Important To Do The Necessary Homework

Foreword from ShareInvestor

This article “Important To Do The Necessary Homework” by Mindy Tan was first published in The Business Times on 17 Oct 2011 and is reproduced in this blog in its entirety.

MINDY TAN highlights various methods that will help you in making better investment decisions

PLAYWRIGHT and writer Kin Hubbarb once said: “The safest way to double your money is to fold it over and put it in your pocket.” Wise words in today’s stock market? When markets tumble due to external factors, investors may get cold feet and decide to divest their investments to cut losses. Is this necessarily the best strategy to take?

While the strategy an investor decides to employ depends on a number of factors, rule No 1, in the wise words of author Douglas Adams, remains: “Don’t panic.”

Company’s Fundamentals

Before buying any stock, it is important to do the necessary homework to assess the stock’s fundamentals, notes associate professor Fong Wai Mun, department of finance, NUS Business School, citing the profile of the company, the company’s strengths and weaknesses, and studying industry trends as examples.

“For a more formal approach, discount the firm’s projected profits or cash flows using a suitable discount rate that reflects the stock’s risk,” he adds. This should not be a one-off process, he notes.

“One should revisit and perhaps rework this process every now and then, to keep up with changes in the economy, industry, and the firm,” he says. In the event that an investor thinks the fundamentals have changed, it may be necessary to sell the stock and cut losses.

Time Horizon

The general rule of thumb states that property and shares are growth investments that are best suited to those with time on their side – at least five years.

Having a longer time horizon is useful, in that it allows investors to wait for markets to recover, given that stock markets are exposed to fluctuations and are sensitive to global shocks.

Assuming that a long-term investor has done his/her due diligence, dips in the stock market “may present an excellent opportunity to add to the portfolio if the stock’s fundamentals remain good”, notes Prof Fong.

He adds: “I generally do not subscribe to the view that one should time the market by buying or selling when sentiments are good or poor, as such sentiments can easily change and lead to surprises. It is far better to adopt a buy-and-hold strategy for quality stocks.”

Risks Vs Returns

Investments that yield higher rates of returns are also ones that carry greater risk, which means you face a higher chance of losing money or bearing greater losses along the way.

While there is a fine line between being too risk-averse and missing out on good investment opportunities and making overly risky investments, the question of how much risk you feel comfortable with is something that only you can answer.

This may be a good time to relook your priorities and ask yourself – what do you want to achieve by investing? Are you trying to build up wealth in the short term, or are you looking to grow your retirement fund in the long term? After that, assess your risk appetite. These two factors will figure prominently into the shaping of your investment plan.

Rebalancing Your Portfolio

When constructing your investment portfolio, it is important to allocate your assets wisely to ensure they support your risk appetite. Despite the best intentions, portfolios often go out of balance in the course of investing. It is thus important to rebalance it from time to time, to bring the proportions back to its previous weight.

If your portfolio has veered off-kilter and you find yourself exposed to a higher level of risk than you are willing and able to accept, it might be time to consider “safer” alternatives like government bonds or term deposits.

While these investment instruments give relatively low returns, they produce fixed incomes and can go toward balancing other high-risk investments.

Do note though, that while bonds are stable and give regular returns, they are not designed to keep pace with inflation. In times of high inflation, you may see your investment shrink in value.

Index-linked instruments such as exchange traded funds (ETFs) are also a good alternative. Given that ETFs allow investors to buy a basket of stocks that mimic the performance of the entire stock market, they may be a useful tool to diversify risk.

Dollar Cost Averaging

“Don’t try to guess if the stock market has bottomed” is perhaps the golden rule in equity investments. The modern-day equivalent of crystal-balling, even when stocks seem to be at their cheapest, there is no guarantee that the market will recover in the immediate future.

In order to minimise potential losses, investors may consider investing continuously through all the market cycles – a strategy called “dollar cost averaging”.

Instead of investing all their money in a lump sum, investors gradually build up a position by purchasing smaller amounts over a period of time. This process spreads the average cost over the period, hence providing a buffer against market volatility.

While it is impossible to constantly beat the market, thoroughly understanding the investment vehicle, industry, and company fundamentals of a stock/fund you are purchasing will go a long way in helping you make better decisions.