Posted: 23 September 2021
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In an attempt to broaden The Hatch Fund’s reader base, this article serves as a short primer on how to get started with investing. It is aimed at getting people to explore and think more deeply about the topic of personal finance, saving and investing. So if investing is new to you, you have come to the right place. I will keep the information as easy to understand as possible to help you get started on your investing journey.
1. What can I invest in?
Before we can start investing, it is best we understand what we can actually invest in.
Broadly speaking, investments can be categorised into different asset classes. In plain English, an “asset class” is a group of investment/assets that exhibit similar traits. Much like how different species of dogs and cats are classified into “dogs” and “cats” in the animal kingdom, asset class represents a group of securities that have similar characteristics.
Investment Classification by Asset Class
Before we can invest, we need to understand what asset classes are out there so that we know which assets can potentially help us to meet our investment objectives.
Broadly, there are 5 main asset classes that we can invest in:
- Equity
- Fixed Income
- Commodities
- Real Assets
- Alternatives
Equity represents ownership in a company. When you invest in equity instruments, such as common stock, you are effectively buying a share of ownership in a company which grants you the right to a proportionate share of the company’s profits.
You can purchase shares in (1) the primary market, or (2) the secondary market.
- Primary Market
- Purchasing in the primary market means buying directly from the issuer (or the company issuing shares).
- Companies issue new shares to raise funding for their operations. They get cash from investors in exchange for the newly issued shares, which represent a share of ownership of the company.
- Secondary Market
- Purchasing in the secondary market means buying from a seller which is not the issuer (e.g. other investors)
- This is what happens when people talk about “purchasing shares in the stock market”. Effectively, you are using an organised exchange (e.g. SGX, NYSE, HKEX) to buy shares of companies from another investor
Equity investments exhibit a few key traits:
- Indefinite ownership – as long as a company has enough money to continue operating (i.e. remains solvent), your share of ownership lasts until you sell your shares to someone else.
- Residual claim – In company law, debt holders are mostly paid off first before equity shareholders have any claim over the income of the company. Profits must first go towards servicing debt repayments before shareholders can have a claim over the profits. This applies in a liquidation scenario too.
- Right to income – Equity shareholders have claim over any residual income. As such, if a company has excess income after repaying its debt holders, the remaining income fully accrues to shareholders. As a result, as a company grows larger and more profitable, it is expected to accumulate more income which will accrue to the equity shareholder.
- Generally higher potential returns and greater risk – As you can imagine, being able to benefit from the excess income that accumulates as the company grows allows equity instruments to earn potentially higher returns. However, because equity shareholders are typically the most junior (i.e. gets paid last), when the company is not doing well, little to no income accrues to the shareholders. If this continues over the long term, the company’s value will slowly go to zero and shareholders will lose all of their invested capital. This is why equity investment is considered to be riskier than fixed income investment.
- Voting rights – As an equity shareholder, you are able to vote on key decisions that the company makes. When key decisions are made, the company has to call for a meeting (annual general meeting / extraordinary general meeting) to vote on such matters.
Broadly, there are two types of equity – (1) public equity, and (2) private equity.
- “Public equity” means that the ownership of the company lies in the hands of the public (i.e. listed and tradeable on an exchange).
- “Private equity” refers to ownership of companies that are not owned in private (i.e. not listed and tradeable on an exchange)
As the name suggests, this asset class provides a stream of fixed income. In other words, you receive a steady stream of income when you invest in this asset class.
Some examples include bonds, fixed deposits, recurring deposits and commercial papers. These are effectively debt instruments that allows the issuer to borrow money from you. You get paid a fixed interest periodically in return for lending money to the issuer.
Fixed income investments exhibit a few key traits:
- Returns are directly co-related with the risk of an investment. In other words, the more likely an issuer will be unable to pay its obligations, the higher the return they have to provide to attract investors. This is often indicated by the issuer’s credit rating
- Finite life – All fixed income securities will “expire”. The finance term for it is called “mature”. In the most basic structure, investors are paid a fixed interest periodically before the security matures. At maturity, investors are repaid the full principle amount. In other words, if you buy a 10-year bond that pays you 4% coupon (interest) for $1,000, you will receive $40 every year for the next 10 years. On the tenth year, you will receive $40 + $1,000.
- Steady returns – Once invested, the issuer is required to pay you an interest periodically (e.g. quarterly, semi-annually, annually). Regardless of market conditions, this interest rate is fixed until the fixed income security expires.
- Price of fixed income securities are affected by market interest rates – Once issued, the coupon / interest paid under this security is fixed for the entire term of its life. Hence, if market interest rates go up, investors need to price the security more cheaply to sell to other investors.
- Generally lower risk than equity
Commodities are raw materials used in the production process to manufacture finished goods. They are grown, extracted, or mined. There are three board categories of commodities – (1) agricultural commodity, such as cattle, coffee, spices, and soybean; (2) Energy commodity, such as coal, crude oil, gasoline, and natural gas; and (3) Metals, such as aluminium, nickel, and silver.
Commodities are characterised by these traits:
- Fungibility – Commodities are fungible. In other words, they are not uniquely distinguishable from one another and are interchangeable.
- Largely driven by demand, supply factors – This also means that price volatility for commodity can be huge as a large variety of factors can affect its price. These may include storage costs, supply limits and natural disasters. Effectively, anything that affect the demand / supply of a commodity will affect its price.
- Price can be highly volatile – Apart from being affected by multiple demand and supply factors, the main way to gain exposure to commodities is either through actual ownership or financial instruments like futures and options. Often, this introduces financial leverage and speculation into the market, which introduces greater price volatilities to the commodity market.
- Seasonalities – Commodity prices are affected by seasonality, such as weather seasons. For example, during a heat wave like the El Nino, water supply may become scarce in a region and affect the yield of corns. As such, supply of corns will fall for the year and push the prices of corn up.
- Inflation Hedge – Commodity prices are a leading indicator of inflation. In a demand-push inflation scenario, prices of goods and services rise as the market demands more of these goods and services which come in limited supply. As a result, the producers sought after more raw materials, which naturally pushes commodity prices up as well. As such, commodities provide a natural hedge against inflation.
While gold is also a precious metal, it is often considered an asset class of its own. While gold has chemical properties which make it useful in industries like electronics and jewelery, a significant amount of gold is actually held by central banks and investors all over the world for wealth preservation purposes.
A few unique properties of gold allow it to hold its value well over long periods of time:
- Limited supply, allowing it to become increasingly valuable as demand increases
- Hard to mine, which does not allow people to flood the market and destroy its value
- Physically and chemically resilient, which makes it hard to destroy and allows it to last over long periods of time.
These are also the same reason why the world used to transact in gold before our current fiat monetary system was put in place (i.e. paper money).
Gold is often used for:
- Diversification and safe haven asset -- Gold is considered by investors to be a “safe haven” asset. This means that when other asset classes are underperforming, investors will typically sell off their investments in other asset classes and put money into gold. Hence, gold often performs well during times of economic uncertainty, such as during the COVID-19 outbreak last year. Because of this, gold has a negative correlation to stocks and other financial instruments which makes it a good diversifying asset in many investment portfolios.
- Inflation hedge – Gold is a hedge against inflation over the long term as its value has consistently risen. The properties of gold allow it to protect the purchasing power of its holders over the long term.
Real Assets are physical assets that can be further broken down into (1) real estate investments, and (2) infrastructure investments.
Real Estate refers to properties including land, building and other permanent improvements done. These are properties used to house people and can be applied to commercial, retail, residential, industrial, healthcare, agricultural and hospitality purposes. Some examples include office buildings, shopping malls, hotels and warehouses.
Real estate investments are characterized by:
- Intrinsic value – Real estate investments have intrinsic value that are derived from the value of the building and land, which can be sold.
- Low-risk – Real estate investments come with different types of risks depending on when you invest. Prior to the construction of the property, the biggest risk to investors is development/construction risk (i.e. risk of not being able to complete construction). Post-construction, the biggest risk to investors becomes either the risk of not being able to find enough tenants (if the property is leased out), or the risk of not being to sell the property. However, as lease contracts can be rather long term, real estate investments can offer rather low risk to investors once lease contracts are secured.
- Stable, income-yielding – Real estate can be leased out to earn a stable income. Once leased out, real estate investors can earn a steady stream of rental income from their tenants
- Inflation hedge -- Lease agreements may have rent escalation clauses built in which allows real estate owners to increase their rental rates periodically. As such, real estate owners can increase rents during times of inflation to make up for the rising cost of living.
Hence, real estate investments can provide investors with stable income / yield and added diversification while still potentially benefiting from a potential upside if the real estate is subsequently sold at a higher value than cost.
Infrastructure assets refers to physical structures that are needed for the operation of a society. Common examples include airports, roads, highways, power plants and sewage systems.
Real estate investments are characterized by:
- Stable and long-term cashflow – Regulation provides long-term revenue visibility to infrastructure investments. Additionally, ownership of regulated infrastructure is usually transferred to private investors through long-term concession agreements that can range up to 99 years. Concession agreements give the right to operate a business for a given amount of time and under certain conditions. As infrastructure assets are used on a daily basis for people to go about their daily lives, this further improves the visibility of revenue generation. For example, toll road gantries (a.k.a. ERP in Singapore), electricity sales by power plants (e.g. SP / Keppel Electric) are infrastructures that benefit from a stable sales.
- Non-cyclical / Defensive in nature – Infrastructure assets tend to be non-cyclical in nature as they are used on a daily basis. This means that their performance / sales is relatively unaffected by economic cycles. The economic cycle can have more impact on unregulated services, such as airports and seaports, though the essential nature of such services mitigates this risk. As a general rule, when looking at different infrastructure asset types, the stronger and more predictable the regulation and contractual framework for an asset, the lower its sensitivity to the economic context and the more stable its cash flows over the long term.
- Often regulated to increase return predictability – Some assets, such as electricity and gas distribution networks, can be regulated, which can lead to an increase in return predictability. In many jurisdictions, governments will adjust prices of such services / product such that the investor/owner of the asset is able to make a pre-determined profit on the invested capital (e.g. 7% return on capital invested to build a power plant).
- Diversified end-user base – The end users of infrastructure assets are highly diversified. They include governments, local authorities, corporations and retail “customers” like you and I.
- High barriers to entry – The high initial capital outlay acts as a deterrent for potential competitors. Assets can enjoy monopolistic or quasi-monopolistic market positioning and it would be economically unsound, or legally not possible, to build a competing facility.
- Inflation hedge – The ongoing operating costs of infrastructure assets are often passed through to the end users. For example if the cost of natural gas rises, electricity generation companies will charge a more expensive tariff / rate to make up for higher costs.
Alternatives is essentially a ‘catch-all’ term that encompasses everything else that is not captured by the first four categories – equity, fixed income, commodity and real assets.
The first subcategory is “hedge fund”.
Hedge funds are a form of professionally operated investment vehicle that pools capital from individual or institutional investors to invest in varied assets. They employ complex techniques to build its portfolio strategically and manage risks. They are known as hedge funds as these investors are known to employ various financial strategies to hedge the risks exposure of their investment portfolios.
Some common examples include (1) event-driven hedge funds that employ merger arbitrage, distressed or activist investment strategies, (2) relative value hedge funds that seek to buy deeply undervalued companies and short deeply overvalued companies, (3) Equity strategy hedge funds that may be market neutral (long/short), fundamental growth or fundamental value, and (4) Macro hedge funds that seek to make investments based on large impending economic shifts (e.g. positioning portfolios based on an expected recession / hyperinflation).
Hedge funds are characterized by active investment style, high expected returns, high risk exposure, sophisticated investment strategies, and the use of sophisticated financial instruments.
The next subcategory of alternatives that is worth mentioning is “cryptocurrency”.
If you have not heard of cryptocurrency, this term comes from the combination of “cryptography” and “currency”. Essentially, it is a digital representation of an asset such as a currency, an artwork, or whatever you want it to be.
While many dismiss cryptocurrency as a purely speculative asset, cryptocurrencies are in fact far more complex than most people realise.
The term “cryptocurrency” is kind of misleading because not all cryptocurrency is aimed at being a replacement for fiat money / medium of exchange. Instead, you should think of cryptocurrencies as different startups. While you do not get an ownership of the startup, cryptocurrencies are often the backbone that allows the startups’ solutions to function.
Cryptocurrencies can be used as a medium of exchange; It can be used in decentralised finance solutions (DeFi), such as lending, insurance, yield farming, automated market making, and organised exchange protocols. It can also be used to represent non-fungible tokens such as a digital painting, or music label. It can be used to pool together computing power to execute contracts automatically through computing code. The long and short of it is that cryptocurrency is in a very nascent stage and some of the most innovative and smartest talents have flocked here to create solutions to benefit the world.
That said, it is equally important to recognise that there is also quite a significant amount of malicious activities going on in the crypto world such as scams, pump-and-dump schemes and even money laundering.
Cryptocurrency is characterized by its outlandish returns (extremely high and going to zero as well), extremely high risk, high price volatility introduced by financial leverage, and loads of speculative activity / market manipulation.
The final subcategory includes other alternative assets that people also treat as investments. This include, but is not limited to, wine, luxury cars, luxury watches, antiques, collectibles, and intangible assets like patents, domain names, etc.
This category is categorized by the lack of an organised exchange and relatively illiquidity.
2. Risk-return Profiles of Various Asset Classes
Now that we know all the broad asset classes that we can invest in, let’s take a closer look at each of their risk-return profile. In finance, we often talk about returns in relation to the risk. This is an important concept to grasp because you want to be fairly compensated for the risk that you are taking by investing in a certain asset class or financial asset.
Here, we typically use the standard deviation of returns as a measure of risk. In plain English, it is a measure of how much the returns of an asset would typically vary from its expected value (the average return). Hence, the greater the dispersion, the riskier an asset is considered to be.
So what do the risk-return profiles of each asset class look like?
Source: BNP Paribas
A study conducted by BNP Paribas summarizes the risk-return profile of various asset classes in the year of 2018.
- Bonds are represented by green circles;
- Cash / Deposits are represented by the grey circle
- Gold is represented by the golden circle
- Commodities are represented by the orange circle
- Hedge funds are represented by the pink circle
- Equities are represented by blue (public equity) / purple (private equity) circles
- Real estate is represented by the brown circle
As seen in the chart, there is a direct linear correlation between (1) risk and (2) return. Based on BNP Paribas research, if we rank the assets from the safest to riskiest (based on volatility of returns), it will look like this:
Generally, the riskier the asset, the higher the expected return. The keyword here is “expected” because not all risky investments are investments worthy of getting rewarded.
For example, we make a ultra-risky investment by buying into a company that is on the brink of financial collapse (aka bankruptcy). If the company is able to successfully turn its financial performance around, then the expected return will be extremely high. This compensates the investors for taking high levels of risk.
However, in reality, expected return often differs from the actual return of an investment.
High risk does not necessarily equate to high returns: A Luckin Coffee Case Study
Luckin Coffee (aka China’s Starbucks) was a very well-established brand in China that rivalled one of the world’s most famous coffee chains, Starbucks. In 2020, it managed more than 4,500 kiosks across China, which is well-above what Starbucks was managing at that time. The coffee chain takes the 30 cashier-customer interaction out of the equation by handling the entire purchase process through its apps. More than 90 percent of its units are pick-up stores around office buildings and universities to target its millennial customer base.
Luckin Coffee went public in May 2019 and its stock price had been rising consistently on the back of strong revenue growth and improving profit margins. However, in January 2020, Muddy Waters claimed that they had received an anonymous report about Luckin. The report worked with 92 full-time and 1,418 part-time staff to run surveillance and record traffic in 620 stores, alleging Luckin manufactured an astonishing fraud by fabricating financial and operating numbers starting in 2019Q3, just after its IPO. The report also said that the company attempted to instill the culture of drinking coffee into Chinese consumers through huge discounts and free giveaways, which is unsustainable. Yet, these were not reflected in its financials.
After the news, its share price took a nose dive, dipping by ~32% to US$32.40. At this point, buying into the stock would have been considered a risky investment. Many wanted to “buy the dip” – the idea is to buy in during the dip so that if the alleged fraud turns to be wrong, it’s share price will rebound and investors can stand to benefit from buying in at a low price. Sure enough, people started buying up shares and provided support which allowed its share price rebounded to ~US$40.
However, on Apr 2 2020, Luckin reported to the SEC that it had discovered financial fraud, mainly coming from the COO and his colleagues. The amount of 31 financial fraud was reported to be as high as 2.2 billion RMB, accounting for 75% of Luckin’s total revenue in the first three quarters of 2019. This shocked the market and its share price from ~US$ 40 to ~US$ 4.
In this case, buying in at the dip of US$ 30+ was a risky investment that did not manage to meet its expected high returns. Instead, investment return was highly negative. Hence, it is important to understand that a high-risk investment does not necessarily mean a high return.
In Feb 2021, Luckin filed for bankruptcy. It was delisted from the NASDAQ stock exchange in July 2021 but remains traded in the OTC market in the U.S. This week (Sep 2021), Luckin also reached a global settlement of US$187.5mn with its investors. It continues striving to achieve a turnaround, but its success remains to be seen.
Replicating the BNP Paribas asset class risk-return profile study using ETFs
To do the same analysis, I have gathered data on ETFs that represent exposure to various asset classes, including equity, fixed income, commodity, real assets and alternative investments. Below is a quick summary of the data gathered:
As seen, the risk-return profiles of these ETFs can closely replicate the risk-return profiles of the various asset classes as researched by BNP Paribas. Hence, it is important to understand how each of these asset classes help align to your investment goals.
Diversification is Key to Good Risk Management when Investing
One of the golden rules of investing is “Diversification”.
This means investing in different assets from different industries, asset classes, geographies and currencies to reduce the volatility of your investment returns.
With diversification you can aim to smooth out ups and downs in your returns because when one investment performs poorly, another might be performing well. When one industry performs badly, another makes up for it.
For example, during the COVID-19 pandemic, retail companies suffered from poor sales as the economy went into lockdown. In contrast, the healthcare industry experienced some of the best performance during this period.
100% Retail Exposure
If you only had exposure to retail companies, your investment portfolio will be in deep losses as the share prices of retail companies fall on the back of poor performance.
|
Exposure
|
No. of Shares
|
Buy Price
|
Cost
|
Current Price
|
Gain/(Losses)
|
|---|---|---|---|---|---|
|
Retail Company A
|
100
|
$50
|
$5,000
|
$30
|
($2,000)
|
100% Healthcare Exposure
Conversely, if you only had exposure to healthcare companies, whose share price skyrocketed at the start of the COVID-19 pandemic, your portfolio will have gained a lot of value.
|
Exposure
|
No. of Shares
|
Buy Price
|
Cost
|
Current Price
|
Gain/(Losses)
|
|---|---|---|---|---|---|
|
Healthcare Company A
|
100
|
$50
|
$5,000
|
$80
|
$3,000
|
50:50 Retail-to-Healthcare Exposure
In a balanced portfolio with a 50:50 allocation in retail and healthcare companies, your overall portfolio would still have profited despite the COVID-19 pandemic. The gains from investment in healthcare companies would have offset losses from investment in retail companies.
|
Exposure
|
No. of Shares
|
Buy Price
|
Cost
|
Current Price
|
Gain/(Losses)
|
|---|---|---|---|---|---|
|
Retail Company A
|
50
|
$50
|
$2,500
|
$30
|
($1,000)
|
|
Healthcare Company A
|
50
|
$50
|
$2,500
|
$80
|
$1,500
|
|
Total
| | | | |
$500
|
While this is just an illustrative example, the point is that diversification can help the risk of your investment portfolio and buffer losses in case of any unforeseen events like the COVID-19. By spreading your investments into multiple asset classes that have different sources of cash generation ability, you stand to benefit from a more resilient portfolio that is less prone to huge shocks.
The concept of asset allocation and diversification will be covered in greater detail in subsequent articles.
3. What exactly do I buy to gain exposure to different asset classes?
In general, there are quite a handful of financial instruments that retail investors can invest in. These include shares, bonds, fixed deposits, commercial papers, ETFs, ETNs, options, futures, CFDs and more.
Source: OECD Library
The above image gives a high-level view of the different types of instruments that investors can invest in.
However, for starters, the easiest way to get started in investing is to first deal with shares, bonds and ETFs. These are the most straightforward instruments for retail investors to start with since no complex mechanism is involved.
To profit from buying a share or ETF, you will simply do either of the below:
- Sell it at a higher price you buy it at, or
- Collect dividends paid by the companies that you invest in – assuming your selling price is at least the same as your buying price.
This is as simple as keying in (1) the price you want to buy at, (2) the quantity you want to buy, and (3) hitting the “BUY” button.
Financial instruments vary in their levels of complexity and how exchange of cashflow happens between counterparties (buyer and seller). Hence, for starters, it is best to first explore the simplest products, like shares and ETFs, before moving on to more complex products like CFDs, futures and options. This will give you time to read up and understand the various financial jargons, which will prevent you from making any grave investing mistakes that can land you in financial trouble.
In part three of this primer series, we discuss the key considerations when selecting a brokerage firm to setup your trading account with. This will help you think about how to research on the topic of brokerage, and ultimately which brokerage to sign up with. Remember, the end goal is to get you started with investing so click on and find out more!
From now till 30 September 2021, The Hatch Fund will also be collaborating with FUTU Singapore on a promotional offer that will give you a SGD 88 cash coupon + 1 free Apple share. Refer to this article for more information.
Contact
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