The investing world can be intimidating. Technical jargons, complicating investment concepts, and of course, the very real possibility of losing money makes the space a tricky one to navigate.
We think it pays to go back to basics. For some of us, the basics are sometimes forgotten. For others who are new to investing, the basics are what you need to know. Here are four terms that you absolutely need to know before you start investing.
# 1 Risk
When you are first introduced to the world of investing, it’s common to be focusing your attention on returns. We think it makes sense because the reason why we invest in the first place is so that we can good returns. Otherwise, we may as well leave the money in the bank.
The one relationship you cannot forget however is that risk and return are correlated. An investor who wants higher returns must be prepared to take on higher risk. If your investment advisor isn’t reminding you of that, you need to find someone else whom you can trust instead.
Expected higher return does not equate into a better investment. As retail investors, we need to focus on managing our risk, and to allowing the returns to take care of themselves.
# 2 Risk-Free Rate
A 3% per annum return from your property investment looks okay, until you considered the fact that the 10-year risk-free bond from the government is already giving you 2.5%.
Other examples include getting a 5% return on the money from your CPF Investment Scheme – Special Account (CPFIS-SA), which may make you believe you are a savvy investor, until you realise that your friends who have done nothing and taken no risk are already receiving 4%.
The risk-free rate refers to the interest rate that an investor can expect for taking no risk. The risk-free rate can differ, depending on the period of investing. For example, the interest rate for the Singapore Savings Bonds (SSB) is currently 1.04% for 1 year and 2.38% for 10 years. Both these rates are risk-free, but differ due to different time period.
Read Also: How To Invest In SSB
When you look at an investment opportunity, you must consider the expected returns given by the investment against the relevant risk-free rate. The difference between the two amounts is called the risk premium. The risk premium refers to the additional return that you can expect to enjoy for taking on bigger risk.
For example, if the 10-year Singapore Bond is giving a return of 2.38% while a 10-year corporate bond is giving a 5% return, it means investors are able to receive an additional 2.6% per annum for bearing the additional risk.
There is where you, as an investor, must decide if the additional return is worth the risk.
# 3 Diversification
Diversification is an important concept because it is one way where investors can reduce the risk they are taking while keeping their expected returns the same.
Why is that so?
The simple explanation is that for every investment that we make, risks that the investment exposed us to can be broken down into two types. Systematic and non-systematic risk. Systematic risk refers to risk that are undiversifiable while non-systematic risk refers to risk that are diversifiable.
Suppose we think the telco sector in Singapore is going to do well. The expected return for the sector is 7% per annum over the next 5 years. We randomly choose only one telco (e.g. M1) to invest into. Our expected returns would be 7%.
If instead of investing in just M1, we decided to invest across all three local telcos, M1, Starhub and Singtel, our expected returns should still be 7%.
In example 1 however, our risk is higher. It’s possible that the sector does well but that M1 suffers an unexpected management challenge, which caused their stock to underperform. This risk could have been avoided if an investor simply diversified through a better portfolio allocation.
As an investor, you must always aim to reduce risk that is diversifiable. You don’t get rewarded for taking these risks so there is no reason to take on them.
# 4 Long-Term Returns
One big mistake that long-term investors usually make is to look at returns over the short-term (e.g. 10 years or less). For example, they may be shown a chart depicting how certain funds being sold to them have outperformed the market over the past 3 years.
Yet, most financial literature (including Warren Buffet) would agree that for the average long-term investors, putting your money in a low-cost index fund would be the ideal strategy.
We are not saying that there is no place in the world for active funds – there is not true. And active funds do keep index funds in check. Rather, what we are implying is that very often, people based their investing decision over short-term returns despite claiming that they are long-term investors.
Worry about long-term returns, and the factors that could affect it (i.e. transactions costs, volatility of the market, portfolio allocation, market stability). Ignore the short-term fluctuation and factors as long as they do not hinder the fundamentals of your long-term plans.