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:
- Fixed Income
- Real Assets
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?
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.
No. of Shares
Retail Company A
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.
No. of Shares
Healthcare Company A
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.
No. of Shares
Retail Company A
Healthcare Company A
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.