Sunday, November 25, 2007

Did you say the word "invest"?

Updated 25 November 2007: Added Cash asset class

To build up your retirement portfolio, I don't think we can run away from investing. Some people might say... I have already invested in fixed deposits (FD). It's not technically wrong, but you'll take a long time to build up your retirement just by using FDs. Let me give an example of someone investing $10,000 in FD returning 1% compounded, and in a balanced portfolio returning 5% compounded for 20 years:

FD (1%): $12,201.90
Balanced portfolio (5%): $26,532.98

See the difference? It's more than double. Now with Singapore's inflation getting higher and higher, our miserable FD rates will not even be sufficient enough to even overcome inflation. However, not everything is about returns. You must be able to first take the risk that comes with it.

I will just briefly introduce you to the 4 common asset classes for investing.

This is not the money you keep under the pillow, or in the bank's miserable 0.25% p.a. savings account. This usually represents the FDs, Treasury Bills (T-Bills), and the money market funds.

Basically, this means stocks, unit trusts, index funds, and Exchange Traded Funds (ETFs). What are stocks? Basically, it just means that a company allows the public to invest in the company, with the public hoping that it will become the next Apple, or Sony. The company will issue shares which the public can buy from an exchange. In Singapore, its the SinGapore eXchange (SGX). In the SGX, you can find financial reports, and announcements with regards to the company. This is considered very high risk because there is no capital guarantee, and you might not have any returns for some time.

Unit trusts usually invests in a basket of companies (There are some that invest in other investments). Therefore, when an investor buys into a unit trust, they are buying into a basket
of companies, thereby diversifying their risks of the companies going bankrupt. The unit trusts are also available to the public for subscription.

Index funds usually buy into all the companies that are in the index. Giving an example, whenever you hear someone in Singapore say that the market is good/bad, they are usually referring to the Straits Times Index (STI). The index contains a number of companies like Singtel, DBS, OCBC, etc. So if an index fund buys into the STI index, the index fund will own all the companies within the index. The index fund will rise and fall together with the index, minus the fund expenses. The risk is lower than unit trust because very seldom will the whole index collapse. The index usually consists of companies that are the one of the biggest, and influential in the country. It is unlikely, although possible, that all the companies in the index will go bankrupt. Therefore, this risk is one of the lowest among equities.

Exchange Traded Funds are similar to Index funds. The only exception is that they are listed in the exchange (e.g. SGX), and you're able to buy them like stocks.

It just means that you're lending money to a person. Whenever you invest in a bond, you're allowing your money to be lent to another company/orgainization. It's actually similar to FDs, just that its much bigger.

There are many types of bonds like government bonds, company bonds, and the mortgage backed bonds. These bonds can be termed investment grade (meaning it is relatively safe), or junk (meaning it is risky). The current sub-prime crisis in the United States (US) originates from junk mortgage backed bonds.

The bond might give you interest regularly like your FDs, or it can be a zero-coupon bond, meaning that you receive no interest. Instead, you'll get a discount when you buy the bond, and you'll get back the "original price" when the bond matures. Our Treasury Bills (T-Bills) are zero-coupon.

For bonds, it is less risky than equities, but there is still risk. A bond can also run into a risk of default (company go bankrupt), or the risk that the bond interest does not cover inflation.

Alternate Investments:
This covers a wide range of investment products, like gold, silver, wine and property.

Usually, people will choose a mix of investments of the above asset classes so as to diversify their risks. If there is no overweight of any asset class and it covers many asset classes, it is sometimes known as a balanced portfolio. Balance the risks out and you'll find that the returns are relatively safe, compared to the risks involved.

If you wish to read up on more, there are many books in our easily accessible libraries. I've only covered the very basics here. It is always better to know about this, even if you have someone managing your portfolio for you. It's better to be informed.

Next on my retirement series, I will talk about Risk and Returns.

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