Stress-Free Investing (Or At Least, Close To It)

Foreword from ShareInvestor

This article “Stress-Free Investing (Or At Least, Close To It)” by Lorna Tan was first published in The Straits Times on 20 May 2018 and is reproduced in this blog in its entirety.

The severe jolt that rocked global markets early this the year, after 12 months or more of bullish gains, spooked plenty of investors. It was a sharp reminder that shares can fall just as fast as they can rise. Invest editor Lorna Tan lists four approaches that will provide some peace of mind, regardless of where the market is heading.

Diversification 

Not putting all your eggs in one basket is a sensible rule for retail investors. You can diversify by spreading your investments over different securities in various asset classes.

The Investment Management Association of Singapore (Imas) says diversifying gives you a portfolio that can weather the ups and downs of economic cycles and market volatility.

Let’s assume you have invested all your money in shares. Your capital drops by 20 per cent if the stock market falls by 20 per cent

What if you had split your investments equally into shares and bonds?

As they are sometimes negatively correlated, a fall in shares may tend to be associated with a rise in bond prices, says Imas.

Assume that in this case, bond prices rise by 5 per cent. Your share-bond portfolio will then fall by just 7.5 per cent, the average of the return for shares and bonds. As such, there are more diversification benefits when we include more asset classes in the portfolio.

To diversify effectively, you need to invest in a variety of securities and asset classes. You will have to invest in many shares and bonds spread across sectors. You may also want to invest internationally.

However, not many investors have the resources and time to do all these. This is where unit trusts and other types of pooled products, such as exchange-traded funds, can offer you a practical route to diversifying.

With an investment of as little as $1,000, you can invest in a well-diversified basket of securities, adds Imas.

For a two-year period ending in February, The Sunday Times ran a Save & Invest Portfolio Series that featured the simulated portfolios of three individuals.

The series indicated that at different points, different asset classes in the portfolios outperformed their benchmarks. The key takeaway is that it is impossible to predict all the factors that affect financial markets and, therefore, it is best to invest with a long-term horizon in a diversified basket of assets.

Value Investing

This means buying a basket of stocks that are trading below their fair value and with low borrowings.

In addition, these should be firms that are generating cash from the business and paying out some of the cash to shareholders as dividends.

Ms Teh Hooi Ling, portfolio manager of Inclusif Value Fund, says that because of low borrowings, the stocks will not fall to zero.

“Because you buy a big basket of such stocks across various industries and various countries, it is unlikely that all will go down significantly at the same time,” she adds.

“And as you are paying only 60 cents a share for a stock that’s worth $1, your downside is protected. Besides, you get paid regularly because the firms are paying dividends.”

At some point, the market will recognise the value of the stock. When it trades back to, say, 90 cents, you would have made a 50 per cent return.

In the intervening years, you would have collected yearly dividends of, say, 3 or 4 per cent, notes Ms Teh. She points out five ways the value of such stocks can be unlocked.  

  • A company with unrecognised value could be privatised by its majority shareholder.  
  • An undervalued company may be bought by a bigger firm or by another strategic partner.  
  • A company can unlock the value of its assets by divesting some of them or by distributing what it owns to all its shareholders. For example, last August, Pan Hong Holdings said it would distribute all its 73 per cent stake in Hong Kong-listed property developer Sino Harbour to its shareholders. Its share price more than doubled two months after the announcement.  
  • Some news may trigger the recognition of a stock’s value. Malaysian stock Kuchai Development doubled over a three-day period in January when it was reported that it was poised to be a major beneficiary from the impending listing of Great Eastern’s insurance arm in Malaysia. Kuchai owns 3.03 million shares in Great Eastern, which in turn has a stake in Great Eastern Life Assurance (Malaysia).  
  • A small cap can get recognised when it delivers results. Japanese company Nichidai Corporation develops and markets precision dies and moulding products for automobiles. It also produces sintered wire mesh filters used in the aerospace, petrochemical and pharmaceutical industries. Four months ago, its shares were trading at close to a 50 per cent discount to its net tangible asset despite the company being consistently profitable and generating cash from its operations. Earlier this year, it announced that net profit had more than doubled. The stock rose more than sixfold after that. The price has since corrected but it is still trading at close to 100 per cent above its level four months ago.

Dividend Reinvesting

Financial experts such as Schroders say reinvesting dividends is one of the most powerful tools available for boosting returns over time.

The fund manager points out that investors in the MSCI World index would certainly have noticed the difference over the past 25 years.

If you had invested US$1,000 in MSCI World on Jan 1, 1993, the capital growth would have produced a notional return of US$3,231 (S$4,340) by March 7 this year. Annually, that represents a growth rate of 5.9 per cent.

However, this changes once dividends – the regular payments made by companies to their shareholders – and the miracle effects of “compounding” are included, says Schroders.

“By reinvesting all dividends, the same US$1,000 investment in MSCI World would have produced a notional return of US$6,416, representing annualised growth of 8.3 per cent.

“In percentage terms, it’s the difference between your money growing by 323 per cent, without dividends reinvested, or 640 per cent with dividends reinvested, nearly twice as much,” it says.

The reason for this stark difference in returns is the compounding effect, where you earn returns on your returns.

Why could dividend reinvestment be effective?

When buying a share, investors can typically elect how they will receive any dividends.

They can choose to receive cash, referred to as income, or use that money to repurchase more company shares. When you opt to repurchase more shares, it triggers the start of the compounding process.

Compound interest is interest on interest and it helps an investment grow at a faster rate. So by reinvesting dividends, you give your stockholding the potential to earn even more dividends in the future.

Over time, shareholder value rises, especially when share prices increase.

Mr Nick Kirrage, Schroders’ fund manager for equity value, says dividend reinvestment is one of the most powerful investment tools available. Its research shows the potential difference to the rate of return that dividend reinvestment makes could be substantial.

He adds that in an era when interest rates are so low, investors need to be aware of relatively simple investment techniques like dividend reinvesting that can help build returns.

“Over time, those seemingly small amounts reinvested can grow into much bigger sums if you use them to buy even more shares that pay dividends in turn,” he adds.

“Investors need to do their research and make sure the company they are investing in can afford to pay dividends on a sustainable basis. Your original capital is also at risk, so it pays to be picky.”

Beware Of The Dividend Trap

Nevertheless, it is important to remember that firms do not have to pay dividends and that they can be reduced or cancelled at any time. Some firms even borrow money to pay dividends to keep investors happy, which may be unsustainable. Borrowing to pay a dividend could be a symptom of a firm with a weak balance sheet. As with all investments, do your due diligence before making any investment, says Schroders. 

Dollar-Cost Averaging

Even with a crystal ball, you will struggle to predict the market. Of course, if shares are on a clear upturn, investing a lump sum at the lowest point is likely to yield good returns. But what happens when you are unsure?

Many financial experts recommend dollar-cost averaging as a suitable strategy to mitigate the risk of being wrong about the market. Simply put, it involves regularly buying a fixed dollar amount of a particular investment, regardless of the share price. By doing so, you buy more shares when prices are low and fewer when prices are high.

So over time, you will have a lower average share price.

For those who think the stock market is overvalued, dollar-cost averaging lets you invest small amounts over time and not miss out on any big rally.

Studies show that investors who choose to stay on the sidelines waiting for a rally typically miss the best days.

Mr Sean Cheng, portfolio manager at Providend, says the dollar-cost averaging method typically outperforms the lump-sum investment approach when the market is declining and when it is U-shaped.

“The key is to keep investing when the market is down and you would have benefited when it recovers because your average price is lower,” he says.

Mr Cheng adds that it could also help most investors in their emotional stability.

“Ample data has shown us that most investors are unable to withstand the fluctuations of the markets and tend to bail out during tough times, thereby making what would have been temporary losses permanent instead,” he says.

Dollar-cost averaging would help most people to not only stay invested – because they would only have invested a portion of their savings – but to also keep investing through the tough times since it means they can keep getting a lower average price, Mr Cheng explains.

Financial experts advise that dollar-cost averaging is usually more suited for investors with a lower risk tolerance and a long-term investment horizon.

Note that the approach is no guarantee of good returns on your investment.

For instance, it is not prudent to apply dollar-cost averaging to an investment that keeps falling.

You should still do your own due diligence and select investments that have a good track record and that you understand.