Fundamentals of Investing

Successful Investing Takeoff – Discipline and Planning are Key

Becoming a successful investor requires both planning and discipline. Planning means thinking carefully about everything you need to consider when developing your investment plan, including:

• Defining your goals and your investment time frame.
• Understanding asset allocation.
• Looking after your investments over time.

Discipline means keeping market movements into perspective, recognizing the potential impact of risk and regularly rebalancing your portfolio. It is also important to live within your means and decide how much you will set aside for investing before you start to develop your plan.

Define Your Goals and Investment Time Frame

Work out what you want to achieve from your investments and define your investment time frame. Your investment time frame provides a framework for deciding which investments to choose. People have different goals at different stages of their lives. For example, if you are retired, you may simply want to maximize the amount of income you receive. Whereas, your longer-term focus might be building financial security for you and your family. Whatever your goals and your time frame for investing, it is important to be realistic about what you can afford to invest and how best to manage your investments. If you are unsure of what type of investments may suit you, you might find it helpful to seek the advice of a qualified investment advisor.

Short-Term Goals

These goals fall within the next 5 years and where you might need easy access to funds. For example, planning for a dream wedding, buying a new car or your home renovations.

Medium-Term Goals

Goals you wish to achieve within the next 5 to10 years, for example, paying higher education expenses of your kids or saving for the down payment of house loan.

Long-Term Goals

Goals you wish to achieve beyond the next 10 years, for example, paying off your house loan or maintaining your desired standard of living through retirement.

Invest For the Long Term

The old saying ‘time is money’ sums up precisely why it’s so important to invest for the long term. Your financial goals may include launching a business, leaving a legacy for your heirs or supporting a favorite charity. Whatever they may be, one of the best ways for you to reach them is to invest over a long period of time. That’s because the effects of compounding the returns you receive from your investments over time can be significant. In fact, compounding is the engine that powers long-term investment returns. It happens as you reinvest your returns, then reinvest the returns on those returns, and so on.

Decide If You Need Income, Growth or Both

Investments are divided into income assets and growth assets. One of the key investment decisions you need to make during the planning stage is whether you require income, growth or a bit of both from your investments.

Growth Assets

These are designed to provide most of their returns in the form of capital growth over time. Growth assets include UK and international equities, and property investments. Over the longer term, these assets can help to protect against inflation. Therefore, investors with a longer investment time frame tend to invest in a higher proportion of growth assets. Growth assets tend to have more volatile returns over the shorter term, but they have the potential to produce higher returns over the longer term.

Income Assets

These primarily provide returns in the form of income and include cash investments, bonds and certain equities. Income assets tend to provide more stable, but lower returns. If your primary need is for income you may benefit from holding a higher proportion of income assets. Having decided whether you require more income or more growth from your investments, you can go on to working with your financial adviser to develop your investment plan.

Relationship between Risk and Return

A simple relationship exists between risk and return – the higher the potential return, the higher the level of risk involved. Whilst everyone would like to maximize return and minimize risk and would prefer to have a return every year of approximately 15-20% with no opportunity of investments falling in value, the reality is that these investments do not exist. As a common rule, the bigger the potential investment return, the higher the investment risk and the longer the investment time horizon. Your ability and willingness to accept risk will determine the suitable range of assets for your investment. Understanding the risk associated with your investments is crucial. If you are not comfortable with or do not understand the risk you’re taking, you should not invest.

Tradeoff between Risk and Return

The relationship between risk and return can be summarized as:

• Low Risk - less volatile asset classes typically experience lower levels of returns, be that gains or losses. As the investment is less variable in nature, the return offered to the investor is generally lower.
• High Risk - more volatile asset classes may experience higher gains or losses. As the investors return is more uncertain they expect compensation in the form of higher potential gains.

Historically, asset class returns have tended to correspond to their risk rankings. During periods where investors’ expectations about a company or market’s prospects are improving, returns will tend to be highest for the highest risk asset classes. If growth prospects deteriorate, lower risk asset classes should generally perform better compared to the higher risk assets. As economies and companies tend to grow over time, it is typical to expect higher risk assets to outperform over the long term, albeit with some bumps along the way.

Diversify to Minimize Risk

Spreading your money across a range of investments is one of the best ways to reduce risk and protect against sudden falls in any particular market, sector, or individual investment. With a diversified portfolio of investments, returns from better performing investments can help offset those that under perform. Diversification alone does not ensure you will make a profit, nor protect you fully against losses in a declining market. But it can reduce the risk of experiencing a serious loss of wealth as the result of being over-committed to a single investment. With your financial adviser’s help, you can spread your potential risk by investing in a mix of investments. That way, when some investments are under performing, other investments can carry the load and help to even out the ups and downs in your portfolio.

Understand Asset Allocation

The next step to understanding the fundamentals of investing is to examine the process of spreading your money across the different types of investments in order to meet your investment objectives.

Understand Asset Allocation

Asset allocation is one of the key ingredients of a successful investment strategy. With an understanding of your investment goals, time frame and risk, you can work with your investment advisor to begin to create an asset allocation for your portfolio. Asset allocation simply means deciding how to spread your money across the different asset classes (including equities, bonds, property and cash) and how much you want to hold in each. It also means selecting a mix of asset classes that reflects your investment objectives, time frame and attitude to risk. Asset classes consist of a group of securities with varying levels of risk as given below:

• Equities
• Fixed Income
• Cash
• Commodities
• Real Estate

Each asset class has different investment features, for example, the level of risk and potential for delivering returns and performance in different market conditions. A balanced portfolio uses the different characteristics of each asset class in an attempt to smoothen fluctuations in performance and balance risk.

Equities

Equities are shares of ownership in a company. When you buy equities, also known as shares/stocks, you are effectively becoming a part owner of that business. Historically, investing in equities has the potential to generate potentially higher returns in the longer term than other investments, such as bonds, helping you meet your long-term investment objectives. The value of investments will fluctuate subject to the performance of Stock Market with other relevant economic factors, which cause fund prices to fall as well as rise and you may not get back the original amount you invested. When the company performs well, the price of your shares may go up. When it does poorly, that price may fall. A good fund manager essentially identifies a good company and the best time to invest in. By investing in equities you can earn a return in two ways:

• When you sell the shares for a higher price than your purchase price, also known as Capital Gain
• When you receive dividends from the company whose shares you own, also known as Dividend Income

If you hold the shares directly, any dividends will be paid to you as the shareholder, but if you’ve invested in equities via a mutual fund, the dividends are paid to the fund. The managers of the fund then decide to pay an annual dividend to its investors. As a mutual fund investor, you can choose whether you want to:

• receive any dividend distributions as a regular income; or
• have your distributions reinvested into the fund

Fixed Income Securities

Fixed income securities include Government Securities (T-Bills, PIBs etc.) and other debt instruments usually issued by corporates (bonds, TFCs) which normally pay a fixed/variable rate of interest based on the instrument structure over a given period of time period, at the time of maturity upon which the principal amount is also repaid. They potentially offer a more predictable income for investors when compared to riskier asset classes, such as equities, and could help to bring an important element of diversification to your investment portfolio. Fixed Income Securities are generally considered to offer stable returns, and to be lower risk than equities – and hence deliver lower returns than equities. The value of investments may fluctuate subject to the prevailing discount rate, which will cause the investment value to fluctuate. When you buy this type of securities, you’re effectively extending a loan to the issuer. T- Bills/Corporate Bonds/Sukuks can be issued by governments or companies. Government securities are generally issued to fund public spending on projects like new roads and schools, while a company may issue Corporate Bonds/Sukuks as a way of financing new business opportunities. You can earn a return from investing in Fixed Income Securities in following way:

• You receive an income through pre-determined regular interest payments from the bond issuer known as the Coupon.
• You receive an income on pre-determined terms & conditions through rental (for ijarah based) or profit sharing (for musharaka based) from the sukuk issuer known as the Coupon.

On the day that the bond matures, known as the ‘redemption’ or ‘maturity’ date, you usually get back your original investment also known as the Principal. After buying a bond, you don’t have to hold onto it until the maturity date. Just as a company’s shares can be bought and sold on the stock market, bonds can also be traded throughout their lifetime. The amount borrowed/ purchased Sukuk by the issuer that must be repaid to the holder of the bond is known as the 'principal'. This is also known as 'face value' or 'par value' and is set when the bond is issued. The price of the bond will change between the date of issue and the maturity date, as the bond is bought and sold on the open market.

Cash

Cash tends to be normally held within a bank account where interest can be earned. Among investment instrument, cash funds use their market power in an effort to get better rates of return on deposits than you would get in an ordinary bank account. They usually invest in very short-term bonds commonly known as ‘money market instruments’, which are essentially banks lending money to each other.

Commodities

The exchange of commodities characterizes one of the most primitive forms of trade in human history. Markets for goods trading have existed for centuries. Commodities are a distinct asset class with returns that are largely independent of traditional asset classes like stock and bond returns. Today investors have an option to choose from a variety of vehicles for investing in the commodities futures markets including mutual funds, exchange-traded funds or notes, covering the wide spectrum from single commodity based exposure to sector based and broad based commodity exposures. Commodities markets today can offer quite attractive opportunities to investors. Commodities’ low correlation to traditional assets illustrates what may be the most significant benefit of broad exposure to commodities: diversification. Asset classes tend not to move in sync with each other, which tends to reduce the volatility of the overall diversified portfolio. This lower volatility reduces portfolio risk and should improve the stability of returns over time. However, diversification does not ensure against loss. Given their impact on consumer goods prices, commodities can also offer inflation-hedging.

Real Estate

Real Estate as an asset class in a portfolio can offer stable income, partial protection against inflation, and good diversification with other investments in the portfolio. Modern portfolio theory proposes that the most effective way to maximize returns while at the same time minimizing risk is to add uncorrelated assets. Within the context of a multi-asset portfolio (composed of stocks, bonds, and other asset classes), real estate may provide significant benefits, as correlations with stocks and bonds over time have been low. Another benefit of investing in real estate is a hedge against inflation. With inflation increase, your potential rental income and property value increases considerably. With the increasing cost of living, so does the cash flow. The value of investments in property, a physical asset, and the income from them, will fluctuate. Property investments can be harder to buy and sell when compared to investments in fixed income securities and equities. An investment in the real estate fund may be linked to those risks normally associated with an investment in company shares or fixed income securities. Of the major asset types equities, bonds, property and cash, historically equities have the highest potential to deliver strong returns over the long-term. That’s why many people who invest for the long run make equities the biggest portion of their portfolios. But remember that equities can be volatile.