The Need to Invest

THE NEED TO INVEST
By: Lino Nabon



Why Do We Invest? The simplest but still incomplete answer to that question is to make more money, of course. More than that, we should invest for a definite reason , Is the goal of making more money to prepare for your retirement, for your kids education or for having that second car in a couple of years?

Starting Early With Investments
Start right now your investment plans. Don't procrastinate.

Failing to plan is planning to fail. When you start early, these three things are on your side:
the power of compound interest (for investments with compounded interest),
property appreciation (for real estate investments) and long-term capital appreciation (for stock investments). Insurance premiums are much lower when you are younger. So time can be really your greatest ally when you are young. By starting young, investment learning will be easier and less painful because the risks are usually smaller at first and there's more time to experiment on what works better for you. You can afford to make a few mistakes as part of the learning process and still have time to recoup losses. Investment mistakes are fine as long they are not fatal to your financial health and you are learning from them to get better the next time around. When you're 60, it will be hard to experiment anymore with higher-risk investments like stocks. You may not have the time to recover any longer, especially if you happen to hit the market at the end of the bull run.





Before You Invest



1. Personal debts delay your investing plans so you should avoid them. If you already have personal debts, get out of them first, especially if these are high-interest debts like credit card debt. Getting into debt is deciding today to tie up your future income – part of which could have been used for investments.


2. Before putting in a lot of money into different types of investments, make sure you cover your risks first. Build an emergency fund and get the necessary insurance, especially life insurance. Not everyone needs life insurance. Do you?

Accumulate enough cash savings and maintain it for emergency purposes (medical emergency, death in the family, calamity or temporary loss of job). This is your emergency fund. Investment money should never be the money to feed the family. Separate it. A cash or near cash equivalent of three to six months of living expenses would be a good amount to target initially.

3. Strive to be healthy and get a good medical insurance if you do not have one yet to further protect you from medical bills that can wipe out your savings and investments. Healthy people have lower insurance premiums so it makes sense on your pocket to be physically fit.

4. Invest in your financial education. Your master's degree or doctorate degree is not a guarantee that you will be financially successful. "Ignorance is bliss," as they say. But not so in the financial and legal arena. Something you don't know can potentially harm you. People who fall for scams or Ponzi schemes usually don't care to understand well what they are investing in and how the system works. They are just concerned about the big returns, without any regard to the risk. Although there are family members and well-meaning friends that are ready to give advice, they are usually not financially literate enough to give profitable advice.

5. Lastly, you should only invest in something you understand. If you are not comfortable about an investment, either leave it alone or expand your comfort zone by learning about it. The former is in-the-box thinking while the latter is out-of-the-box thinking. Define your boundary – stay in it and possibly miss out on other opportunities or expand it.

Investment Vehicles

There are many investment vehicles to consider: bonds, stocks, real estate, precious metals, commodities, and currency. And there are different kinds of managed funds like mutual fund, UITF, ETF and even hedge fund. Hedge funds, especially those invested in the subprime lending business, have been in the news lately. You don't have to be involved in all of these investment vehicles. Besides, not all of them are available locally. Your financial goals (what you want, when do you want it and how much is> expected) and your financial literacy will dictate your risk preference, return target and liquidity requirements. These, in turn, will dictate your kind of investment vehicle.

Money Market

For practical purposes, a savings account is not considered an investment vehicle since the interest rate is usually much lower than the inflation rate. Though the bank guarantees the savings rate, you are also guaranteed to lose purchasing power over time. But still you need to park enough liquid assets (cash or near cash) somewhere to be ready to catch the next blowout, the next big wave of investments or the next big market correction. In this strategy, a money market account becomes a necessity. Money market is a short-term instrument. Money market generally refers to debt instruments that are maturing in one year. Therefore, even a long-term 10-year Treasury Bond can be considered part of this market if it is to mature in less than a year. Otherwise, it is part of the capital market (maturing in more than a year). Money market returns are low but are usually higher than savings. Just don't leave a lot of money in the money market longer than is necessary. Make your money work harder for you in other investment vehicles (bonds, stocks, real estate, etc).

Bonds 101

When corporations want to raise cash for their business expansion, they have a few options at their disposal. They raise cash through initial public offering (if not listed yet in the Philippine Stock Exchange), through follow-on stock offerings (if already listed) or they borrow money. Ther are advantages and disadvantages for each approach but I will not discuss them here. When companies borrow money, corporate bonds are used as the debt instruments. When the government borrows money, the debt instruments used are called government bonds. Bonds are basically debt instruments. The government or companies borrow money and in return they give out regular interest returns and with the promise of returning the principal after a certain period of time, which we call the maturity period. The government bonds are called Treasury Bills (91 days up to 1 year), Treasury Notes (2 to 10 years) and Treasury Bonds (more than 10 years). There are less-common bonds issued by government-owned and controlled corporations and local governments. The safest bonds of course are the government bonds (backed by the taxing power of the National Government) and as result have the lowest returns. Bonds are as simple and straightforward as that. They are debts. You lend your money, the borrower signs a promissory note, and then the borrower pays you regularly the interest. The higher the interest, the better for you as the lender. At the end of the agreed period, you hope to get back your entire money. But why are bonds confusing to some? Here's why. They could get a little complicated. You see, bonds can be traded in the secondary market. That means you can sell that "promissory note" of yours to other investors. The bond price (price of the "promissory note") can go up or down depending on investor sentiment. If the interest rate is in a downward direction, bond prices usually trade higher. There's an inverse relationship. For example, if you are holding a corporate bond with a face amount of P20 million, a maturity of 10 years and interest rate of 7%, it is possible to sell your bond in the secondary market at a price> higher than P20 million if the prevailing interest rate has gone down to 5% and still appears to go downwards based on projection. When everyone else is getting close to 5% with newly issued bonds, your buyer is lucky to be getting 7% from your older bond if you sell it. Therefore, he is willing to buy your bond at a price higher than P20 million. That's selling your bond at a premium. When the interest rate outlook points upwards beyond 7%, you might have difficulty selling your bond at a price of P20M. Why will they want to be a bondholder of a 7%-yielding bond when they can get a 9% bond, which is the prevailing interest rate? In order to attract them to buy your 7% bond, you have to sell your bond lower than P20M. That's selling your bond at a discount. In the secondary bond market, you have to watch out for one item – that is, where the interest rate is going. As of mid 2007, the peso bond market is not doing well compared to a year ago because of interest rate hike leaning of the BSP. The special deposit account for banks and the removal of the tiering mechanism by the BSP have effectively cut the money supply. Cutting the money supply (less money in circulation) has the effect of increasing the interest rate. Why would BSP not want a very low interest rate? Well, too low interest rate discourages people to save in banks. Enough funds will not be available for the borrowing public. The banking industry is a necessary ingredient to economic expansion since money is borrowed from banks for establishing or expanding businesses. Very low interest rate could also lead to a stock market bubble since people will rather bring out their savings and put them into the stock market. Lower rate can promote economic overheating and, therefore, fuel inflation since consumers will be encouraged to consume a lot more than is usual (housing, cars, appliances, travel, etc.) in a very low interest scenario. Note: Since this is an introductory topic on bonds, I won't touch on several other things like current yield, yield to maturity, yield curve, call provision, mortgage-backed securities, asset-backed securities, credit ratings (Moody's, Standard & Poors, Fitch, Duff & Phelphs, etc.).
Stock Market 101
As previously mentioned, when corporations want to raise cash for their business expansion, they can do it through initial public offering (IPO) or follow-on stock offerings in the stock market. This is how the stock market helps in expanding the economy. Never think for a moment that the stock market was established for gamblers! Having said that, I acknowledge that there are those who play in the stock market as if they are gambling. You see, a knife is a kitchen tool but it can be used for not-so-good motives also. It depends on who is using it. If done right, stocks are usually good for long-term investments since the short-term volatility and market corrections get smoothened out through a longer period of time. In the long run, stocks in general go up. But with a shorter timeframe, timing may be a key consideration. Buy and hold strategy is generally best at the start of a bull market. Starting early enables you to catch a few bull-bear market cycles. We have to realize that a company's stock price should ideally track the company's earnings. Earnings or profits are a factor to consider in determining the company's underlying value. Since it takes time for profit to rise, you have to give its stock price some time as well. It is not normal to see a company profit jump 500% higher than last year - something> that will justify a corresponding 5000% increase in its stock price, right? If a company is not making money but its stock price is going through the roof, that definitely is speculation about the future earning potential. Stocks that have gotten ahead of themselves fall the hardest. You could be burned when you get in at a high price and things did not turn out to be as expected. In stock market, there are two analysis approaches: fundamental analysis and technical analysis. Let's go through them. Fundamental Analysis (FA) In FA, you focus your analysis on the economy, industry and, specifically, the company. On the company, you do qualitative and/or quantitative analysis. Qualitative analysis looks at the business potential and the company management. Quantitative analysis looks at the financial statements and the different financial ratios like profit margin, EPS, debt to equity ratio, current ratio, quick ratio, asset turnover and other things to determine how healthy the company is. Your analysis will help you forecast the growth and profitability of the company, and therefore, the possible direction of its stock price. Growth means increasing profit over time and> this should hopefully drive the company's stock upwards.
Technical Analysis (TA) TA is basically chart analysis, period. The input data are: stock price, volume, opening price, closing price, highs and lows. There's data collection, analysis and some modeling – automatically done by software. You analyze the price trends, price patterns being formed and momentum indicators like moving averages, MACD, RSI, etc. You establish the support and resistance levels. You use a simple trend line or the more sophisticated Japanese candlestick. The analysis will help you predict if the market is about to move up or down, whether it is overbought or oversold. The analysis is relying on the assumption that history repeats itself. This means that investors will behave in the same manner as they did in the past – governed by the emotions of fear (panic selling) and greed (euphoric buying). This buying and selling will explain why the stock price can never move in a straight line. One important rule to follow in technical analysis is: "Never\ trade against the trend." FA vs TA So, which analysis approach is better to use? FA definitely takes a lot of research and information to look at. It requires understanding of economics, business and accounting. But fundamental analysis gives you a certain peace of mind especially with your long-term investments. You could sleep better at night. TA, on the other hand, doesn't take much time. A quick look everyday at a company chart by a trained eye is all that is needed to make a decision. TA doesn't require any knowledge of the company at all and this is where the danger lies. The price of Company X, which you follow only technically, may quickly plunge and become worthless with just one bad news. But if you have studied the company, you might not have invested in it in the first place because you knew that it wasn't earning any money for the past three years, it was highly leveraged, its cash ratio is almost nil, its management team is questionable and the stock price is just being driven mainly by speculation. An approach wherein TA is used together with FA is a much better approach. But even if used together, success in prediction can never be 100%. It's just like weather forecasting!

Mutual Fund
Mutual funds are a good way to invest in bonds and stocks especially if you don't have the time to manage your investments and you have limited capital to invest. The fund manager will do the investing decision for you. They get paid for their professional management. Your invested money is pooled together with other investors so the fund manager is able to buy bigger number of shares of several companies. This enables you to diversify with just a little amount, which you can't do on your own. In a mutual fund, your money is considered liquid since the fund manager is always ready to buy back your shares if you plan to redeem them. In mutual fund, there's money market fund, bond fund, balanced fund and equity fund. A balanced fund combines bond and stock investments together. What are the disadvantages? Well, you don't have full control as to what specific investment to choose because you have given that control to the fund manager already. The fund manager is also restricted to do certain things based on Securities and Exchange Commission (SEC) rules and company policy. One example is that the fund manager may not be able to invest more than 10% of its net assets in just one company and may be prevented from investing in certain stocks that may be considered speculative.
UITFs
UITF stands for Unit Investment Trust Fund. Like mutual funds, they are
pooled investments. But unlike mutual funds, which are regulated by the SEC, UITFs are under the BSP supervision. UITF sellers are not required to pass a licensure examination similar to what mutual fund representatives take but they are required to undergo training, based on guidelines set by the Trust Officers Association of the Philippines (TOAP). Investments in UITF and mutual funds are not insured.
Other Investment Vehicles
Real estate investments are good for inflation protection but are illiquid. So if you need the money for the next 5 years, don't invest it in real estate. Someone said, "Don't wait to buy real estate. Buy real estate and wait." That is just to show the long-term horizon for real estate. Investment in precious metals and commodities are not available locally so I will not bother to discuss them here. Foreign currency investments are even riskier than stocks. They will not be discussed here either. Asset Allocation – Do We Diversify Or Do We Focus? When you are just starting in the investment world, you probably don't have much money to invest with anyway. So it might make sense to focus your resources on very few high-quality investments. Unless you put your initial (and limited) investment in a mutual fund to diversify at once, you may be forced at first to put your few eggs in just one or two baskets. In that scenario, you must watch these few baskets like a hawk - to avoid losing your eggs. But as you have more money to invest, begin putting eggs in other baskets, aside from putting more egss in existing baskets. More baskets, the better. That is asset diversification. The good thing about diversification is that if one or two baskets got lost, you still have more baskets left to enjoy. But too many baskets to watch may be a hard thing to do. Don't over-diversify. Do not scatter your attention and resources too much to the point it is no longer efficient to do so. The baskets we have talked about are the different asset classes such as cash, money market, bonds, stocks, real estate, precious metals and commodities. An example of a simpler asset allocation strategy would be as follows: Cash/Money Market 10% (not counting the emergency fund) Bonds 40% Stocks 40% Real Estate 10% Total 100% The allocation percentages are not fixed. The percentages will depend on your age, risk preference, return target, liquidity requirements and financial literacy. Also, if you have a strong conviction against investing in a certain asset class (certain people don't believe in debts for example), then there's no reason why you have to allocate money there. For stocks, there should be a second level of diversification. That's very important. I will not discuss that sub-diversification here. In times of possible widespread instability, cash allocation needs to be beefed up more. Diversification is a wise move to cover one's ignorance. Now that's a rather bold, an even arrogant, statement. Ignorance? Let me explain. By diversifying you are merely, and humbly, acknowledging that you don't have all the pieces of information and the time to find out every scenario that may affect your investments. Can you anticipate a bombing or an earthquake that may cripple the industry you are invested in? Do you know all the information about the company you are heavily invested in? Do you personally know the members of the Board and the management team of each of the company? The answer is most likely no. Now there are people who do make a lot of money by focusing their investments instead of diversifying. But be warned. Focused investing requires expertise, concentration, great timing and, above all, guts! This approach is not for the faint-hearted. You can be wiped out if you are not prepared. In Matthew it was said, "The kingdom of heaven is like a merchant looking for fine pearls. When he found one of great value, he went away and sold everything he had and bought it." That's focus. It's a good thing to focus your investment if, and only if, you are highly confident that you have found a fine pearl. No matter what the uncertainty is, no matter whether others are panicking amid the difficult moments (severe market correction for example), you hold on to your investment. Because you know it is a fine pearl! Happy investing!