Bagan

 (Check this! Bagan 18 bar and restaurant or “Penang‘s closest brush with fabulousness” 🙂 )  

(continued from part one )

Here’s my 2 cents worth to Mike.  

He should manage his portfolio according to the asset allocation model appropriate for his circumstances. Asset allocation is just a fancy phrase for the process of dividing up our investments into various asset classes. Primarily the asset classes are shares or equities, bonds and cash. For example you may decide on a 60:30:10 asset allocation model which means 60% of your money is in equities, 30% in bonds and 10% in cash.  

How much money Mike devotes to each asset class is a function of various things. I’ve covered these in my earlier posts but just as a refresher: 

1. Your risk profile

 This depends mainly on:

  • your age (or years to retirement) – the younger you are the more able you are to take more risks and vice versa
  • income stability – do you have a stable job, with good advancement prospects which allows you to take a more aggressive risk position? Are you self-employed and faced with income volatility reducing your ability to take risk?
  • your personality or what I like to call the “sleep test” i.e. if you are going to lose sleep every time the stock market fluctuates or you see some of your investments going into negative return territory, then it is probably best to reduce the portion of your portfolio invested in riskier investments.

(You can also read more about risk profile from my earlier post here)  

2. Your investment time-frame.

Are you in it for the long haul? Or are you just saving up for a short-term or medium term goal like putting down a deposit for your first property? If it’s for the long term, you would be able to take a higher level of risk and invest more of your funds into riskier classes of assets like shares. 

So what should Mike’s asset allocation model look like? There have been many books dedicated to this topic. But I’ll try to keep it simple and easy to remember!  

Cash (low risk)

We should all keep at least 3-6 times your monthly living expenses in cash (fixed deposits or savings). I would also lump in capital guaranteed funds under this asset class provided you are able to fulfil the minimum lock-in periods. Keep more if you feel that you need to (so that you can go to sleep peacefully at night!) but remember that with FD rates currently around 3.6%, this is not much of a buffer against inflation in the long term. In my case, cash deposits make up about 10% of my investment portfolio, but Mike who is self-employed keeps more than 12 times his monthly expenses in the form of fixed deposits. Another thing to bear in mind is that as you are nearing retirement you would want to keep more of your money in cash and bonds as these asset classes are less risky. 

Bonds or fixed income securities (low to moderate risk)

A Bond is simply an ‘IOU’ in which an investor agrees to loan money to a company or government in exchange for a fixed interest rate. The easiest way to invest in bonds is to buy a bond fund from a mutual fund company. For asset allocation purposes, the rule of thumb is to keep your age in bonds (but add 10% more if you are a new investor or you feel that the stock market is trading a little too high for comfort). For example, if you are 30 years old you would hold 30% of your investment portfolio in the form of bonds. A 30-year old investor with an investment portfolio that amounts to RM20,000 should therefore hold RM6,000 of his money in the form of  bonds. 

 Equities (moderate to high risk)

The rest of your money should then be kept in equities or equity funds. Since cash and bonds provide you with a return of between 3-6% generally, putting some of your money into stocks should greatly enhance your returns. The higher the allocation, the greater your potential portfolio returns. There is risk of course, but then if you intend to hang on to the shares or mutual funds for some time then this risk should be manageable (see note * below). 

Deciding the asset allocation ratio is just the starting point. There are no hard and fast rules but hopefully, the above gives you some kind of guiding principles.  Then you need to decide on what to buy within each class of assets. Interestingly though, what they taught me at CFP class was that it’s not really which stocks or bonds you bought that is important. Nor is it that important to time the market either. A survey of the best-performing mutual funds in the US by some researchers showed that approximately 90% of their returns was due to asset allocation, and not market timing or stock selection.  

Once you’ve aligned your portfolio to your asset allocation model, you will need to monitor it at least once every year to make sure that the ratio of your various asset classes is maintained. For example, because of the recent stock market run-up, most people should have seen their % holdings in equities increase somewhat. So if your model was 60:30:10 originally, you may now find yourself with a ratio 70:22:8. That’s when you need to realign the percentages by selling or switching out of equities.

Because the stock market is now hovering around 1,200 points, you may even decide to adopt a more conservative asset allocation model by holding less stocks and more bonds eg. 50:40:10! 

So what did Mike do? Recall that he had invested RM30,000 in the Ittikal fund in June 2006. When the market started rising in December, he immediately set his mind on a target return of 20% for him to cash out. When that was achieved in the weeks that followed, he thought his options were 1. to cash out and invest in a capital guaranteed fund from Hwang DBS or 2. to switch to a bond fund from Public Mutual.

After some careful deliberation about his asset allocation needs, he decided to go with 2. since he wanted the flexibility of switching back to equities later on when the market had calmed down, without having to incur the 6.5% sales charge again. Yes, it’s true! The front end charges for investing into a mutual fund that invests in equities is generally between 5.5% to 6.5%…very hefty if you compare this against similar funds in the US.

Mike eventually decided to switch the whole of his RM30,000 into the Public Enhanced Bond which invests 80% in bonds and 20% in equities, leaving behind only the profit earned in Ittikal.

*Note: In investment principles, risk equals how volatile a market is over a period of time. Volatility is measured by the standard deviation (remember your statistics lessons from school?) from the average return of a portfolio over time. Empirical studies have shown that over the long term, equities give a higher return compared to bonds or cash. And, the longer the time-frame that you intend to invest in equities, the lower the standard deviation or risk will be. 

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