Question: I am ready to invest in financial securities for a better future. Which investment, given today’s pandemic, is the best that I should buy? Asked at “Ask a Friend, Ask Efren” free service at www.personalfinance.ph, SMS, Viber, Twitter, LinkedIn, WhatsApp, Instagram and Facebook
Answer: Whoa, hold your horses.I am always asked the question of which investment is a good one when, in fact, all legitimate investments are good. When I say legitimate, I am excluding the scams.
Think of it as shopping for a car. Let’s say you have narrowed down your choice to two with almost identical exterior and interior features. The advantage of one model in one feature will be offset by the advantage of the other model in a different feature. It’s confusing. But you have one more category to look at and that’s the engine performance.
While both cars have the same sized engine, if efficiency is what you are after, you will go for the car that can travel the farthest distance on a liter of gas.
In the same way, investing needs to be efficient.
Let’s say you are choosing between two investments. Investment A has the potential for earning 15 percent a year while investment B has the potential for 12 percent a year. You are happy with earning just 12 percent but you cannot avoid the lure of the higher potential return. So, the correct choice will be to go for Investment A, right?
Actually, not yet. You need more information.
Investment returns always have twins and they are called risk. Please note that I repeatedly used the term “potential” in presenting the returns of investments A and B. That is because there is only one investment in the world that is risk-free, and that cannot be found in capital markets. All other investments bear risk. But rest assured that risk is not the reward. It is there to temper your greed and help you realize what investment is truly suited for you, and not the other way around.
So, rather than asking for what investment is good, you should ask what good an investment can do for you.
Going back to our two investments, let’s say investment A has a risk measure of 1.3 while investment B has 0.9. To know which investment is more efficient, you will need to compute for their risk-adjusted returns. At the risk of oversimplifying it, just divide the potential returns by their respective risk measures. Doing so will result in a risk-adjusted return of 11.5 for investment A and 13.3 for investment B.
Between the two investments, and assuming that you are happy with potentially earning at least 12 percent a year, investment B would be more appropriate for you because it is the more efficient portfolio. In other words, investment B earns more return for each unit of risk that it will be leading you to take.
Since investors normally buy a number of investments and not just one, for diversification purposes, the actual risk measures to be used should be those for portfolios of securities. These measures are Jensen’s alpha, Treynor ratio and Sharpe ratio.
By now you have probably lost the feeling in your legs with all of the discussion. Do not worry, the feeling will come back. And so as not to go through the same harrowing discussion when you are buying portfolios like those of pooled funds (e.g. mutual funds, unit investment trust funds, single pay variable unit-linked insurance), just ask such funds for their risk-adjusted returns whether historical or expected. Doing so will put your options on a level playing field.
But even before looking at your investment options, make sure you know what your target return and risk appetite are. An expert and experienced financial planning coach can help you in this department.
Oh and one more thing, that one investment in the world that is risk-free can be found in Luke 6:38. Go look it up. INQ
Efren Ll. Cruz is a registered financial planner of RFP Philippines, seasoned investment adviser, bestselling author of personal finance books in the Philippines. To consult with a YAMAN Coach, email yaman@personalfinance.ph. To learn more about personal financial planning, attend the 92nd RFP Program this October 2021. To inquire, email info@rfp.ph or text at 0917-.6248110
Copyright 2021 Efren Ll. Cruz, RFP. All rights reserved. This material may not be published, broadcast, rewritten or redistributed without the prior written consent of the author.