Having learnt the benefits of investing early, the next step is to further enhance one’s wealth. In this last of a three-part series, CIMB Private Banking defines wealth enhancement and how asset allocation can have a positive impact on investment returns.
To be wealthy, one needs to create wealth, but to stay wealthy, one has to enhance, optimise and preserve his assets and investments. The question is how to enhance one’s wealth when the investment choices and offerings are becoming more complex?
Wealth enhancement is a methodology of planning a strategy and executing a plan to achieve certain financial objectives through the following process: Determining the investor’s goals and objectives, understanding the investor’s risk profile, analysing the investor’s current financial state, planning a financial strategy, detailing a recommendation and action plan, and executing the plan.
The key areas to focus on are the last three. For an investor, wealth enhancement is about maximising returns based on a certain level of tolerance for risk to returns.
The concept of risk to returns is also known as volatility in returns and is best described as the odds of expected returns not materialising, deviating from what an investor is expecting to earn from an investment.
Investors will always choose an investment that is able to generate the highest returns with the lowest level of risks possible. This is known as the Efficient Frontier (see Chart 1). According to this frontier, Investment X is more desirable than Investment Y because the former has the potential to earn higher returns based on the same level of risks than the latter.
Therefore, by choosing Investment X, an investor is able to maximise his returns given his appetite for risk, which in turn would enhance his wealth. To achieve this, prior to executing an investment plan, it is imperative for an investor to determine and know his level of tolerance for risk.
One of the most effective ways to have an investment portfolio that maximises risk-adjusted returns is to invest in a range of different investments or undertake diversification, particularly those that have low or no correlation to one another.
In short, investments with returns that do not move in tandem with one another.
To illustrate the importance of diversification, the table outlines four different investment proposals for an investor looking to invest RM10mil.
Portfolio A is fully invested in fixed deposits and it is the safest portfolio from a returns perspective since it is free from volatility in returns. However, it is also the one with the lowest returns.
When the investor decides to take on 20% equities in search of higher returns, referred to as Portfolio B, the volatility of his portfolio increases to 2.4% per annum although returns now stand at 5%.
He can increase his exposure into equities, but the volatility of his portfolio will also increase to a point where he could get uncomfortable with the volatility.
To enhance risk-adjusted returns to the portfolio, the investor now, via Portfolio C, starts shifting some of his fixed deposits and invests 30% in bond papers, which he holds till maturity.
Bond is a fixed-income instrument that generally has low correlation to equity returns. While maintaining his 20% exposure in equities, the investor now has higher returns than Portfolio B for the same volatility.
To further illustrate our point on risk-adjusted returns, in Portfolio D, investor now allocates 20% of his portfolio into other low-equity correlated investments, such as in private equity and absolute return funds.
In this case, returns increase faster than volatility and the portfolio has the highest risk-adjusted returns as measured by returns/volatility compared with the other portfolios.
By taking this approach, the investor has been able to maximise his returns, provided he can accept the degree of volatility that comes with it.
Devising an appropriate portfolio with suitable investments and a proper asset allocation strategy is a demanding and dynamic process that requires an awareness of the investor’s volatility tolerance level and a deep understanding of the various investments’ risk-and-returns profile.
In achieving this, investors need to be aware that there are various investment choices available today that deliver varying magnitude of returns with distinct volatility of returns as shown in Chart 2.
Given the complexity of products and the process of enhancing wealth, engaging the service of a professional financial advisor will help ensure a higher degree of success in wealth management.
In summary, it is worth noting that by diversifying the investments, it can act as the primary defence against unexpected market volatility, as was the case recently with the US subprime housing loans fiasco.
A common mistake investors make is to load up on what’s hot and find that when markets turn, they face difficulty in dealing with the volatility in their portfolio.Disclaimer: Reading materials in this site are obtained from its respective website and it is for information purposes only. It is not Malaysia Unit Trusts - administrator view and it is not to be used against Malaysia Unit Trusts - administrator.
