Before Making any Investment...

Oooh. It has been a loong time since this blog is updated. This post is on structured products. The recent debacles on DBS High Notes 5, Lehman Minibonds and Merrill Lynch Jubilee 3 Notes have brought our attention to understand what actually is a structured product.

Basically, a structured product is a combination of various financial securities packaged into one product. These financial securities may include stocks, bonds, options, currencies, indices, funds etc. A structured product derives its payoff based on these underlying financial securities. The word 'derive' is extremly powerful. Think of the financial securities as colours (Red, Yellow & Blue). From these basic colours, one 'derives' many other colours through different combinations and proportions, and possibilities are infinite. The same goes for structured products where basically any kind of payoff can be derived from the primary set of financial securities for as long as the risk-return tradeoff rule is adhered to. 

Instead of giving a lengthy explanation of each structured product and what causes each to fail, a simple way is to understand the risk-return tradeoff rule. As the name goes, Risk-Return Tradeoff is a principal that potential return rises with an increase in risk. With high risk, comes high returns or NO returns or NEGATIVE returns. And the principal holds, firmly. There is no free lunch in this world. Banks love to advertise potential returns BIG on their structured products, 27.5% returns in three years for example. The idea is not to think returns but to think RISK. You may think a 1% return as almost risk-free (for this is current fixed deposits rate and our SG Governement is guranteeing it), average 8-10% returns on stocks where you run the risk of your initial investment being wipeout. Correspondingly, a potential 27.5% returns is indeed HIGH risk. 

The lesson here is to always think of the potential downside (RISK) before making any investments, nothing is too good to be true. Structured product is one great invention in the financial industry and there are definitely more to come. Nevertheless, the risk-return tradeoff always hold firmly no matter what the product is. Bring this principal with you, you will go a long way. 

Insurance Savings Plan

Let's clear some doubts regarding savings policy. Insurance savings policies (a.k.a endowment policies) are defined as insurance policies that accumulate cash savings which pay a lump sum after a specified maturity. We exclude life insurance in our discussion. Life insurance are also savings policies but they are only redeemed after the policyholder's death or retirement. The difference between endowment and life is the length of the maturity.

The truth is insurance is cheap. Take a good look at the sum insured of your policy and compare with the market rates of term insurance. A $100,000 sum insured only cost a premium of $11 per month if you are below 45yo. Endowment policies costs much more because they also include riders like Total, Permanent Disability(TPD), Critical Illness (CI) and savings portion.

Comparing with endowments, the disadvantage on term insurance is that they do not include these TPD or CI riders. Furthermore, the savings portion have to be invested separately which might really cause heachaches for some beginners. In this way, endowments save people lots of trouble by transferring all the dirty jobs to insurance companies. Savings plans are good.

My argument on the insistence of term insurance is picking on the returns insurance companies are providing on the savings portion. The savings portion normally takes up more than 80% of endowments' premiums and the guranteed returns is often less than 2% (although non-guranteed returns goes up to 6%). Such endowment policies have long horizons of at least 20-30 years. Taking a viewpoint from finance, the savings portion should have better investment alternatives and the long horizon makes volatile investment vehicles like stocks generally safe. Considering the potential that the savings portion could provide, I feel that it would be a pity putting them in savings policies.

However, I would like to emphasize on the importance of understanding and knowing. Choosing to invest in stocks puts you in higher risks as explained in previous post. Choosing to terminate policies puts you in risk of high losses on administrative costs charged by insurance companies. Understand before you act. Otherwise, it would always be better to leave the dirty jobs to the experts.

How to Pick Stocks?

Should I pick stocks?
This is the first question to ask before picking any stocks. Stock picking requires considerable time to learn and to analyse. Stock investing requires consistent monitoring of your holdings and their performance. Besides time and effort, there is the concern of risk appetite. Some may not be able to accept the fact of losing their initial investment or the fluctuations of the stock prices may give some insomnias. Understanding the nature of stocks is important before entering the market. Otherwise, buying without knowing is equilvalent to gambling.

There is always the alternative of leaving the dirty job to portfolio managers and let these professionals handle your money. They probably have better expertise and after all, monitoring your money is their full time job.

Stock Picking
The idea of picking individual stock opposes the notion of diversification such that by selecting the one best stock, you would want to put everything in that number one. Otherwise, it's stock screening. Stock screening is the process of searching stocks using criteria elimination. For example, suppose if you only have $10k to invest, A DBS stock is likely not to be in my consideration since one lot of DBS cost >$18k now. Therefore, stock price is a possible criteria. Personal criteria will also include industries you are familiar with, dividend payout. Perfomance criteria inclue P/E multiples, ROE, profit margins.

Besides fundamental calculation of stock value using discounted cash flows or relative valution with industry or market comparables, I believe it is even more important to understand the business. The Management style gives an idea on the company's future growth prospects. Understanding whether the business can be easliy replicated gives a clue on future competition. The company's competitve advantage will allow it gain an edge and whether it will last. These qualitative factors must be forward looking which means information on the company must be researched based on the future. This is because the past information is always already incorporated in the stock price.

As such, I would like to conclude that stock picking is more of an art than science. It is very much due to intuition and how one feels about the particular stock. There is no right or wrong investment decision now, there is only right or wrong investment decision then. No one predicts the future and no one knows for sure what will happen. All the best.

Bearish

Bear Stearns
A stock selling for $60 drop to a mere 5 bucks over the weekend. Checking the prices, BSC is going for $170 over a year ago. The once 4th largest commercial bank in US, 87 years of history, the prestigious place for top graduates, first-class honours, and MBAs. Now in deep trouble. Does none of these brilliant elites saw it coming?

I doubt so. Theoretically, banks would probably want to help each other. The fall of one bank would have severe impact on confidence for the entire industry which we have seen financial stocks underperforming further with BSC incident. However, the reason for BSC's fall probably dates back to 1998 when they refuse to help the then troubled Long Term Capital Management. Poor relationships with other banks and institutions results.

Fed Funds
The Fed Funds target rates have been hitting headlines for the past two quaters as Bernanke attempts to ease lending rates. Numerous cuts have been made but it seems the the inter-bank offer rate in euros and pounds just rose to its highest since Dec 07 (according to Bloomberg). This shows European banks remain sceptical on lending and liquidity will continue to be a problem. At 2.25%, there is little ammunition left for Bernanke on Fed Funds target rate to ease lending. We shall see what is left in his arsenal.

USD-Yen Carry Trade
The yen has always been a cheap currency to borrow because of its extremely low interest. Investors used to borrow yen and invest the greenback to take advantage of the interest rate parity. However, poor market sentiments in US has been causing this carry trade to unwind. Investors have been closing their position in dollar, sending yen to rise.

Nevertheless, it is still cheap to borrow, especially in Singapore dollar. If you do have a mortgage, I would really advice for some re-financing during this period. Readjusting your interest rates can probably provide you with much savings.

Market Sentiments
The volatility index on S&P has recently rose to its highest since the Great Depression. This high volatility really just shows no clue where the market is heading. Higher volatility makes the market extremely sensitive to any information and the trend of market overreaction is extremly evident. Does the assets of BSC worth $60/share today and ends up $5/share over the weekend. Irrationality. Lehman is probably the next victim with the upcoming negative information.

To sum up, financial stocks remain unsought for in near term and the continued weakening dollar will give US companies slight headaches. In Asia, recent political change in Taiwan is really an optimistic boost for the region. Fundamentals have been fairly good since the lesson learnt from 97 Asian crisis. We shall see more free trade agreements coming and i am pretty hopeful on Asia.

Financial Planning

"Fail to plan, plan to fail." The same goes for finance, proper financial planning is the passport to financial freedom and peaceful retirement. It is pretty widespread that people claim they are poor and do not have money to plan, thereby giving the excuse to avoid financial planning. This is absolutely wrong. The poorer you are, the more you need financial planning. With the humble salary one might be getting, every dollar and cent really counts, which makes it even more important that the money goes into the correct channel. Careful spending and discipline saving are cool hobbies to start off financial planning.



The above personal financial pyramid resembles the Maslows's where the bottom must be satisfied first before moving up to the next level. Therefore, wealth protection is the most important and should be attended to first.

Wealth Protection

Wealth protection, in my interpretation, consists of personal financial habits, insurance and debt planning. As mentioned earlier on, financial habits like discipline saving is probably the first step before one can even go into insurance and planning to reduce your debt. Buying a insurance policy is a way to force compulsory saving but the plan might upset if you do not pay your premiums on time.

I am a firm believer of term insurance. Term insurance is the original form of life insurance and is considered pure insurance protection because it do not builds up any cash value. Savings and insurance should not be mixed as they incur additional administrative costs charged by the insurer. Putting savings in risk free government bonds should be able to provide returns higher than savings policy. Besides savings policy, Investment-linked policy provide little insurance coverage and the insured has little funds or investments to choose from these policies. There are more than hundreds of performing funds out there so it is really not wise to be restricted only to those funds given by the insurance companies. I recommend term insurance.

Debt-free is really an unpopular goal amongst Singaporeans. Every graduate seems can't wait to get their credit card once they land on their first job and don't mind paying installments to quickly get a car. The catch here is that interest is not cheap. Delayed credit card payments, car loans and even tution fees loans are debt you owed to banks and these banks earn the extra interest you are paying which really can be a huge amount. I really think debt-free is very important and investing should come after paying off your debts. Think about it this way, the interest most banks are charging for loans is probably 4-6%, this is the average returns bond portfolios give over the long run. Unless you are confident your Return on Investment (ROI) of your investments can beat the interest rate, you are contradicting yourself to be investing and paying off your debts at the same time. You may argue that stock portfolios may give higher returns but that comes with higher risks and the returns are volatile. I believe the only exception is housing loans but that can be paid off using CPF. Otherwise, debt-free before investing.

Having sufficiently insured and debts paid off, you should also keep a sum of emergency fund. In unexpected situations when you may suddenly lose your job, the emergency fund can be used to tide over the crisis. The rule of thumb is that the emergency fund should be 6 times your monthly salary. With all these in place, you are well protected and you should move up the ladder.

Wealth Accumulation

Wealth accumulation is basically long term investing for future goals such as home ownership, children's education and retirement planning. Depending on individual's appetite for risk, now is the time to build up your portfolio to accumulate your wealth. Stock portfolios are generally pretty safe when invested long term (20-30 years) and the returns are more likely to be optimistic. A non-finance person do not necessary need to pick stocks and create your own portfolios. There are unit trusts available in the market where each of them is already quite diversified, depending on the fund strategy. You may also try to opt for a portfolio manager for advice. Otherwise, it is always useful to look at the past performance of the fund and the record of the fund manager before choosing a unit trust. Once you have constructed your portfolio, you basically leave it and allow it accumulate over the years. The portfolio may be reviewed yearly to adjust your needs but basically you do not to change your fund holdings to speculate.

Wealth Distribution

This is the final stage where you will be thinking of estate planning and writing your wills. Estate are taxed heavily but there are some ways to go around being taxed. Therefore, it is always wise to find an estate planner should you have loads of wealth for your descendants.

First Post

I aint a person who is interested in blogging but sometimes boredom really kills. Instead of putting down how I am really getting killed with nothing to do, I finally decided to blog on finance. Finance is what i am currently reading, finance is my interest, finance is my passion. So what is FINANCE?

fi·nance /fɪˈnæns, ˈfaɪnæns/ Pronunciation Key - Show Spelled Pronunciation[fi-nans, fahy-nans] Pronunciation Key - Show IPA Pronunciation noun, verb, -nanced, -nanc·ing.
–noun
1.
the management of revenues; the conduct or transaction of money matters generally, esp. those affecting the public, as in the fields of banking and investment.
2.
finances, the monetary resources, as of a government, company, organization, or individual; revenue. –verb (used with object)
3.
to supply with money or capital; obtain money or credit for. –verb (used without object)
4.
to raise money or capital needed for financial operations.

The above lump of paragraph is cited from dictionary.com and serves to give a basic explanation of my interest. Finance in my own definition is the handling of money, how money works, how the banking system works and why do we need money and banks.

Money is simply pieces of paper used for exchanges of goods and services in replace of barter trade. The reason why these pieces of paper is much more valuable than your A4 printing paper or color paper is because of its legal tender status. Legal tender is an enforcement by law that the seller cannot reject any payment in the form of "legal tender" paper. It also bottoms down to the public's confidence on the particalar Government's enforcement of law. If the legal tender is not properly enforced, the pieces of papers is deemed useless. On the same note, people who use money have the confidence the Government will back the use of the currency.

Banks are simply legalised "Ah longs". Their main operations should be lending and borrowing and they play a very important role in the world of finance in ensuring efficiency. Banks borrow money from savers who have extra cash [these are your savings & current accounts] and lend out these money to entrepreneurs who are funding their investments or to new car/house buyers [your mortgages]. Unlike "Ah longs", banks are intermediaries who act as a link between savers and borrowers. With banks, a saver located in U.S. can end up lending money to a newly wed buying a house in S'pore. Banks removed global boudaries and save everyone the need to look for lenders or borrowers personally. When you had a money problem, you simply go to a bank.

Investment is used to describe depositing a sum of money on any particular asset in hope of a future return or interest from it. In short, how money makes more money! This is what strucks me most when i first read up on finance. Today, most graduates end up with a job drawing a particular salary and everyone hope for a pay rise soon and it seems no one exactly knows when can they even retire. I call it financial literacy. The sad truth is most graduates are financial iliterate. Many people knows how to make money but they do know how to make use of the money they made. Knowing how is understanding investments.