000 advisers in total.
Does this mean that you should only go with untied fi nancial
advisers who can off er you products from many companies rather
than a tied fi nancial adviser who can off er products from only his
company? Th is is a huge, ongoing debate that is not about to cease.
Depending on which side of the fence an adviser sits — tied or untied
— you will hear an impassioned endorsement for the side he sits on.
Th is is the bottom line — products do not make the valued
adviser, good advice does. If you take the trouble, you can buy many
investment products directly on your own. Products are always
available, but not good advice.
One study by CEG Worldwide in 2003 by Russ Alan Prince, a
renowned researcher on the wealthy in the U.S., showed that
investors are generally starved of good advice and that a mere
26.7 per cent of investors surveyed were very satisfi ed with
their current advisers. Th e remaining three-quarters regard
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259their advisers as “fair” or “poor” and are willing to work with
someone else.
FINDING A GOOD ADVISERJust what should you look for in a good adviser? Here are three
“must-have” factors to look out for.
The Adviser is Licensed Financial advisers are licensed by the Monetary Authority of
Singapore when they pass the required regulatory exams and are
registered as advisers with a fi nancial advising company.
Registered financial advisers have a fiduciary responsibility
to provide financial advice that is in your best interest. They
typically have to sit you down and take you through the
seemingly tedious process of answering questions from a form
called the Financial Needs Analysis. It would be silly of you to
take this lightly.
Th e questions help you and your adviser learn about your
fi nancial objectives and risk profi le — two critical components
to fi nding suitable investment products for your portfolio. Just as
your doctor would not know what is wrong with you unless you
tell him, your fi nancial planner will not know how best to help
you if you do not tell him your fi nancial goals.
Comfort ZoneIf you come across an adviser who annoys you no matter how
clever he is, you might want to drop the fellow. While you and your
adviser need not be soul mates, you need a basic level of comfort
and rapport to get anything done.
When we present lectures to fi nancial advisers on investing, we
convey this important message — it is not worth the money to work
with a client that you do not like, or do not get along with.
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260Making SenseDo you generally agree with how your adviser thinks? Or are you
always arguing with the recommendations your adviser makes?
Th e fact is that if you are always in disagreement with him, there
is probably some fundamental diff erence between the way both of
you think.
Whether you or your adviser turns out to be right in the end is
secondary. What matters more is that you and your adviser have
a fundamental diff erence in thinking about an important issue —
how you manage your assets.
PREPARING TO TALK TO YOUR FINANCIAL ADVISERFinancial advisers cannot make decisions for you. You give them
the facts, they off er advice and you have to decide what to do. It
is a mistake to assume that they can take away the risks and make
predictions. Th at is why it is a good idea to do some preparation
before you meet.
If you only have 10 minutes to spare, here are fi ve questions we
recommend you ask:
1. Do you invest yourself? Tell me about your investing experience.
2. What kind of expertise does your company have to help me?
3. How are you being paid to give me advice?
4. How can I lose money if I follow your investment plan?
5. What problems can I face if I need my money back earlier?
HOW DOES YOUR ADVISER EARN WHEN YOU BUY INVESTMENTS?Your adviser earns from the investments you buy. He could earn
from upfront, one-time-only commissions, or he could earn
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261a recurring fee based on the amount that you have invested
with him.
What? Keep paying your adviser year after year?
If that sounds crazy to you, then you will be surprised to hear that
this is actually becoming a popular way of managing investments.
TABLE 25.1. TYPICAL PAYMENT MODES FOR ADVISERS
Commission
structureUpfront commission Recurring fee
Traditional
commission-based5% None
Recurring fee-based 2% 1%
Source: Authors’ own illustration
Example of Traditional Versus Recurring Fee StructureTh e traditional commission-based adviser gets paid a lump sum
when investment purchases are made. Th ese purchases can be
either outright new purchases or switches (where you sell out of one
investment and buy into another one).
Th e recurring fee-based adviser often charges a lower upfront
fee, plus a low, recurring annual fee based on the value of the
investment assets under advisory (AUA). For example, your adviser
may charge you an upfront 2 per cent (as opposed to 5 per cent)
and subsequently on an annual basis, he charges you 1 per cent
based on AUA.
You will see that it will take about three years before you will have
paid a total of 5 per cent (2 + 1 + 1 + 1) in terms of fees. In the
meantime, you can evaluate whether your adviser is doing a good
job or not. Your adviser does well when your investment portfolio
does well. So he has the incentive to do a good job over many years
rather than just during the fi rst year.
If you are planning to pay your adviser annual recurring fees,
do ask about a wrap account. Wrap accounts off er free switching.
When you sell one investment and buy another within a wrap
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262account, it will not cost you any money and your adviser does not
earn from the switching.
Paying for Financial AdviceYou have found your ideal adviser. He is competent, has a team of
experts and he even has a great sense of humour. Would you pay him
a fee for fi nancial advice? NTUC conducted a survey in 2002 and
found that seven out of 10 people were not willing to pay for fi nancial
advice. Are you one of the seven?
Suppose you have $100,000 to invest. Here are two questions you
should ask yourself:
1. Would you value free fi nancial advice?
Imagine going to a dentist who says he will not charge you for
the time and advice he gives you. You will be worried if he
might pull your teeth out to sell you dentures. You see, paying
a fee helps ensure that the fi nancial adviser does his best.
2. Would you be doing the best for yourself?
Suppose you want to learn Chinese. Your colleague off ers to
teach you for free every Saturday afternoon. Good deal? Bad
deal. When things are free, you just will not take things as
seriously. When you pay a fee, you take greater responsibility
for your own aff airs.You will ask better questions. You will
keep better records. You will take greater interest in what is
being said and done. Your fi nancial adviser will serve you
better if he is paid.
Th ere are exceptions, of course, because paying a fee does not
make sense in certain situations. You may know exactly what you
want — for example, a mortgage. Or the amount may be small — you
want to invest $2,000 in a balanced fund. In both situations, a simple
product purchase will do the job. A fee is not paid for any advice, and
the fi nancial adviser earns a commission from the product sold.
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263As a rule of thumb, paying a fee makes sense when the amount
invested or managed is large, such as $100,000; the situation is
complex enough that analysis and advice are needed, such as
creating a comprehensive fi nancial plan; or the objective is a long-
term one that requires regular monitoring and adjustments, such as
managing a portfolio of investments for your retirement.
What is generally true is that many of our fi nancial needs are long
term and they have to be managed over the course of our lives. We
need a structured process to look after these matters. In return for
getting a regular dose of good advice, you should consider paying a
regular fee. Your fi nancial adviser may give you good advice for free
today, but he may not be around too often to help you in future. Be
mindful, though, that paying for advice does not necessarily mean
you will get good advice.
ARE YOU A GOOD CLIENT?A lot of the success of an investor has to come from the investor
himself. Sure, we know that fi nancial advisers have a responsibility to
act in a prudent manner with regard to your money. Th ey have to go
through a fact fi nd with you, ask a zillion questions and then crunch
all sort of numbers. But how prudent are you yourself in making sure
you succeed with your fi nancial objectives?
Let's look at three activities that will help you help yourself — and
better your relationship with your rep.
1. Keep Up-To-Date Records — Do you keep your investment
accounts in a special fi le or do you put them anywhere you can
stuff paper, such as under your car seat or your messy work
table? Do you even know what investments and insurance
policies you own? You’ll be surprised how many people don’t
even know this.
2. Take Detailed Notes — When you communicate with your
adviser on the phone, via email, or in person, take notes. Th is
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264 will give you a hard copy of the experience, and if you are not
so savvy with investments, you will have your notes to refl ect
on and learn. And if there is ever a confl ict between you and
your adviser, these notes will serve as evidence of what
transpired.
3. Track Commissions — Commissions can take a big bite out
of your investment returns, and can be very painful when the
market is going down. So make sure you are being charged
what you are supposed to be charged. Don’t assume that
just because your fi nancial adviser uses a large, fancy computer
programme to generate reports, mistakes can’t happen.
THE BOTTOM LINEOne of our mutual friends who is a very successful adviser was asked
how he became so successful. He replied that 25 per cent of his clients
were, in his words, super-charged investors. Th ey would constantly
hound him for information, question his advice, expect regular
updates on the economy, and quite often, even give him really useful
insights on investments. His super-charged clients keep him on his
toes and as a result, he does know more than other advisers. Are you
a super-charged investor yourself?
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1If you had a $100,000 portfolio that fell by 50 per cent to $50,000, your portfolio
would have to go up 100 per cent in order to get back up to $100,000.
Protecting Your Portfolio in
Downturns and Upturns
We have advocated many of our long-held beliefs about how
successful investing should be carried out in this book:
• Place most of your retirement funds into a diversifi ed portfolio.
• Buy and hold because you can’t time the market.
• Get a professional to help you.
If you have done this throughout the years running up to your
retirement, you will have done fi ne.
When the subprime crisis began unravelling, many people found
their portfolios drop by 30-50 per cent in a matter of a few months.
In the fi ve months between October 2007 and March 2008, the
STI fell over 1,000 points. If you were one of the unfortunate ones
whose portfolio fell by 50 per cent or more, here are three points
to consider:
1. Your portfolio will now have to rise by 100 per cent in order for
it to go back to its pre-crisis level.1
2. Where was your fi nancial adviser when all this was happening?
3. What can you do to make sure you don’t get into such a mess
again?
26
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266Let us take the fi rst point. With a 100 per cent climb ahead, you
would be asking when your portfolio would regain its value and
continue its long-term upward trend. We’ve seen that markets do
adjust quickly and with more governments working together to
avert and manage disasters, it might even be faster.
But suppose you don’t have the time because you were planning
on retiring when the crisis hit. Or your children are going to
university next year, and you just lost two years of tuition fees. Th is
would be a very bad situation to be in and not uncommon at all
whenever a crisis hits.
Now what if you do have time to recover because you’re still
young? Well-meaning fi nancial advisers are apt to say that given
time, your portfolio will recover, so don’t sell … hold. Well, you may
be surprised to know that this does not work all the time and when
it does not work, the pain can be excruciating and last a long time.
Look at the STI during these two periods:
Year Level
1996 2400
2006 2400
Th e STI hit 2400 in 1996 on the heels of the Asian fi nancial crisis.
While the STI recovered to pre-crisis levels in 2000, it didn’t go
much higher than the 2400 level. It was only in 2006 that the STI
went appreciably beyond 2400. You see, even when you have time
on your side, you may also have pure bad luck.
Th e next question is how well your fi nancial adviser served
you during this time. Did he contact you when the crisis hit or
did he hide away to avoid your anger? Did he have the ability to
distinguish between safe and unsafe market conditions?2 And
even if he did, would he have asked you to liquidate your positions
when the crisis hit?
2Judging from their huge multi-billion losses, you’ll see that the largest banks in the
world had a tough time fi guring this out too.
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267Probably not. Financial advisers and fi nancial institutions rarely
emphasise selling strategies. Everyone from banks and brokerages
to private bankers and fi nancial advisers all emphasise buying
strategies. And once you have bought, they try their best to
have your funds stay with them since assets under management
(AUM) are a recurring source of income for them. Even when
prospects for an investment have turned very poor, advisers rarely
downgrade its rating from “buy” to “sell”, but instead downgrade
them from “buy” to “neutral”, or from “buy” to “hold”. Tune in to
the business news to listen to analysts and corporate executives,
and try counting the number of buy versus sell recommendations.
Professional advice is often tainted by confl icts of interest and
you have to understand that. In the end, we all need professionals
to do the things we cannot do, but you have to keep both eyes and
ears open. Th e important rule is that you really can’t trust anyone
100 per cent, not even your own spouse or your parents, to monitor
your portfolio the way it should be monitored. It is you who has
that ultimate responsibility.
So the question really is, “Where were you when the market was
falling?” Did you keep up with the news? Did you contact your
fi nancial adviser? Did you speak to your friends in the know about
what was happening? Did you take care of your own fi nancial
well-being?
Finally, what can you do to avoid such situations in future? We
will examine this very question the rest of this chapter.
PROTECTING YOURSELF IN AN UPTURNTh ere’s no typo here. Many people get euphoric and blind when
the market is doing well. Th ey get into riskier instruments, ignore
their fi nancial advisers, give everyone they meet investment tips and
throw their long-term asset allocation down the canal.
When your portfolio is rising in value, there are a few things you
can do to keep it structurally safe.
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2681.Rebalance your portfolio regularly
When your stock allocation rises above the recommended long-
term allocation, rebalance the portfolio. If stocks have outpaced
bonds, it means you should sell stocks and buy bonds to return
your portfolio to its long-term allocation. Buy-low, sell-high
always works. Studies show that rebalancing not only produces
better results than not rebalancing, but also reduces your
portfolio’s risk.
2. Try a short-term momentum strategy
One criticism of rebalancing is that you are selling investments
before they reach their highest point. Here’s an alternative.
Studies have shown that when funds do well in the recent past,
chances are that they will do well in the near future as well.
Th is is a short-term momentum strategy of “buying high” that
appears to be quite opposite to the buy-low sell-high tactic
of rebalancing.
According to a study by Gerald and Marvin Appel, it was
found that funds with above-average performance during a
three-month period have a better chance of returning above-
average profi ts during the subsequent three-month period.3
Th ey showed with the help of ETFs how they were able to
outperform the underlying benchmarks consistently with this
momentum approach. Th is is a strategy we can carry out quite
easily by simply switching into the top-performing funds within a
category every three months. What this would entail for you for
Asia ex-Japan funds, for example, is to access www.fundsingapore.
com every three months to fi nd out which funds outperformed
and to switch into that fund, and to do this every three months.
You should try this only if you are prepared to monitor your
portfolio regularly. We have not back-tested this strategy on our
regional markets although we believe it makes sense because
3“Beating the Market, 3 Months at a Time,” by Gerald and Marvin Appel.
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269when securities are on an uptrend, they tend to remain on that
trend for some time.
3. Redo your risk profi le once a year
Your risk profi le is meant to be a long-term indicator of an
appropriate asset allocation. If you are deemed an aggressive
investor, then your asset allocation should refl ect that view
accordingly with larger amounts of stocks versus bonds in your
retirement portfolio.
You should still do your risk profi le once a year, particularly
when you are at the threshold of the next risk level. For
example, if you are planning on retiring soon and your risk
profi le was done three years ago when you were deemed an
aggressive investor, you should redo your risk profi le right away
and make any necessary adjustments to your asset allocation.
Long-term indicators can change from year to year for short
periods of time. For example, suppose:
• You just won a huge lottery.
• You and your spouse are expecting twins.
• You contract a rare disease and the doctor says you need 12
months to recover.
• Your apartment went en bloc.
• Your daughter won a university scholarship.
• Your retirement portfolio lost 50 per cent this year.
Th ese negative and positive situations are not remote at all. Th ey
happen all the time and they are unpredictable. Do hang on to your
long-term asset allocation, but please do your short-term checks
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270also. Unexpected short-term events can permanently alter your
long-term plans.
PROTECTING YOURSELF IN A DOWNTURNTh e market is falling. If you want to be more active about managing
your portfolio, and not just buy-and-hold, here is a list of strategies
you can consider:
1. Sell your holdings and move to cash
Th is is not our favourite recommendation because it means
incurring selling costs and moving your funds into cash that
earns you less than the infl ation rate.
2. Stay diversifi ed
You should do this without question.
3. Move into more favourable sectors in small steps
Th is requires some monitoring. If the U.S. is faltering and
China is hot, then reallocate fi ve per cent to China or an Asian
investment. If stocks are doing poorly, reallocate fi ve per cent
more to commodities or to bonds. We recommend that you do
such active reallocation in small steps and such that your
portfolio is not completely out of sync with your long-term plan.
4. Buy quality
Buying quality such as blue chip stocks is a defensive move that
works regardless of market conditions. So don’t wait for the
market to be in a downturn before you invest in quality.
5. Buy absolute return investments
Hedge funds are a good choice as they focus on absolute
returns. If you are not an accredited investor, then there are
quite a number of absolute return unit trusts available in
Singapore. While hedge funds can short-sell stocks, use
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271 various derivatives and leverage, unit trusts cannot, but can
use derivatives to generate income and hedge market exposure
in order to generate absolute returns.
6. Invest in commodities
As stocks are falling, commodities have been rising. Not
only is there a low correlation between stocks and
commodities, commodities have provided good protection
against infl ation.
7. Sell derivatives
If you want to protect your Singapore portfolio, for example,
you could short sell STI futures. In the event of a market
downturn, your losses from your actual portfolio can be
compensated by the gains from your short futures position.
8. Invest in the market through ETFs
Th is will save you expenses when you are in a tight spot although
you will have to accept that ETFs are not expected to outperform
their benchmarks.
You see that many of the protective steps you can consider
taking — whether the market is in a downturn or upturn — may
be outside the expertise of your fi nancial adviser, or outside the
scope of products the fi nancial institutions he belongs to off ers.
We’re not suggesting that you have four or fi ve professional
advisers to advise you on your portfolio. After a certain number,
too many cooks will ruin your soup unless perhaps, you have at
least a mega-million dollar portfolio, in which case you may not
even need this book.
Th e Asian fi nancial crisis in 1996 changed a lot of perceptions as
it showed how interlinked the world’s economies are. Th ese days,
we have a globalised fi nancial system that allows billions of dollars
to move from one jurisdiction to another in seconds, hedge fund
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272managers taking a bad situation such as the subprime crisis
to make billions, and the invention of technically challenging
products because of innovations made by fi nancial engineering.
We believe that as you move forward, you really need to pay
attention more actively to the markets, monitor your portfolio
actively and get the best fi nancial advice you can. Yes, we believe
in buy and hold, but please actively monitor your portfolio at the
same time.
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