Building a Portfolio for Retirement
Previously, we gave a general overview of
of Investments Available. In this post, we will delve deeper into the “whys”
and “hows” of investing. Let’s be clear: investing is not a roadmap to instant
wealth. Investing is a plan for the future.
Your retirement years may feel very far
ahead, but it is crucial to start investing early as you will reap more
benefits the sooner you start. Investing’s leading ingredient is time: the same
investment made at age twenty and age thirty would yield significantly
different returns. The same investment made at age twenty can produce double
the returns of the investment made at age thirty. The longer money is put to
work, the more wealth you generate in the future. And you’ll want to generate
enough wealth to replace the steady paychecks you collected when employed.
It’s not enough to invest early, however.
You have to invest smart. You do this by building a diversified portfolio.
There are two rules of law in investing:
(1) Risk can never be fully eliminated, and (2) The higher the potential
returns, the higher the risk – and vice versa. These principles create a
difficult quandary for most investors: high-risk investments may have higher
returns, but who among us wants to gamble with his hard-earned cash?
To mitigate risk, diversify your
investments. Diversification simply means allocating your funds among many
different asset classes – spreading your eggs in different baskets, in other
words. The more diversified your investments, the more protected you are. Even
if an investment fails, your returns will stay positive.
Here’s an easy illustration: you decide to
buy stocks. Perhaps you have chosen to invest in transportation because it
seems safe. After all, people always need transportation. But what happens when
oil prices hike dramatically? Airline and taxi companies will struggle to make
a profit and stock prices will drop. Worse, what if the company goes under? You
will lose all of your investment. But if you spread your money across stocks of
three, five, ten, or more companies, the impact of one company going under will
be less painful on your overall investment.
Yet diversifying across many company stocks
isn’t enough. What happens when the stock market is in trouble? Good
diversification is more than buying into many of the same asset class, but
spreading risk across different asset classes. In other words: don’t just
invest in stocks, invest in bonds, time deposits, and gold too.
Keep in mind, however, that everyone’s
investment portfolio will look different. This is because every investor
balances risk and reward according to his or her risk tolerance and future
Risk and age are the two primary factors
that determine the contents of an investment portfolio. People with a high risk
tolerance will aim for investments with the highest returns, no matter how
risky. The older people become, however, the more their risk tolerance will
shrink – and thus they are more likely to lean towards safer, income-generating
products to ensure passive income during retirement.
An aggressive investor can spend 90% of
their investments on high-risk instruments like stocks. However, to diversify
and to hedge against volatility, he should supplement the other 10% of his
portfolio with bonds and other low-risk investments.
Most people are risk-averse. For a risky
investment to be worth it, they will demand a higher return. Otherwise, they
will stick with safer instruments – even if the interest rates aren’t high.
Based on a low risk tolerance, an investor could spend 70% of his investments
on safer products like bonds and time deposits, 20% in stocks, and 10% in cash
(Note that the percentages we have given
are relatively arbitrary and are meant to show examples of diversified
portfolios based on risk tolerance)
The main idea here is to balance risk and
reward via diversification according to your personal tastes. You should look
at all asset classes and see how they
will fit into your portfolio. For example, go ahead and buy stocks of varying
companies or buy different precious metals – not just gold, but also silver and
platinum. However, it is just as or even more important to diversify into
different asset classes to hedge against risk. That way, the risk within each
asset class is spread out.
When stock markets are bleak, stock prices
will tumble but gold prices will generally rise. If you have a well-balanced
portfolio, your loss in stock value would be hedged and minimized due to the
rise in gold prices. Your overall portfolio may still be making a positive return
depending on your asset allocation.
When you are young and risk-tolerant, you
can afford to hold, say, growth stocks – stocks of quickly growing and
expanding companies. Their value increase rapidly but pay back no income or
dividends. You can only earn your money back if you sell the stock away. (And
be warned: growth stocks are volatile investments, with dramatic price changes).
Yet as you grow older, you will want stable
investments. Not to mention, most people are risk-averse – which is why most
portfolios are comprised of income-based products.
An income-based product is an investment
that provides returns or passive income in the form of fixed periodic payments.
Whether an investor is paid back monthly, quarterly, half-yearly, or annually,
an investor is paid back interest in fixed periods. He will also earn back his
principal at the investment’s maturity. Investing in instruments that provide
passive income is prudent as they can replace your paychecks when you retire.
For instance, you can invest in dividend
stocks rather than growth stocks if you wanted an income-based product.
Dividend stocks pay stockholders part of a company’s earnings in fixed periods
– thus, replacing an investor’s income.
Other examples of income-based products are
time deposits, bonds, and peer-to-peer loans. All these instruments replaces
your principal in fixed periods. Time deposits and bonds are relatively less
risky, but their interest rates aren’t high. Peer-to-peer loans can be
considered higher-risk as the businesses you fund may default. But investing in
peer-to-peer lending requires little entry cost. At our own Funding Societies
platform, for example, investors can start funding SMEs from as low as S$100
with relatively high returns up to 14% p.a. The risk of peer-to-peer investing
can also be mitigated by diversifying across many loans.
To build a good portfolio, one ought to
diversify. All forms of investments have risks, advantages, and disadvantages –
which is why it is imperative to balance risk and reward across many asset classes
to protect your investments. After all, your investment portfolio is vital – it
is your retirement income.