Lecture Note #2

Module I: Introduction to Investments

Fundamental Principles of Investment

Know the difference between Saving and investing
Most successful wealth creators know how to save – and that’s important. In order to be in a
position to invest, you must first be in control of your cash flow, otherwise you have nothing to
invest. However, if you want to create real wealth, you need to be more than just a good saver.
You must make the transition from ‘saver’ to ‘investor’. Why? Because if all you do is save money,
you are not building wealth. The returns you earn are eroded by inflation.
Investing is different to saving because it involves putting your savings to work and accepting an
element of risk in exchange for growth potential. Investing is all about being active with your
money now so as to build something in the future.
Many people believe that to create real wealth you need a lot of money to begin with. Not true.
What you really need is the discipline to put your money to work on a regular basis. And, the
sooner you start the better.
Investing works because of the principle of compound interest
Each dollar you invest has the potential to earn a return and if you reinvest that return, it earns a
return and if you reinvest that return, it earns a return and if you … and so on.
This principle, known as compound interest, is why investing creates wealth. It turns your savings
into earnings and those earnings into wealth. Creating wealth doesn’t necessarily require a lot of
money. It just takes discipline, consistency, time and the power of compound interest.
Trade-off between risk and return
Risk and return are directly linked; you won’t receive an adequate return without taking on some
risk. i.e., risk and return go hand in hand. While risk is inevitable and integral to investing, one of
the most important questions you should ask yourself is: How much risk are you willing to accept?
Seek to manage risk, not avoid it. Put simply, ‘be risk intelligent, not risk averse’.
If you’re in your 20s, you may have another four decades before you plan to retire. If you’re in
that age category, you may consider pursuing higher-risk investments that would weather the long-
term market fluctuations. However, if you’re in your 60s and retirement is within sight, you may
want to create a portfolio that has a lower risk profile
Separate out Risk from Volatility
It is important to separate risk from volatility because they’re quite different.
Risk = the chance you will lose money permanently and not achieve your financial goals.
Volatility = prices going up and down.
When talking about risk, many investors are actually talking about volatility – the usual ups and
downs of investment markets. When the actual return from an investment is lower than expected,
investors believe that they have lost money in a physical sense. But in fact they have only lost
money ‘on paper’. It is only when they actually sell the investment at the wrong time (when returns
are at their lowest) that they permanently lose money.
Trying to avoid risk may be the riskiest strategy of all
Money invested defensively is eroded by inflation.
Investing in assets like cash can seem like the safe option – returns can be attractive and the lack
of volatility allows you to sleep at night. But are you actually receiving the return you think (or
need)? No, because inflation eats into defensive investments. Remember, inflation means an
increase in the cost of goods and services and when it occurs, the value of a dollar is worth less
because it can buy less. Another way of looking at it is you need more dollars to buy the same
thing. The need to beat inflation is why at least some exposure to growth investments is important.
While cash has beaten inflation over time, the real return from defensive style assets is much less
than you think. The true objective for any long-term investor is maximum total real return after
providing for inflation and taxes.
Growth assets generally provide a higher expected return over defensive assets, but you
must expect higher volatility as well
The term asset allocation refers to how you spread your investments across the different asset
classes. These asset classes can be grouped as either defensive (cash and fixed interest) or growth
(property and shares). As you allocate more money to growth assets, the expected return increases,
however the volatility associated with the portfolio increases also.
Diversification is key to managing risk
When you invest in growth assets, you have to expect some volatility in returns. Volatility can be
managed by diversifying your portfolio.
Diversification is the process of allocating investment holdings across various asset classes,
industries, companies and countries, at home and abroad. Diversification seeks to enhance
investment returns and reduce risk via professionally managed allocations to a variety of globally
diversified asset classes.
By building a portfolio made up of different investment types and asset classes, we will help
smooth volatility under a range of economic conditions. Why? Because not all investments and
asset classes move up and down at the same time. It should also be noted, that diversification not
just insures against volatility, it is also a fundamental way we protect our clients against pure risk –
the adverse effects of an investment failing.
Volatility can be managed by looking at things over the longer term.
Invest for the long-term is the principle. The importance of aligning your asset allocation to how
long you have to invest cannot be under stated. Why? Because of the market cycle. Asset classes
move through periods of good returns, great returns, not so great returns and sometimes negative
returns. So, if you are investing in shares, for example, and you want to access your money within
a couple of years, you may sell out at exactly the wrong point of the cycle – you must let your
investments run their course. You need to be sure that your investment horizon is consistent with
the asset classes you are investing in because over time, volatility is reduced and returns are
smoother.
The chart of the best and worst 1 year, 3 years and 5 years returns over time illustrates this point.
By taking your money out after only 1 year (blue bars), you run the risk of receiving a very high
return or a very low return. By leaving your money invested for longer (green and purple bars), the
difference between the high return and the low return narrows. By investing for longer, returns
become smoother.

Asset allocations drive outcomes

Asset allocation entails allocating your investment holdings to different asset classes including
stocks (equity), bonds (fixed income), real assets and cash. Asset allocation is widely recognized as
a key factor in investment performance.
Don’t let your emotions drive your investment decisions.
It’s one thing to understand that markets move in cycles, it’s another to remain calm when that
cycle is producing negative returns. Why? Because it’s your money and when you feel like you are
losing it, it can be a very stressful situation.
Market volatility is inevitable; reacting emotionally can be detrimental to investment success.
Jumping in and out of the market can lead to missed opportunities. Investing should be considered
as a long-term game. Sudden losses can stir your emotional impulse to withdraw or suddenly
change tack – no-one likes to see their portfolio go down in value – but staying put and resisting
the temptation to tinker can pay off in the end.
Data on global developed market stocks going back over the last 50 years demonstrates that the
probability of losing money on your investment goes down the longer you stay invested. The green
line on the chart below, based on data from 1970 to 2021, shows the power of long-term investing
in drastically reducing your chance of losses.

History demonstrates that after periods of volatility, the markets have not only recovered—but
reached new highs. Missing even just a few of the best days of returns can materially impact your
portfolio’s performance.
Many investors who cannot cope with the constant bad news during periods of economic
turbulence ends up selling out risky investments for the safety of cash. In doing so they miss the
turn of the market and more importantly missed the recovery – turning a paper loss into a
permanent loss.
Those investors who are able to keep sight of their longer term strategy will be able to regain the
earlier paper losses and benefit from the bounce back.

Additional resource
https://www.franklintempleton.com.sg/resources/investor-education/investing-
101/ten-principles-to-investment-success