A friend of friend of mine named Roderick won a Lotto in Australia worth A$3 million 5 years ago. He used $500,000 to pay off his mortgage and $500,000 to travel around the world. He decided to invest the remaining $2m in a term deposit account earning 7% per annum or around $140,000 income per year. $140,000 is already above average annual income in Australia. It’s an annual salary of a financial controller of a middle size listed Company or a CFO of a small private entity who can live an above average comfortable life in Australia. His main investment objective is to protect the principal amount of $2 million until he gets old and use the annual income of $140,000 for his operating expenses and never work at all! What an ideal life isn’t it?
Five years later his $2 million is still $2 million because he only withdraws the interest and never touches the principal amount. The question is, is his $2 million now still the same amount of $2 million 5 years ago? Was he actually able to protect the principal amount or lost some part of it? If you ask him or any other normal person not in the investment profession they will of course say yes. An investment professional will normally say NO. Why is that?
Term deposits, money market instruments and investments in bonds are called fixed income investments because they give you fixed return every year. This is in contrast with investment in shares where the return may be skyrocketing or unlimited or maybe negative. If he has just invested his money in google shares when google went on IPO in August 2004 for a price of $85 per share his money could have grown to around $10 million! The share price of google as at May 16, 2008 is $581 per share or a growth rate of 584% since IPO August 2004.
Investing in just a term deposit account will give you a fixed guaranteed return but is not enough to cope up with inflation. Therefore the $2 million 5 years ago will no longer be equal to $2 million now. Investment in shares is a good protection against inflation. Investment professionals would normally advise high net worth individuals like Roderick to invest some of his money to equity shares and some to fixed income investment for diversification reason. Diversification reduces the risk of losing your investment while enhancing the return. My friend’s friend has now learned a lesson when he consulted an investment professional. It was never too late though.
That’s the tale of Roderick, the naive investor!
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This Roderick character sounds like a really cool guy. Please share your fortunes mate.
Wilson, can you please help me with investments? I wish to use my time to play with my investments. I have a A$100 grand bonus to be received in September. Thanks for my manager MC for a very encouraging spirit promoted in our team!
Hi Nig, just let me know when you’re free to talk about your investments objectives and constraints to discuss your investment options. I’m still a naive investment advisor though but I can give you insights.
Wilson, I’m saving up for a $100,000 worth of engagement ring that I will buy in 3 years time. My annual salary is $130,000 per annum and my current liquid assets amounts to only over $1 million invested in ANZ shares. Let’s discuss how I’m gonna meet my investment return objective.
Oh Oracle of Wisdom, what if I had invested my money in the newly created Fed security TIPS?
Although I would have had to accept a lower interest rate, my default risk is zero and I am protected against inflation.
If I am really so naive as to be playing lotto, perhaps my choice of stock market equity investments would also not be rational, therefor I would be accepting a high level of risk for my (possible) higher return. It might be more prudent to invest in TIPS and protect my capital while enjoying a safe and steady stream of income. Remember, I have paid off my mortgage, so not only do I have reduced operating expenses, I also have a sizable equity investment.
Oh Oracle of Wisdom, what if Roderick had invested his windfall in the newly created US Fed security TIPS?
Then he could protect his capital while still enjoying a safe and steady income, with no risk of default?
Considering that he was apt to enter a lottery, do you not think his choice of equity stock investments might be equally irrational? He might well be accepting a much higher level of risk for a (possible) higher level of return.
Wouldn’t you recommend the investment in TIPS, to reduce his risk, even if it results in a lower income stream? Remember that having paid off his mortgage, he has also significantly reduced the housing costs portion of his operating expenses, while also retaining a significant equity position in his portfolio already.
If I were to win a lotto of that prize amount, I wouldn’t care if its value 5 years from now would be less than its value from now if invested in term deposits. For as long as it’s still intact and I’m getting regular interest from it. That’s already big money, you know. I’ll already be satisfied with it.
If I really want its value to increase, then I’ll spare some of the interests I receive to add to the principal amount. What do you think?
Wilson I need your advice. I’m a young, single, handsome man with no debt and a steady income. What should my main investment focus be at this age? To date, my investment strategy is to build a deposit for buying property, through investing in equity funds. However, given the recent instability in the share market, I feel as if i’m taking the wrong route.
Hey Nigel - since you’re still young, investing in the sharemarket and the property markets are good options for the timebeing to enhance your return throughout your lifetime. You should not focus on the short-term returns of the sharemarket but focus more on the long-time horizon because over the long-term a well diversified equity returns increases your wealth. You should also incorporate your salaries that you will receive in the future as like your current investments in risk free instruments or investments in bonds that have lesser risks compared to equities. The higher amount of present value of your future salaries gives you the ability to take risks and therefore gives investing in equities is the best options while you’re still young and handsome as you said.
You should bear in mind that investing in the property market also gives you higher return in exchange for lesser liquidity. It will take time before you can liquidate your investment though.
Hi Mr Deuts, thanks for visiting my website. You should not just be satisified with a little return on your investments because overtime your investments principal will be eroded because of inflation. As time passes by you will not notice that your investment return will not be enough anymore to meet your required return.
Adding the interest on the principal investment is also not a feasible option because you won’t have enough money for your operating expenses.
Mr Rod’s Financial Advisor - thanks for commenting on my blogs. thanks also for permitting me to use the name of your client. haha. Actually you are right about investing on TIPS gives protection on inflation. However, you should bear in mind that the return on the TIPS includes the return on short-term risk free rate adjusted by the inflation index. If inflation index increases, return increases. If the short-term risk free rate decreases because the economy is not doing well, the yield on your TIPS decreases. Therefore, it is still more attractive to include equities on your investments.
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Hi Mr Wilson,
I have financial difficulties and would like some advise from the expert… Here is my story…
I’m a pretty lonesome mother living in a remote village. My husband works everyday from 9 to 5 and earning less than what we expected. We have rent and mortgage to pay. Our expenses are greater than our income. As per our calculation, our saving will go negative by the end of this year. What should I do to make my life more lively? and to get extra income or probably someone is kind enough to donate me some dollar.
ASAP advise will be greatly appreciated
Krisnma you sound like a desperate housewife.
Hi Krisnma - i would advise that you go back to work as the budget proposed by the Rudd government is very favourable to working families. You need to have little sacrifice though because you need to put your child in a day care center during the day.
Hope this helps!
Hi Krisnma - you sound like you don’t live in Australia. hehe. You can also consider to have one more baby to take advantage of the baby bonus scheme of the Rudd Government. What do you think?
Kuya Wilson, help me too..Currently, I have savings in Peso, TT$ and US$, but Im still confused…Am i making the right combi of my savings? Iv been planning to invest in shares but too afraid to take the risk..hehe
Hello Wilson. Hope you don’t mind me giving some insights to Ann (and also hoping that she finds this useful). Investing in general would depend on your risk profile and broader timeframe with which you plan to cash in on your investments (liquidity targets). INvesting in equity (on normal market conditions) involves a medium to long term outlook to be able to fully maximize a security’s earnings potential. However, the recent credit crunch and issues on market liquidity has opened up vast opportunities for a moneyed investor. Security prices are at a low and markets all over the world are vulnerable to profit taking. We are also currently 5 months well into the US recession and economists believe that a recession in the US normally does not last more than 12 months. So expect equity prices to skyrocket by mid 2009 (hopefully - otherwise the whole world might fall into recession!). I have always been fascinated with the emerging markets (i.e. south american markets, india, shanghai, south east asia, turkey, russia) and the unbelievable returns they have provided over the last few years. And i believe that they are an excellent choice for short term investments (1 year money in money out). I suggest also that you look into doing more research before actually plunging in. Investment managers are sweet talkers. They care more for their commissions than your capital.
Interesting to hear also that hedge funds are starting to buy up cheap sub prime mortgage instruments (CLOs, CDO, MBOs, etc). they definitely know something that we dont!
by the way, great blog spot wilson!
Thanks Mr Boldon for that great and very informative insights! I totally agree with what you said that investing in equities requires a more than short-term time horizon because you may incur a lot of transaction cost if you’re just after for the short term capital gains.
To Ann, I want to reiterate what I advised to Nigel above. Since you have a lot of savings, in pesos, tt$ and US$, it would be helpful to invest them in shares as you have an above average ability to take risk because you’re still young. You’re present salary will keep your total investment risk low since it is a constant cash flow. Investing in equities involves higher risks than savings account. But remember, the higher the risk the higher the return.
Thanks Ann and Boldon for dropping by at my website. See you again soon.
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