BT: The best bet in these tumultuous times is to work out an investment plan with proper asset allocation (20 Sep 2008)

WEALTH INSIGHTS
Back to basics

The best bet in these tumultuous times is to work out an investment plan with proper asset allocation

By Albert Lam
Investment Director,
IPP Financial Advisers


WE ARE living in the worst of times and the best of times. Why do I say that? We are in the worst of times because the tide of bad news seems never-ending. Each wave looks set to outdo the previous wave - bigger, higher and more destructive.

The bailout of Freddie Mac and Fannie Mae is not only costing the US Government US$200 billion but involves assuming about US$5 trillion of potential liability. The last I checked, as at Aug 29, 2008, the US had about US$75 billion of reserves. So money seems to have been created out of thin air with the stroke of a pen. Last year at this time, the estimated cost of US sub-prime losses was about US$500 billion. Today, it is put at US$1.5 trillion. And that may not be the final figure.

The sub-prime crisis started in August 2007, as a result of lax lending standards applied to borrowers for residential property. These toxic mortgages were repackaged as CDOs and CLOs and sold to investors. They ended up in the books of big investment banks, insurers and perhaps some aggressive hedge funds. The toxic debt did not remain in the US. It spread to European financial institutions, fear began to grow and finally panic arrested investors.

Shares of US financial institutions have been sold down massively - Citigroup was trading at above US$40 in July 2007 but was trading at US$19 on Aug 31, 2008. Banks dealt with one another behind shrouds of doubt, either refusing to provide credit or levying high interest rates when they did.

Sovereign wealth funds performed the role of knights in shining armour, rescuing some large banks by pumping in billions to rebuild their capital base. But just as we thought the situation at the banks was looking up, Freddie Mac and Fannie Mae, with almost half of the market for US residential mortgages, were nationalised. If you are still reading by now, you probably think I have forgotten about the best of times. Not at all. I am now going to share with you the importance of going back to basics during times of volatility. With many equity markets having been beaten down, investors are presented with a rare opportunity to pick up gems at a steep discount. Some companies are trading at a steep discount to their NTA - and even below their cash. As Warren Buffet said: 'We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.'

There is little doubt that volatility in financial markets will continue for months at least. But it is not advisable to rush for the exit. Don't invest aggressively either. Rather, the best approach is the cautious one - pay attention to basics and use a strategy that emphasises a strong foundation.

This is not the time to be making concentrated bets in specific sectors. First, work out an investment plan with proper asset allocation. Set aside about six months of your monthly expenses as an emergency liquidity fund. Build a diversified portfolio, with some money reserved for a regular savings programme. Assuming initial capital of $100,000, this is how I would construct an investment portfolio:


Set aside one-fifth of the capital for a regular savings programme or tranche investing.


Invest one-fifth in defensive funds.


Invest one-fifth in a core portfolio of funds.


Invest one-fifth in an absolute-return type of product.


Put the remaining fifth in offensive funds.

The savings programme or tranche investing

In warfare, you must always make sure you have enough bullets in case the fight drags on. Similarly, keep a portion of your investment capital for future use. This portion can be deployed via monthly savings or invested in offensive funds when markets correct.

Invest one-fifth in defensive funds

Place this portion of your capital in low-risk money market or short-duration fixed-income funds. The objective is to protect against downside risks, yet possibly earn returns that beat the savings deposit rates offered by the banks.

Invest one-fifth in a core portfolio of funds

Some funds have given decent returns over 10-year or even five-year periods. You can look at Asian equity funds or balanced funds. They will have declined in value during the current bear market. But look the funds' objectives, the managers' track record and the regions and/or sectors they invest in. If these factors suggest strong fundamentals and possibility of the funds recovering when the broad markets do, investing in the funds now means you are getting fair value.

Invest one-fifth in absolute-return funds

The purpose of such funds is to control downside by preserving your capital value. In bull runs, when almost all funds scale the heights, investors usually ignore such funds. Their low but potentially stable level of return is not thrilling enough. But do not brush them aside now. Have another look at them. The low returns, though boring, can help preserve what you have. And in bad times, capital preservation is superior to capital loss.

Invest the remaining fifth in offensive funds

The last portion should be used to plant seeds in offensive funds that should flourish when markets regain strength. These will be funds that have been beaten down in the current bear market. Examples would be funds in fast-growing emerging markets, the Middle East or commodities. With such a portfolio set-up, you will have taken care of downside risks through the defensive and absolute-return portions.

At the same time, you will be continue to be invested in areas that will accelerate when markets turn better. Finally, the regular savings programme allows you to average down your cost and better your overall return.

Success in investing depends on having a long-term horizon, asset allocation and a strategy that protects you from downside risks while offering upside potential when markets begin to recover.


The author can be contacted at albert@ippfa.com



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