Investing based on the return on investment is old school. There is more to it than meets the eye.
By Kevin K.M Neoh
Often, people would pay unwavering attention to how much return they can get from making an investment, and they spend much of their attention discovering and hunting for good investment opportunity.
Investment can be defined as a process of allocating resources towards some assets with the expectation that it would generate income or appreciation in the value of the capital invested.
Simply put, an investor would have to set aside their investment capital in something, and hope that it will eventually provide them an income stream or more in value after some time.
The word Expectation and Hope is as important as the magnitude of the rewards or income stream one particular investment will provide to the investor. What it means here is that investors need to be aware that such potential income or capital appreciation may or may not materialise, and this is where the word ‘risk’ comes into the picture.
Sadly, when people think about making an investment, they would usually end up thinking of risk in the context of ‘losses’ OR ‘no profit’. When we regard risk in this context, we are prone to have our investment decision be driven mainly by the motivation to avoid losses, or to avoid not having profit.
When we focus on the former, we tend to not be holistic about making an investment and be over conservative since this means we can have a strong certainty of avoiding losses; on the contrary if we focus too much on the latter, we will be victimised by greed, and most of the time, people make investment decision based on greed, instead of logic.
In some extreme cases, or rather, unfortunate cases, investors may have to settle for no potential income or appreciation in value, and simultaneously suffer capital loss. Hence, it is rather clear that a logical investor should first set their sight to understand the degree of risk they are exposed to before making investing decision based solely on the potential upside alone.
We are not short of unfortunate news where investors have invested their hard-earned savings into guaranteed schemes, into so-called fantastic opportunities, only to end up losing not only their own savings, but also borrowed money from friends and families.
It was also reported that most of these victims are people who are retired, and have very limited experience in investment prior to that, and that they decided to invest because the promise of safe return is too difficult to resist.
How is it possible that these investment schemes that promise a fixed return (and most of the time proven to be real before victims increase their investment), promise safe protection on capital, promise to be genuine and “sold like hot cakes”, turn out to be create a deep hole on investors?
This is because the understanding of risk should not just stop at verbal or written promise of safeness, but as a responsible investor, we must conduct a deeper due-diligence to uncover what is really underneath all those sales pitches and marketing materials.
Due-diligence is a process whereby we do information gathering, and also conduct assessment towards a subject matter.
In terms of investment, a reasonable due-diligence process should include:
- Understanding the source of investment income (how the operator generate the return they promised),
- Where is the scheme domiciled?
- Whether it is regulated by regulators?
- If capital protection is promised, how is it achieved?
- If capital guaranteed is promised, who is the guarantor providing such guarantee should?
More importantly, investors should understand the exit strategy available and if things go wrong, what are the options they can fall back on.
All these efforts may require tremendous amount of time and diligence, but it only helps investors to understand more about the risk of such investment before they step into the arena.
Minimising the chances of losing is a good way to avoid losing, and losing may hurt more compared to not winning, especially when we are dealing with your live savings. Wouldn’t you agree?
Apart from understanding the risk-reward profile of the investment we are considering, it is also very critical for an investor to understand the risk appetite of himself/herself.
Your risk appetite will tell you about the degree of risk you are willing to take and be exposed to. For instance, if you cannot stomach the risk of your investment value to have high fluctuation, then you should not invest into things that have high volatility.
Risk appetite can be understood by conducting Risk Profiling, which usually involves a set of questionnaire that the respondent will answer to gauge the attitude towards certain risk, as well as the investment literacy of the respondent.
By conducting Risk Profiling, we will then be able to understand the approach that is suitable for the particular investor, as well as to make evaluation whether or not a particular investment strategy or product is indeed suitable, or able to support the investment objective or goal of the investor. Risk profiling will also help you to understand how much you can afford to lose.
If you are a very conservative investor and your investment objective is to achieve a 12% per annum return, your risk profiling will reveal the gap between your expectation and your willingness to take risk to be huge.
This means you are in a very good spot to reflect on your goal. If you are unwilling to increase your risk and remain status quo, you know that your expectation will remain unreachable for you; hence you will either have to make an adjustment on your expectation or your appetite for risk.
On the other hand, if your risk profile reveals you are an aggressive investor but your investment objective does not require you to take on excessive risk, then you will be able to manage your risk exposure by not taking on it unnecessarily.
Risk profiling is important because it helps us to match the investor to the investment product, or financial assets that fit with the risk profile.
If you are investing based on a promise of good return or strong past performance but never pay attention to your risk profile, you will not be able to stick through with your investment plan, because your emotion will come in and make you change course, which only leads to losses ultimately.
Bad experiences like these will force us to choose to remain safe and keep our savings in deposits account, which in the long run will only hurt our financial well-being due to the presence of inflationary pressure.
After some time, we will feel the need again to make an investment to avoid shrinking purchasing power. However, we would possibly be guided by greed yet again, and this could become a vicious cycle for investors, who only want a better future for themselves.
If you wish to grow your wealth, you must first understand two important component of the investment equation. The first one is YOU, the investor; and the second is what you are investing into.
Plan based on these facts, not based on promises of returns as it could become empty promises. Don’t take the risk as we cannot turn back time!
About the author: Kevin K.M. Neoh, RFP, MBA, CFP CERT TM is a Licensed Financial Planner, licensed by the Securities Commissions Malaysia and Bank Negara Malaysia, Kevin was awarded the Malaysian Financial Planner of The Year Award (MFPYA) in June 2016. Kevin is one of the financial planners from VKA Wealth Planners Sdn. Bhd.