Traditional knowledge and practices for working with money have evolved over generations, especially those that involve saving and investing. Saving is generally the first step towards financial planning, however, investing a certain portion of the money saved leads to wealth creation in the long-term.
The perception of ‘investing’, which was historically restricted to only the affluent class, has now become a reality for the common man, thanks to digital technology and an emerging number of investment instruments. Investing has also become easy and accessible through the evolution of fintech services as they offer advisory services along with secure options based on financial goals. Time horizon and risk tolerance are two key characteristics of investing and building robust portfolios.
Moreover, long-term investing, coupled with diversification of portfolios, are generally the first line of defense in reducing investment risk. These characteristics also enable the investment portfolio to navigate through unprecedented events or economic recessions/ depressions.
Investment gurus or financial advisors have always emphasized investing early in life to reap the benefits of compounding wealth. However, one can start investing any time as it is never too late.
Retail investors are concerned about the concept of investing, especially the fear of losing the principal amount. Wealth protection is an important concept in investing, and thankfully it can be mitigated by diversification across various asset classes, geographies and industries. Regardless of the strategy adopted by an investor, the duration is an important parameter in building wealth, while reducing the overall risk and volatility of the portfolio.
The tech impact
The advent of technology has had a profound impact on every aspect of our lives. Consumers today prefer the convenience of managing everything online, which is primarily the reason for digital transformation within the global financial services industry. As a result, this has changed the face of investing, which is now easy and accessible to everyone. Online trading was introduced by banks and other financial institutions to expedite and streamline the transacting experience. The success of online trading encouraged traditional financial institutions to offer similar services to other asset classes.
Meanwhile, the wealth management industry continued operating in the traditional way since it was limited to the affluent class. However, the evolution of fintech firms transformed the wealth management industry by eliminating the need of human intervention with cost friendly fee structures. Hence, today, an individual can easily open an account with zero balance on any of the digital platforms to start investing with no minimum investment criteria.
Points to consider
One of the key considerations of investing is determining the appropriate allocation strategy, which is dependent on three factors – investment objective, risk tolerance and time horizon. A typical allocation would include traditional asset classes, namely equities, fixed income and money market instruments.
A risk-averse or conservative investor would ideally prefer to invest in low risk instruments to protect principal, such as dividend paying stocks or municipal/government bonds. On the other hand, a risk-taking investor would prefer higher returns with a justified level of risk.
Another important risk mitigation strategy is portfolio diversification, which can be done by investing in other geographies and industries. A sophisticated investor could further diversify through alternative asset classes, thereby improving the overall risk-return characteristics of the portfolio. Once we have an optimal asset allocation strategy, it will enable us to weather the ups and downs of the market, such as the uncertainties we are experiencing now due to Covid-19 and the global financial crisis in 2008.
For instance, an analysis of asset class performance during the past two decades clearly indicates that a diversified portfolio generates healthy returns with an appropriate level of risk. To understand this better, let us consider three investment cases with an annual investment of $12,000 for a period of 25 years.
- In case A, we have a traditional style of savings/investing, which is 100 per cent into fixed deposits/savings at an average rate of 2.5 per cent per annum.
- In case B, we have a balanced portfolio for a low risk or risk-averse individual with 50:40:10 split between equities, bonds and gold.
- In case C, we have a dynamic portfolio for a calculated risk-taker with 70:10:10:10 split between equities, fixed income, private equity/hedge fund and gold.
Based on the above assumptions, the investment values under the three cases would have grown to $0.42m for case A, $0.69m for case B and $1.29m for case C.
Clearly, the investment strategy indicates a staggering difference in values over the long-term. Hence, it is important to understand the risk and reward of investing and accordingly select a strategy that would help in maximizing returns. Although this is a simple example, these cases do illustrate the compounding effect of investing by varying levels of risk.
Limitations to keep in mind
Now that we have established the importance and the process of investing, it is equally important to understand the limitations and the way forward. Firstly, an investment strategy often requires long-term commitment and discipline, and liquidation at any interval could be detrimental to the portfolio.
Secondly, in a rapidly changing economic landscape, it is always advisable to rebalance the portfolio strategy to align with new realities. It might be prudent to seek the services of professional managers while re-allocating in unprecedented times like the current one and the global financial crisis in 2008. Although the fee structure could be on the higher side compared to digital platforms, the professional advice is often worth the money spent.
Today’s smart investors have realized the importance of using their savings to invest for a secure financial future. In investing, it is important to focus on what we can control, such as setting up a sound financial plan, a realistic target, adequate protection, proper diversification, and a commitment to a long-term strategy to achieve our goals.
Moreover, an investment plan should not be reduced to a single strategy – it is wise to diversify across assets and geographies, depending on your risk profile and financial goals. Time invested is more important than timing the market, hence one needs to be invested for a longer period of time to build wealth and enjoy financial freedom. I will be making such recommendations every month on various strategies to benefit investors.