The basic objective of financial planning is to provide appropriate investment recommendations that meet the needs, goals and objectives of the client. Investment is thus the solution for the clients’ financial goals and problems identified in the financial planning process. While inheritance also provides the financial resources, generally, it is what we do with the financial resources that will eventually make it grow to satisfy the numerous future needs. As can be seen, investment plays the most prominent and vital role as a mechanism for financial liberation and future wealth.
The process of investing could be guided by well-developed plans that are formulated to meet the investment objectives. There can be several steps in plan formulation as follows:
STEP ONE – Meeting the prerequisites. This step says that before any one talk about investment, he/she should have adequate provision for the basic necessities of life. This category should include food, shelter, clothing, and transport for himself and his dependents. In addition, the provision for contingency of funds to meet emergency is also necessary. One will find that the definition of basic necessities and contingency differ from one person to another. It is precisely because of these differences that no standard financial plans could be designed for all.
STEP TWO – Establishing investment objectives. Examples of investment objectives include retirement funds, education funds, funds for purchasing a car or a residence, and adequate funds to set up own business. The objectives must be specific, quantifiable and achievable within a time frame. Investment objectives are also part of life goals that could be qualitative and quantitative.
STEP THREE – Adopting an investment policy. After investment objectives are established, there should be a written plan as to how funds are invested. Is the amount to be invested in one lump sum or over a period of years on a regular basis? If regular savings are to be made, will the frequency be on a yearly, half-yearly, quarterly, monthly, weekly, or daily basis? Each and every objectives should be listed in order of priority. Certain goals are more serious than others and the level of risk should be low. For example, funds for education should not be built up based on investment vehicles that are highly risky.
STEP FOUR – Evaluating the investment vehicles. This involves evaluation of investment vehicles based on their expected returns and risks. Measurement of historical performance and fluctuations in returns will give indications of expected returns and risk. The potential of the investment vehicles in the light of changing domestic and international environment is also to be evaluated.
STEP FIVE – Selecting suitable investment. After proper evaluation, the next step is the selection of investment vehicles. The investment objective should form the primary criterion in the process of selection. Other criteria used include the risk tolerance level and age of the investors.
STEP SIX – Constructing a diversified portfolio. The key word here is to optimize the returns and risks, in order to achieve the investment objectives. A diversified portfolio might consist of common stocks, bonds, and cash deposits. The percentage of each investment vehicles could differ from one person to another. Some investors may simply opt for indirect investments by picking unit trusts and/or fund managers with proven track record. Before unit trusts and/or fund managers are selected, the investors should study the prospectus of the funds to ensure that they are in line with the investment objectives of the investors.
STEP SEVEN – Review the portfolio. A proper review should include measuring the performance of the funds, regardless whether it is direct or indirect investment. If the investment results are not in line with the objectives, there is a need to take corrective measures. These measures include switching if it is permitted under the indirect investments. When there is a need to switch funds, one will have to bear in mind the costs associated with switching. Some unit trust funds allow free switching up to a certain number of times a year whereas some will not allow switching, meaning investors will have to liquidate the position in order to enter into a new position! The cost associated with liquidation in order to go into a new position is definitely very high.
Here, you will be exposed to additional computation techniques relating to evaluation of investment proposals such as IRR and NPV. Techniques relating to investment portfolio management include standard deviations under three approaches and computation of correlation coefficient using financial calculators. Financial calculators can help to solve complex models and formulas relating to investment with ease. Computation of investment risk has been presented in much greater details in this edition. This is due to the increased emphasis that investors should be well informed of the risk associated with investment. In order to identify high risk or low risk instruments, quantitative techniques are inevitable but again they can be simplified using financial calculators. In the era of globalization with extremely keen competition, financial planners should be better equipped.
One must be aware that this is the study materials for investment planning for individuals. Hence, it is inevitable that the area of emphasis may differ slightly from the literatures that focus on investment for corporations. An example is the inclusion of selection of housing loan packages for individuals in this module. Asset acquisition is often financed by loans to individuals. In the case of real estate, most individuals rely on mortgage loans to complete the purchase of real estate. Extremely keen competition amongst bankers has seen the advent of numerous types of loan offers. Computations of housing loan instalment amount based on multi-rates housing loan package have therefore been included. Readers will find two approaches in selecting housing loan packages in this module. Investment for individuals is an art and science of managing money to meet personal financial goals. Since it is not a pure science, certain areas and theories are subject to challenges and debates which remain unresolved. One may therefore find conflicting views on investment approaches in the text materials. Examples are technical analysis vs fundamental analysis and bottom-up approach vs top-down approach in securities selection. On the more scientific aspect of investment analysis, changes in variables relating to bonds and their consequences on values of bonds are more predictable.
Understanding The basic Concepts of Investments
The basic objective of financial planning is to provide appropriate investment recommendations that meet the needs, goals and objectives of the client. Investment is thus the solution for the clients’ financial goals and problems identified in the financial planning process. While inheritance also provides the financial resources, generally, it is what we do with the financial resources that will eventually make it grow to satisfy the numerous future needs. As can be seen, investment plays the most prominent and vital role as a mechanism for financial liberation and future wealth.
What is investment?
Investment is generally construed as the conversion of surplus money to financial assets that are expected to generate income or capital gain to increase the investor’s wealth. In the context of personal financial planning, the general definition is somehow a bit narrow because it ignores the fact investment can be funded by loans. In other words, investment need not be funded fully by surplus funds. In addition, individuals’ investment need not be confined to financial assets which differ from real assets. A more appropriate way to define investment is: the placement of funds in any assets with the expectation of capital gain and/or periodic income in future. The later definition defines investment in such a way that it does not exclude acquisition of assets that are funded by loans and advances. It also does not restrict investment to financial assets. Base on this definition, several observations and conclusions can be made:
(a) Placement of funds in savings account or fixed deposits constitutes investment. Hence, conservative clients who could not accept investment have actually invested their money without knowing it. In the investment vehicles they have chosen, the return is merely in the form of interest income. There is no capital gain whatsoever.
(b) Purchase of shares in the stock market is a form of investment. Investors expect dividend payments and capital gain in the form of increase in share prices.
(c) Purchase of real estate also fits into the definition. In this case, the periodic income is in the form of rental. Increase in property prices is an example of capital gain.
(d) Purchase of loan stocks is also a form of investment as interest income can be expected. Changes in price of loan stock also provide an opportunity of capital gain.
(e) Purchase of warrants is a form of investment. However, this instrument will only provide potential of capital gain. There will not be any periodic income.
(f) Contribution to EPF is a form of investment, particularly if the contributions are made by the self–employed and by those who are not required to do so under the law.
(g) Purchase of life insurance policies with surviving cash benefits is also part of investment. In this case, payments of claims are not part of investment gains.
(h) Charity is not an investment activity since contributors do not expect any return from their contributions. Interestingly, this also means that contribution of funds with expectation of personal gain, whether in tangible or intangible form, does not constitute charity.
From the few examples of investment, one can see that investment involves placement of funds. Return can come in one or two forms.
Based on the definition and the examples of investment, it is important that one must not have the thought that all investment must be profitable. Note that the definition merely suggests that all investments are expected to generate capital gain and/or periodic income. For any rational investor, the expectation in investment has to be positive. Otherwise, the investor will not invest in the first place. In reality, a lot of investments failed. Capital gain can end up as capital loss. Periodic income from investment may also turn out to be periodic losses as in the case of the obligation to pay maintenance charges with no rental income from apartment. The definition also touched on financial assets. In our society, the production capacity of goods and services is a function of the real assets of the economy. Real assets refer physical assets such as land, buildings, knowledge and machines that are used to produce goods and services. On the other hand, owners of financial assets provide the capital for business operations. As such, financial assets represent claims of income generated by corporations or the government. Examples of financial assets are ordinary shares, preference shares and loan stocks. These financial assets are unique in the sense that they are intangible. They can be created when corporations go for listing in the exchange. They can also be cancelled when loans stocks mature or when corporations go for delisting. In this chapter we will introduce the basic concepts on types of investments such as short-term and long-term investments, investment vehicles, direct and indirect investments, and the relationship of risk and return on investment. In addition, we will also cover briefly the investment process and the types of securities market. Various steps of investment planning to meet the various types of investment objectives are also included. Unit trust funds are covered in later chapters. Broad Classifications of Investment Instruments We have earlier defined investment as placing funds into any asset in expectation of generating future income and/or capital gain. The investment or placement of funds may be with government or other organizations. As the government and organizations compete for funds, investors will invest with the one they think best suits them and their available resources, goals, knowledge and personality. There are various types of investments that can be differentiated on basis of a number of factors. Such factors are ownership, risk, liquidity, nature of investment, and direct or indirect investment. The differences are described briefly in the paragraphs below. The details are covered in later chapters accordingly.
1. Securities investment – these are evidence of ownership or debt of a business or other assets or legal right to acquire or sell ownership interest in a business or other assets. Examples of such securities are shares (equity), bonds (debts), and options (derivative).
2. Tangible assets investment – these are holding of real property or tangible collectibles. Real properties are land and building which are permanently affixed to the land. Tangible collectibles includes items of gold and jewelry, artwork, antiques and other collectibles.
3. Direct investment – this implies that the investor directly acquires a claim on a security or property. In other words, the investor directly holds the property or shares or bonds in the investee entity (entity where funds are being invested in).
4. Indirect investment – this implies that an investor invests through a third party. An example will be investment in unit funds. These fund management companies consist of members who have the expertise in investment, who will then invest on their behalf in the form of portfolio.