KEY INVESTING CONCEPTS

Investment is the employment of funds to get the return on it. In general terms, investment means the use of money in the hope of making more money. In finance, investment means the purchase of a financial product or another item of value with an expectation of favourable future returns.
It is eminent that all investors should understand these essential investment concepts:

⦁ Evaluating Investment Performance:

Choosing investments is just the beginning of your work as an investor. As time goes by, you’ll need to monitor the performance of these investments to see how they are working together in your portfolio to help you progress toward your goals. Generally speaking, progress means that your portfolio value is steadily increasing, even though one or more of your investments may have lost value.

If your investments are not showing any gains or your account value is slipping, you’ll have to determine why and decide on your next move. In addition, because investment markets change all the time, you’ll want to be alert to opportunities to improve your portfolio’s performance, perhaps by diversifying into a different sector of the economy or allocating part of your portfolio to international investments. To free up money to make these new purchases, you may want to sell individual investments that have not performed well, while not abandoning the asset allocation you’ve selected as appropriate.

How Are My Investments Doing?

To assess how well your investments are doing, you’ll need to consider several different ways of measuring performance. The measures you choose will depend on the information you’re looking for and the types of investments you own. For example, if you have a stock that you hope to sell in the short term at a profit, you may be most interested in whether its market price is going up, has started to slide, or seems to have reached a plateau. On the other hand, if you’re a buy-and-hold investor more concerned about the stock’s value 15 or 20 years in the future, you’re likely to be more interested in whether it has a pattern of earnings growth and seems to be well-positioned for future expansion.

In contrast, if you’re a conservative investor or you’re approaching retirement, you may be primarily interested in the income your investments provide. You may want to examine the interest rate your bonds and certificates of deposit (CDs) are paying about current market rates and evaluate the yield from stock and mutual funds you bought for the income they provide. Of course, if market rates are down, you may be disappointed with your reinvestment opportunities as your existing bonds mature. You might even be tempted to buy investments with a lower rating in the expectation of getting a potentially higher return. In this case, you want to use a performance measure that assesses the risk you take to get the results you want.

⦁ Asset Allocation:

When you allocate your assets, you decide — usually on a percentage basis — what portion of your total portfolio to invest in different asset classes, like stocks, bonds, and cash or cash equivalents. You can make these investments either directly by purchasing individual securities or indirectly by choosing funds that invest in those securities. As you build a more extensive portfolio, you may also include other asset classes, such as real estate, which can help to spread out, and thus moderate, your investment risk.

Asset allocation is a useful tool to manage systematic risk because different categories of investments respond to changing economic and political conditions in different ways. By including different asset classes in your portfolio, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. This is known as diversification. Put another way, you’re reducing the risk of major losses that can result from over-emphasizing a single asset class, however resilient you might expect that class to be. This is especially true if your assets are “uncorrelated,” meaning they react to economic events in ways independent of other assets in your portfolio. Stocks and bonds, for instance, often move in different directions from each other, which is why holding both of these asset classes can help manage risk.

⦁ Diversifying Your Portfolio:

When you diversify, you aim to manage your risk by spreading out your investments. You can diversify both within and among different asset classes. You can also diversify within asset classes. In this case, you divide the money you’ve allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class.

These smaller groups are called subclasses. For example, within the stock category, you might choose subclasses based on different market capitalizations: some large companies or funds that invest in large companies, some mid-sized companies or funds that invest in them, and some small companies or funds that invest in them. You might also include securities issued by companies that represent different sectors of the economy, such as technology companies, manufacturing companies, pharmaceutical companies, and utility companies. Similarly, if you’re buying bonds, you might choose bonds from different issuers — the federal government, state and local governments, and corporations — as well as those with different terms and different credit ratings.

Diversification, with its emphasis on variety, allows you to manage nonsystematic risk (company or industry risk) by tapping into the potential strength of different subclasses, which, like the larger asset classes, tend to do better in some periods than in others. For example, there are times when the performance of small-company stock outpaces the performance of larger, more stable companies. And there are times when small company stock falters.

People may ask how much diversification?

In contrast to a limited number of asset classes, the universe of individual investments is huge. Which raises the question: How many different investments should you own to diversify your portfolio broadly enough to manage investment risk?

No simple or single answer is right for everyone. Whether your stock portfolio includes six securities, 20 securities, or more is a decision you have to make in consultation with your investment professional or based on your research and judgment.

In general, the decision will depend on how closely your asset classes, and investments within each asset class, track one another’s returns — a concept called correlation. For example, if Stock A always goes up and down the same amount as Stock B, they are said to be perfectly correlated. If Stock A always goes up the same amount that Stock B goes down, they are said to be negatively correlated. In the real world, securities often are positively correlated with one another to varying degrees. The less positively correlated your investments are with one another, the better diversified you are.

⦁ Rebalancing Your Portfolio

As market performance alters the values of your asset classes, you may find that your asset allocation no longer provides the balance of growth and return that you want. In that case, you may want to consider adjusting your holdings and rebalancing your portfolio.

Assets grow at different rates — which means that your portfolio might end up out of line with the allocation you have chosen. For example, some assets might recently have grown at a much faster rate. To compensate, you might reallocate some of the value of fast-growing assets into assets with slower recent growth, which may now be poised to pick up steam while recent high-performers slow down. Otherwise, you might end up with a portfolio that carries more risk and provides a smaller long-term return than you intended.

Although there’s no official timeline that determines when you should rebalance your portfolio, you may want to consider whether you need to rebalance once a year as part of an annual review of your investments.

Some Rebalancing Approaches Includes;

You can rebalance your portfolio in different ways to bring it back in line with the allocation balance you intend it to have. Here are three common approaches to rebalancing:

i. Redirect money to the lagging asset classes until they return to the percentage of your total portfolio that they held in your original allocation.

ii. Add new investments to the lagging asset classes, concentrating a larger percentage of your contributions on those classes.

iii. Sell off a portion of your holdings within the asset classes that are outperforming others. You may then reinvest the profits in the lagging asset classes.

All three approaches work well, but some people are more comfortable with the first two alternatives than the third. They find it hard to sell off investments that are doing well to put money into those that aren’t. Remember, though, that if you invest in the lagging classes, you’ll be positioned to benefit if they turn around and begin to prosper again.

⦁ The Reality of Investment Risk

When it comes to risk, here’s a reality check: All investments carry some degree of risk. Stocks, bonds, mutual funds, and exchange-traded funds can lose value, even all their value, if market conditions sour. Even conservative, insured investments, such as certificates of deposit (CDs) issued by a bank or credit union, come with inflation risk. They may not earn enough over time to keep pace with the increasing cost of living.

What Is Risk?

When you invest, you make choices about what to do with your financial assets. Risk is any uncertainty concerning your investments that has the potential to negatively affect your financial welfare.

For example, your investment value might rise or fall because of market conditions (market risk). Corporate decisions, such as whether to expand into a new area of business or merge with another company, can affect the value of your investments (business risk). If you own an international investment, events within that country can affect your investment (political risk and currency risk, to name two).

There are other types of risk. How easy or hard it is to cash out of an investment when you need to is called liquidity risk. Another risk factor is tied to how many or how few investments you hold. Generally speaking, the more financial eggs you have in one basket, say all your money in a single stock, the greater risk you take (concentration risk). In short, the risk is the possibility that a negative financial outcome that matters to you might occur.

There are several key concepts you should understand when it comes to investment risk.

Risk and Reward. The level of risk associated with a particular investment or asset class typically correlates with the level of return the investment might achieve. The rationale behind this relationship is that investors willing to take on risky investments and potentially lose money should be rewarded for their risk.

In the context of investing, the reward is the possibility of higher returns. Historically, stocks have enjoyed the most robust average annual returns over the long term (just over 10 per cent per year), followed by corporate bonds (around 6 per cent annually), Treasury bonds (5.5 per cent per year), and cash/cash equivalents such as short-term Treasury bills (3.5 per cent per year). The tradeoff is that with this higher return comes greater risk: as an asset class, stocks are riskier than corporate bonds, and corporate bonds are riskier than Treasury bonds or bank savings products.

Managing Risk:

You cannot eliminate investment risk. But two basic investment strategies can help manage both systemic risk (risk affecting the economy as a whole) and non-systemic risk (risks that affect a small part of the economy, or even a single company).

i. ⦁ Asset Allocation: By including different asset classes in your portfolio (for example stocks, bonds, real estate, and cash), you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. Put another way, you’re reducing the risk of major losses that can result from over-emphasizing a single asset class, however resilient you might expect that class to be.

ii. ⦁ Diversification: When you diversify, you divide the money you’ve allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class. Diversification, with its emphasis on variety, allows you to spread your assets around. In short, you don’t put all your investment eggs in one basket. Hedging (buying a security to offset a potential loss on another investment) and insurance can provide additional ways to manage risk. However, both strategies typically add (often significantly) to the costs of your investment, which eats away any returns. In addition, hedging typically involves speculative, higher-risk activity such as short selling (buying or selling securities you do not own) or investing in illiquid securities. The bottom line is all investments carry some degree of risk. By better understanding the nature of risk, and taking steps to manage those risks, you put yourself in a better position to meet your financial goals.