Fundamentals of Investing - Part VII

RISK, RETURN AND LIQUIDITY

There are numerous investment vehicles [i.e. things!] that you can use your money to invest in. However, there are three important dimensions when considering what to invest in:

1. Risk
There are two dimensions of risk:

(a) Capital Preservation: What is the volatility of your investment vehicle maintaining the Ringgit value spent buying it?
The less volatile the investment vehicle, the less risky it is and vice versa. In other words, if you bought shares in Bear Stearns at USD100 per share a year ago, how likely is it that it will depreciate in value? Recent events have resulted in shares in Bear Stearns worth only USD10 per share, so investing in shares is a risky investment.

(b) Certainty in Rate of Return: What is the level of comfort that you will obtain the expected return on your investments?
The more certain the rate of return from your investment, the less risky the investment and vice versa. For example, if you invested RM10K in a fixed deposit with a local bank @ 3.70% per annum, it's virtually certain that you will obtain an interest of RM370 per annum. So there is a very high level of comfort on the rate of return.

2. Returns
Return is the combination of:

(a) Capital Appreciation
This means the increase in value of the investment class (excluding the recurring income generated). For example, if you bought a house for RM200K and rented it out, you would obtain rental income. However, you may find buyers approaching you to buy the house from you at RM250K. Therefore, your capital gain [IF YOU SOLD YOUR HOUSE!], would be RM50K.

(b) Recurring Income
Recurring income are the returns generated by the investment class on its' own.
Example: Interest Income from Fixed Deposits, Dividend Income from Shares.

3. Liquidity
Liquidity merely means how fast you can convert your investment into COLD HARD CASH. For example: Your house is a relatively illiquid asset as you need time to sell it. Conversely, investment in shares are highly liquid as you can easily sell your shares on the Bursa Malaysia.

So, what is the best investment vehicles to invest in?

Let me ask you, who is one of the three richest person in the world today, excluding Bill Gates?
WARREN BUFFETT!

Let me ask you another question: What investment vehicles does Warren Buffett usually invest in?
SHARES IN PUBLIC AND PRIVATE LISTED COMPANIES

Now, why do you think one of the world's richest person prefers to invest in shares?

Well, let's consider three different Investment Vehicles:
_________1. Fixed Deposits_______2. House________3. Shares in Public Listed Companies
Risk:_______Minimal_____________Medium_____________High [Medium risk with skill & experience]
Return: ____Minimal_____________Medium______________High
Liquidity:___High________________Low_________________High

Between the three investment vehicles:

(a) Fixed Deposit is the safest but with the lowest rate of return. The current FD rate might not be sufficient to offset the inflation rate now!

(b) Investing in a house is less risky but requires a huge capital outlay [i.e. a lot of money]. Sometimes, you might make a bad decision and it might be your last. Take for example, if you bought a house in Rawang in 1997 in the expectation that area will be developed extensively [rumours of Putrajaya and Proton City being located there]. Currently, there is a lack of development and you might make a loss on your house if you sold it now. You can't even rent it out for a good price to cover your loan interest. So, there is a moderate risk in investing in houses.

(c) Shares
You could make handsome gains in a year without doing anything. There's a good chance of capital appreciation [increase in share price] whilst you get dividend income from your shares. It's highly liquid and you can cash out anytime. The income is also TAX FREE. What more could you want?

Unfortunately, it's RISKY! Yes. You need to put in the effort to analyze and research into the Companies before buying them. Otherwise, like one of my readers mentioned, you could be fooled by the RED HERRINGS [aka shitty companies in the stock market].

Imagine a USD100 stock dropping to USD10 in less than a week. Now imagine your retirement fund of USD1MIL dropping to USD100K in a week. Scary? Darn right, it's scary. That's why you need to be very careful when investing in shares.

How to tell the SHITTY companies from the GOOD ones? Well, that's the topic my future post: An introduction to Value Investing.