Friday, August 06, 2010

Investment 101 - Benchmark

Let’s talk about investment.

Rule #1 of investing, you must know your own benchmark.

i.e. when you get your
return on investment (ROI), you must be able to see, whether has it been a profitable investment, or otherwise.

For instance, in Malaysia,
- The
inflation rate is about 3% a year, whereas
- 12-months fixed deposits (FD) give you about
3.70% per annum.
Unit trust A, with 100% equities exposure gives you 8% return a year.
- Direct investment in stock B listed on KLCI 15% p.a. (tell me if you can find one!)
- 1 banana is selling for RM1. (c’mon, tell me you do have some sense of humour!)

Ok, so what does all these numbers and facts mean?

Let’s start with a simple scenario. You’re 25 years old. Work your arse off for 2 years and manage to save up RM 5,000. What an achievement.
But you know for sure RM5k savings won’t bring you anywhere. So you have decided to take a bold move and ready for some investment.

Naturally, and traditionally, most of our “investments” are in Banks’ FD. Correct?
If, and only if, you keep your savings underneath your pillow, so what have you actually “lose”?

Beginning of the year you have RM5k, in terms of purchasing power, you can afford to buy 5,000 bananas. Wow. Ok, then you decide to put 5k underneath your pillow.

After 1 year, you dig out your RM5k notes, go to Giant or Tesco and want to reward yourself with 5k bananas, only to find out that due to inflation, 1 banana now costs you RM 1.03.

So in terms of purchasing power, your RM 5k no longer can buy you 5k bananas, but only RM 5k / RM 1.03 = 4,854 bananas, 146 bananas less than one year before!

So in the end, you still have your money in hand, but, it has lost its value. Thanks to the erosion caused by Inflation!

Same scenario as before, but you use the RM5k at the beginning of the year to buy RM5k worth of bananas, i.e. you have 5,000 bananas in store. Assume that you can store it in superb condition for a year (ignoring storage costs……); at the end of the year, you sell all the bananas at market price of RM 1.03. At the end of the year, you have RM 5,000 * RM 1.03 = RM 5,150.
Oh wait, have I made 150 bucks for trading bananas? Not bad eh! But wait a minute, something is not right here.

Actual return on investment = RM 150 / RM 5000 = 3% = inflation rate p.a.!

So you thought you made some, but in the end, you only manage to
hedge your savings!

So instead of buying bananas, you put your money into FD. Smart move.
After one year, you have RM 5,000 plus 3.70% interests = RM 5,185. Not bad.
You withdraw all the money from the bank and go get yourself some banana.

At the end of year banana price of RM 1.03, you can buy RM 5,185 / RM 1.03 = 5,034 bananas! Crikey! 180 more than
case 1, 34 more than case 2!

That’s investment!

You want more bananas?

CASE 4 & 5:
Just lump the two investments together, basically they will tell the same story.

Instead of putting in the FD, you have decided to buy Unit Trust A or direct investment into stock B.

Maybe it’s pure luck or maybe you’re inspired by
financial geeks, you get 8% return back from investment A and / or 15% back from investment B. Bravo!

So how much have I made? You asked yourself. Let’s get back to the real finance and stop playing so much with bananas.

You should know by now that inflation will eat into the amount of bananas that you can buy at the end of year. Good.

So now you have made 8% (15% for B). But which
benchmark do you compare against?

Both the investments have beaten inflation rate of 3% like how Bruce Lee smashes
financial_cicak. If you lose me here, it means that you can buy yourself a lot more bananas.

But is that your real
benchmark? You should be smart enough to put your savings in FD.

Instead of putting your money with the bank which gives you 3.70%, now you’re investing in unit trusts or share.

So by not investing in FD has become an
opportunity cost for you! Is it really worth it?

Absolutely. Investment A gives you an extra 5% return while investing in stock market gives you a handsome 12% return!

Thus your actual
benchmark is … your next best investment opportunity! In this case, FD.

But hey, are we missing out something here? I am afraid so.

Rule #2 of investing – Risks vs Return

The above example has one major flaw. It has totally ignored one of the most important elements in terms of investing. RISK!

Basically the illustration here assume that all the investments, either in bananas, hide underneath pillow, FD, A or B have similar risks. Is this the case?

No no… so how do we measure risks? That's another story altogether that deserves a whole chapter to itself...

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