Investment 102: Traditional investment and personal wealth management
Last time I briefly introduced you to the world of investment, concept of diversification and current investment environment. Today, I would like to summarize different types of investments and provide you with basic information on how to allocate your wealth in the most optimal matter.
The complex world of investment can be intimidating at first, but it really isn’t the case. The golden rule of finance is “higher the risk, higher the reward”. The opposite is true as well. Thus, let’s go through the “investment ladder” from the lowest risk (and the lowest return) to the highest risk (and the highest return) asset classes.
You might have heard “cash is king” and there is a good reason behind it. Cash and its equivalents, including bank deposits and certificates of deposit, have the lowest risk of losing its value and the investors have a clear understanding of how much interest they will earn over what period of time. The downside is since it is such a low risk investment, the return is also low and often times a local currency deposit doesn’t overcome the combined purchasing power depreciation of inflation and foreign currency appreciation. In March 2021, MNT deposit weighted average interest was 10.2% and foreign currency deposit rate was 3.4% for individuals. Furthermore, MNT deposits are insured up to MNT 20 million while FX deposits are not insured at all.
For example, let’s say you placed your excess tugriks in a bank deposit for 12% per year. During the same period, let’s say the national inflation was 8% per year and USD appreciated from ₮2,500 to ₮2,750. Given such context, your purchasing power in USD will have reduced by 12% (MNT) — 8% (Inflation) — 10% [(2750–2500)/2500] = — 6%. Since we live in an import dependent economy, it would be in your best interest to preserve or increase your purchasing power no matter the currency.
Bonds are a form of debt obligation, a loan provided by the investor to the borrower. Similar to deposits, the interest rate and maturity of bonds are clear at the time of investment. Unlike deposits, the bondholder can trade his/her bonds to exchange for cash in accordance with the market price. Public and private sector entities utilize bonds extensively to finance their operations, expansion and existing debt.
Mutual funds and ETFs
While there are many different types of investment funds, one can think of mutual funds and ETFs as a publicly listed company. Only, the company doesn’t have any workers and only exists in legal documents. Investment funds are special purpose companies (SPC) that are managed by professional investment managers to carry out operations mandated by its investment policy. Similar to bonds, investors of mutual funds and ETFs can sell their share back to the fund or trade on securities exchanges to other investors.
Stock investment grants the investor the same privileges and responsibilities as the company owner, proportionally. Like the owner, the stock investor enjoys the value appreciation of the company and its profits. Also like the owner, the investor suffers the value depreciation and losses. While the company may choose to pay a dividend, there is no guarantee of any return and the investor can lose all of its investments should the company go bankrupt. On the other hand, if the company does very well, the initial investment amount can increase many folds.
As the name suggests, anything that doesn’t fall under the above mentioned categories, it falls under alternative investment. Common types of alternative investments include real estate and real estate investment trusts (REITs), private equity and venture capital (private investment fund that locks up investors’ funds for a certain period, typically 10 years), hedge fund (actively managed private investment fund with a goal to earn higher return than the market), commodities (e.g. gold, silver, copper, iron ore, corn, coffee) and derivatives (financial instrument that derives its value from another asset or instrument). Since these types of investments are typically illiquid, i.e. take longer to turn into cash, there inherently is a high risk and high return.
Now that we have basic understanding of different asset classes, let’s explore how one should optimize his/her investment portfolio based on goal, investment horizon, risk tolerance or appetite and age.
Personal wealth management and portfolio allocation
Since there are countless investable assets and every person’s situation is different, there is no one-size-fit-all solution to personal wealth management and portfolio allocation. As I mentioned in my previous article, one should not put all of his/her eggs in a single basket and on top of that, the eggs should be placed in different risk/ return baskets as well. In general, the longer you can afford to invest, the more of your eggs should be in a higher risk/return basket.
Let’s look at how one’s investment portfolio might change over the years with the following example:
- Name: Bold
- Age: 25 years old
- Risk appetite: Moderate
- Desired retirement age: 50 years old
Portfolio 1 (age 25)
As a young professional with stable income, Bold doesn’t need the guaranteed interest revenue of bank deposits or bonds and he is planning to work for 25 more years, Bold would benefit greatly from allocating most of his funds to higher risk investments that in the long run return greater value over low risk investments. Thus an example allocation could be the following:
Portfolio 2 (age 35)
When Bold is 35 years old, he will have 15 more years left till retirement and may need additional income to support his family or pursue other ventures. Thus, his portfolio might be as follows:
Bold has reduced his stock holding to purchase bonds, real estate and alternative investments to supplement his income with expected large payoffs when he nears retirement age.
Portfolio 3 (age 45)
WIth 5 years left to work, Bold is ready to enjoy the fruits of his labour and let his money work for him.
While Bold further reduced his stock holdings to purchase more bonds, he is still keeping a substantial amount of his networth in alternative investment (total 40%) for future capital expenses such as education for his children and inheritance.
Please be noted that these illustrations are for informational purposes only and aren’t in any way investment advice. Should you be interested in identifying your investment risk tolerance and explore further, please click on the appropriate links.
As a conclusion, I’ll leave you with this eye opening video by analyzingalpha.com, which shows the power of equity and compounding investments over time. In the next article, we’ll explore the exciting world of alternative investment in detail.
Have a good day and until next time,
Finance and investment advisor to Steppe Group