Sunday, June 20, 2010

4 Things You Need to Know Before You Invest Your Hard-earned Money (Part 1)

5-year relative historical prices of BDO UITFs
Image from

1. Your investment objectives

While in general, every investor should choose an investment vehicle that provides the biggest potential return for a given level of risk, an individual’s unique, personal circumstances and preferences define a more specific investment goal that would, in turn, lead to a specific mix of securities.

Traditionally, investors choose among the following four goals:

a) Stability of income
b) Growth in current income
c) Preservation of capital
d) Capital appreciation

These goals are by no means mutually exclusive, although the natural tradeoff between risk and return makes it difficult to achieve the four goals simultaneously.

Goals (a) and (c) involve more investments in safer instruments like bank deposits, treasury securities, and corporate bonds, which feature reliable periodic income (e.g. coupon or interest payments of bonds) or strong or guaranteed principal protection (e.g. PDIC insured bank deposits), or both. Meanwhile, goals (b) and (d) require higher exposure to risky securities like common stock and speculative investment vehicles. And because both (b) and (d) involve the possibility that you’ll lose a portion of your capital, the amount of money are you able and willing to lose will define which of these two pairs of goals you would prioritize.

The choice between income (either with coupons or dividends) and capital appreciation (or capital gains) will be defined by your need for cash flows and how long you can afford to part ways with your cash. It is important to settle this issue especially if you’re planning to invest in stocks: while some stocks do pay out dividends consistently (referred to as “income” stocks and are characterized by low price-to-earnings ratio), some only rarely pay dividends (if at all) and consistently reinvest their earnings to spur growth (referred to as “growth” stocks and are characterized by high price-to-earnings ratio).

2. Your liquidity requirements

Liquidity is the ease by which an asset can be turned to cash at or near the asset’s market value: for example, a bank deposit can easily be converted to cash with an ATM withdrawal or a check issue, while it might take some time, and substantial cost, to cash in investments in real estate or personal property.

It’s important to set aside a certain amount of funds in highly liquid vehicles like savings and/or checking accounts for daily purchases and emergency expenses. The problem is that if you invest too much in traditional liquid investments like bank deposits or money market funds, you’ll lose out on the higher returns provided by less liquid investment vehicles. That is why it is often advised that individuals set aside an amount equal to six months worth of salary or expenses as an “emergency fund,” and invest additional savings in better-yielding securities.

What many of us don’t realize is that bond and stock investments are actually also pretty liquid, with the continuing popularity and growth of “markets” where these securities are actively bought and sold (the Philippine Stock Exchange or PSE for stocks, and the Philippine Dealing and Exchange Corporation or PDEX for government securities and corporate bonds).

Click here for Part 2.
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