Understanding saving and investing
Saving and investing are important parts of your financial plan. What you save and invest should help you reach your financial goals. But all investments come with risk. Investments offering potentially higher expected returns also expose you to a higher risk of losing money. This is known as the risk-return tradeoff.
Before you start investing, find out about basic investing concepts like how return and risk are related, how to manage risk through diversification and asset allocation, what investment horizon means and how dollar cost averaging differs from market timing. At all times, you must be clear about your needs, your ability to withstand risk and losses, and also how well you understand a product to be suitable for you.
What is a return?
The return on an investment is the gain or loss made on the investment. It can be income earned from a product and / or the capital gain or loss (price gain or loss) on the product.
Examples of income include interest you earn from a bank deposit, or the coupon you receive from a bond, or the dividend payment from shares or unit trusts you hold. At times, in order to meet its income payout objective, managers may even facilitate a payment out of a fund’s capital.
Capital gain or loss
This is the gain or loss you make if you sell an asset at a higher or lower price than the price you originally paid when you bought it.
Remember to deduct any transaction costs when working out your net returns. There could be sales charges, management fees and brokerage charges depending on the types of products you buy. There could also be financing or borrowing costs if you buy a product using margin or leverage.
What is risk?
The actual return from an investment may be more or may be less than what you expected at the time you bought the product - this is the risk you take when investing.
Investment risk can refer to:
- Lower than expected returns, for example, due to share price volatility or the underperformance of a fund
- The possibility of losing money invested, e.g. when a bond issuer defaults on interest or principal payments. In some cases, you may lose all of the money you invested.
All investments come with the risk of losing money, whether it’s the amount you invested or a loss in earnings. Find out more about the maximum you can lose, types of risks, and the risk-return tradeoff in things to watch out for.
What is meant by investment horizon?
An investment horizon is the amount of time you have to invest to achieve your financial goals. A longer time horizon may mean you have more time to ride out short-term price fluctuations on your investments. If you cannot afford to lose money, you should only invest in less risky assets if you have a short investment horizon.
The longer your investment horizon, the more time you also have to grow your savings through compounding. Compounding is about earning returns on previous returns. In other words, earnings that you earn are reinvested and increase the amount upon which more earnings are generated. If you start early, your investments will be able to compound over a longer time period. The earliest returns are reinvested for the longest time and therefore generate greater returns.
Do you buy one product or diversify?
Some consumers buy one specific product to meet one goal, for example an endowment policy for their children’s education. As with all financial products, you take on risk when you do this. The plan could underperform or the insurer could run into financial difficulties and become unable to deliver on its commitments.
Similarly, if you invest all your money in a single product, for example a bond, you may lose all of your investment if the issuer becomes insolvent or bankrupt. A diversified portfolio helps reduce the risks that a pool or concentration of similar assets is exposed to.
What is diversification?
The idea that the prices of some assets historically move together in the same direction is called correlation. Diversification is about building a portfolio of lowly-correlated investments that do not all move in the same direction at the same time or even if they do move in the same direction, it should at least be by different degrees. Diversification means you may give up some gains but should also reduce some of the risk of losses in your portfolio.
When building a diversified portfolio, the focus is as much on upside gain as it is on managing against downside risks. A diversified portfolio might comprise different asset classes like cash, bonds, shares, commodities and even properties. It may also be spread over local, regional and global markets, and different economic sectors and industries.
A diversified portfolio can help you better withstand the fluctuations of economic and market conditions and cycles.
What is asset allocation?
Asset allocation is about deciding what proportion of your investment portfolio is to be invested in the different asset classes to achieve diversification, and ultimately your desired balance of risk and return.
Here are some factors to consider when deciding your allocation:
i) Age and your investment horizon
If you are young and retirement is still far away, you might have a relatively longer investment horizon ahead. But if you are nearer the time you need some money for a goal, for example if you will be retiring in a few years, your investment horizon will be relatively shorter.
ii) Your risk profile
This is mainly about your ability to absorb or tolerate losses.
iii) Your investment objectives and your understanding of expected risks and returns from the different assets.
Make sure your investment objectives are clear. If you are accumulating capital, find out what products are suitable for this objective. But if you are nearing retirement and cannot afford to take risks with your money, the assets you choose may be quite conservative.
Arriving at an asset allocation that suits you is a balancing act – you need to understand the different asset classes and how they might work together or offset each other’s gains and losses, when included in the same portfolio. Take care when selecting a product from the asset classes you are considering. For example, if you choose to invest in junk bonds or emerging market bonds for the potentially higher returns, your risk exposure could be quite different from if you had bought better rated sovereign bonds. It is important to review your asset allocation regularly so that it suits your personal circumstances as they change.
What are dollar cost averaging and market timing?
Dollar cost averaging involves investing a fixed sum of money at regular intervals, whether the market is up or down. For the same amount of money, you buy more shares when the market is down, and you buy fewer shares when the market is up. With dollar cost averaging, the total average cost per share could be lower. It is also a disciplined approach to investing compared to market timing.
If you adopt a market timing approach, you buy or sell shares when you think the market is favourable for you. The difficulty of the market timing approach is in deciding when this is.
The above information is prepared in collaboration with the Association of Banks in Singapore, Investment Management Association of Singapore and Securities Investors Association (Singapore).