“Do not put all your eggs into a single basket”
If we had to sum up what having a diversified investment portfolio means, this would be it.
Managing Your Risk
The fundamental reason behind having a diversified investment portfolio is to manage our risk. This is important because any form of investment that we engage in is by default, risky.
Imagine if you had RM 500,000, and you’ve invested all of it into a single stock. If the stock crashed, you would have lost close to RM 500,000, an amount that might take you another 20 years to accumulate.
The Risk Spectrum Of Various Investments
There exists a wide spectrum of investment opportunities that we can participate in, from bond funds, mutual funds, REITs, fixed-income funds, endowment plans, properties, property speculation, conventional businesses, high-growth technology start-ups, to stocks, futures and options.
Most of us wouldn’t have enough capital to participate in all of them. Hence, we need to pick and choose the investments that we are comfortable with, and which are suitable for us to invest in.
High Risk High Return, Low Risk Low Return
In general, the higher the risk of an investment, the higher the expected returns would be. The lower the risk of an investment, the lower the returns tend to be.
Low To Medium Risk Investments
Low to medium risk investments are investments that tend to keep their value well.
In other words, you are not likely (not impossible however) to lose your capital if you invest your money in them. However, they also tend to give a much lower return than higher risk investments.
Typically, a low to medium risk investment would give you a steady annual return of 3% to 6%.
#1 Fixed Deposits
One of the most common and safest investments that you can make comes in the form of a fixed deposit. It is basically a contract between you and a bank to keep your money in the bank for certain duration of time, after which the bank would return you your capital plus a pre-agreed annual interest on your deposit.
However, it is important to note that the interest rate provided by fixed deposits of around 3% to 4% hardly qualifies as a proper investment opportunity.
Most investors only use fixed deposits as a temporary place to park their capital while searching for better investment opportunities. The rationale behind their thinking is that if the annual inflation rate stands at approximately 10% per annum, getting a return of 3% to 4% equates to a nett loss of 6% to 7% per annum.
One would still be getting poorer despite getting a return of 3% to 4% a year.
#2 Bond Funds & Fixed-Income Funds
Besides fixed deposits, bond and fixed-income funds are also popular low-risk investments that can give you anywhere from a 3% to 7% return per annum.
Bonds are loan contracts issued by reputable companies who would like to borrow money from the public to finance their projects.
For example, if Petronas intends to open up a new oil well in the middle of the ocean, they may prefer to raise money from the public by issuing bonds, and promising to repay the capital with interests via an agreed repayment schedule. This might be a quicker way to expand, rather than to draw on their cash reserves or raise capital by issuing more shares.
Given the scale, size and financial stability of a company like Petronas and the nature of their business, the likelihood of them defaulting on their bond repayment is very low. That is the reason why bond funds are generally considered to be low risk investments. Furthermore, a bond is a straightforward loan contract by which creditors can bring debtors to court to recover their money should the debtors default.
However, it is also important to note that bonds have different grades to them as well. Bonds issued by smaller companies who are not as reputable have a higher risk-rating as these companies are more likely to default on their bond repayments.
#3 Endowment Plans
Endowment plans from insurance companies can be used as a medium-term forced-savings plan from which you would get back the capital you’ve invested over the years plus a fixed accumulated interest at the end of the 10-20 year term by which your endowment plan reaches maturity.
#4 Insurance Balanced-Funds
The way to invest into an insurance balanced-fund is through an investment-linked policy that’s optimised for investment purposes, rather than protection and insurance benefits. Insurance companies usually get the best deals because of their massive available cash reserves. They could generate a pretty good return of anywhere between 7% to 15% per annum.
#5 Long-Term Commercial Properties
If you can afford the large amount of capital required to acquire a commercial property in a prime location, commercial properties like shops are a good and considerably low-risk investment you could consider.
However, it is important to note that location is of utmost importance when it comes to investing in properties. If you’ve acquired a commercial property in an area that doesn’t have high traffic or a new area which has yet to be fully developed, you might face serious trouble trying to get rent-paying tenants, in which case your loan repayments and maintenance costs for the property might turn into a significant burden for you.
REITs, which stands for Real Estate Investment Trusts, is like a mutual fund for properties, where a property developer would put together a basket of professionally managed commercial properties, collect rent from their tenants, and distribute the earnings as dividends to unit holders.
It can be seen as a way to own a small share of commercial properties without putting up a huge amount of upfront capital.
Medium to High Risk Investments
Medium to high-risk investments would typically give you an annual yield of around 20% to 40%.
#7 Conventional Businesses
A conventional business like opening up a restaurant, a cafe or franchise can be considered a medium risk investment.
This is because a business is something you would have considerable control over. If something isn’t working, you can do all you can to fix it. If the marketing isn’t working, you could change your marketing strategies, if the management isn’t efficient, you could improve your management structures and operation procedures.
However, starting a conventional business still requires a sizeable amount of capital and not everyone can afford to do that. A business would also take a considerable amount of time to breakeven.
Furthermore, not everyone is good at running a business and 80% of businesses don’t survive past their 5th year. But if you make it, it can be a good source of passive income.
#8 Mutual Funds
Mutual funds are a collection of stocks that are professionally picked and managed by professional fund managers according to the fund’s prospectus and risk profile.
If you don’t think you have the time to dive too deep into analysing each stock individually, you might be better off investing into a mutual fund, where professional fund managers are doing most of the work for you. All you need to do is to choose your risk profile and the type of fund you want to invest in based on their past performance & prospectus.
However, it is important to note that mutual funds usually charge an upfront administration fee when you invest and a yearly management fee thereafter. Hence, your investment term might need to be more than 2 years long for it to be worth the fees.
An equity-based mutual fund can generate a return of up to 40% on a good year and can also lose up to 40% of its value on a bad year. It generally follows the general trend of the stock market, which follows the economic cycle.
You can invest in mutual funds by opening an account in the investment arm of certain commercial banks.
You stand to make a lot from high-risk investments. However, you also stand to lose a lot from them if things don’t go well.
Any stock investment would be considered high-risk simply because capital markets are volatile and unpredictable by nature. Even if you’ve bought into a fundamentally strong and financially stable blue-chip stock, you still wouldn’t know when the next global recession might hit and when the market might crash.
Even if a company’s fundamentals are strong, their stock price would still crash along with the entire stock market in a bear market due to the tremendous downward pressure and outflow of capital from the stock market. If you’re successful, you stand to double your investment value in a year; if you’re unsuccessful, you might end up losing your total investment value.
Hence, we advise that you only invest money that you can afford to lose in the stock market.
#10 Property Speculation
Property speculation, or “flipping”, is another example of a high-risk investment. This is because you’ll never know whether there will be an increase in demand and value of the property once it is completed.
If you can’t get the property off your hands in time at a higher price, then you’d probably be stuck with a mortgage to service for a considerable amount of time.
Furthermore, with the implementation of the Real Property Gains Tax and various cooling measures by the government, it doesn’t really make sense to engage in property speculation activities anymore unless you’re tipped in for a deal that’s drastically below market price. Even if you do find one, it’s probably too good to be true.
Futures, options and forex trading are by definition very high risk investments, simply because you’re trading pieces of paper which gives you the right to buy a certain commodity at a certain price at a certain time in the future.
To do well in trading futures or options contracts, one needs to be very well versed in technical analysis and willing to invest the time and effort required to monitor the movement of the market closely.
Liquidity Of Investments
Besides their risk profile, the liquidity of the various investment opportunities should also be taken into account. Liquidity is the measure of how easily you can exit from your investments and turn them into investable cash. This is important because you would need a certain amount of liquidity to prepare for emergencies or to finance sudden investment opportunities that might come along.
Stock holdings and bond fund units are considered liquid because you can sell them for cash anytime. On the other hand, properties and businesses are considered illiquid as it could take anywhere from 6 months to a year to find willing buyers to take them off your hands in exchange for cash.
Now that you have an idea of the risk profiles of various investment opportunities, you could proceed to build your diversified investment portfolio by building a balanced portfolio of investments according to your age, available capital, risk appetite and preferences.
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DollarsAndSense Malaysia is a website that aims to help people make better financial decisions, one interesting, bite-sized article at a time. Like us on Facebook to stay in touch with our latest articles.