Managing investment risks

Many people are risk averse. They are afraid of taking investment risks and making a loss. The investments that gives the best long term return are equities, but they are also the most volatile, i.e. the price can go up and down by a large percentage in a few days or weeks.

A long term investor should not worry about the short term changes in the price of the shares. As long as they keep the shares, they do not have to take a loss. The value of the shares will eventually recover and give an attractive return. This has been the trend over the past years.

There is the risk of selecting the wrong shares, which may perform worse than the market or may even go bankrupt. This risk can be minimized through diversification, i.e. investing in a fund comprising of 10 or more shares. Some shares in the fund may perform badly, but they will be offset by the other shares that perform better than the market.

There is still the market risk. In a bad stock market, most shares will perform badly. The bad market may last for a few months or even a few years. A long term investor is able to ride out the bad years and will be compensated by the good years, to get an above average return. I describe this strategy as "averaging out the good and bad years".

By investing in a fund, the long term investor does not have to worry about picking the right stocks, or managing the individual investments, such as collecting the dividends and subscribing to the rights issues and other corporate actions. These fund manager will take care of these activities.

It is important for the long term investor to choose a fund that have low initial and annual charges. They can choose an exchange traded fund (ETF) that meets these two criteria. The STI ETF has a transaction charge of 0.3% and an annual management fee of 0.3%. Some other ETFs have higher annual charges, but they are usually less than 0.7%.

The investor can choose a unit trust that has an upfront charge of about 2% and an annual fee of about 1%. The unit trust is actively managed and is aimed at producing a better return than an ETF through the active selection of the fund manager. Research has shown, however, that over the longer term, the actively managed unit trusts perform worse than ETF, after deducting fees.

If you select the right unit trust, you may get a better return than average, but the challenge is selecting the right fund. It has been found that past performance is not an indication of future performance. Choose the funds that performed well in recent years may not be a good strategy.

For a long term investor, the tip is, invest in an exchange traded fund that have low annual charges, of less than 0.5%. Invest for the long term and do not worry about the fluctuations in the market. This type of investment is better than investing in life insurance policies, due to the extremely high charges taken by life insurance companies (usually 3% per annum).

Tan Kin Lian