Should I Invest In This?
It is better to be roughly right than precisely wrong.
Every other month, the financial industry churns out a seemingly endless array of fresh investment options. It could be a hot stock that profits from the upcoming recession to a newly launched perpetual that taps into the hunger for income, or even a special fund that purportedly can navigate this environment of rising rates. Thankfully, the process of evaluating the merits of these investments remains the same even if the themes or names of these products change.
Before jumping in and picking up this new hot investment, you can use the following steps to assess the tradeoff between the pros and cons so that your investments do not suffer in case something goes wrong.
What Role Does This Investment Play?
Looking at whether something belongs in your portfolio starts with establishing your goals and how it could help you reach it. As such, you would need to determine if the investment either helps to a) increase your expected return or b) help to manage risk.
Increasing Returns
If the objective is to increase returns, then you will need to check whether the asset can live up to its promise. For example, the chart below shows the best performing asset classes over the past 10 years with the long term annualised performance in the right-most column.
So, how would you know that it can perform up to expectation before adding an investment to your portfolio? One of the first things you would notice from the chart is that the best performing asset class for every year is different. Unpredictability is built into our world, it would merely be a guess whether an investment would perform similarly or better than previous years. For an optimal outcome, your best bet would be to allocate to something (like diversified equities) which has a very long track record and where you can reasonably estimate a long-term return.
But what if it is a newfangled investment — something that just came onto the scene not too long ago? Perhaps it was some frontier market investment, an “opening” at company for private investment or a form of digital currency? It would be difficult to make an assessment about future returns with limited data. Short track records and lack of information create problems in trying to find out actual risks and returns.
Decreasing Risk
If the investment you are looking at was supposed to decrease your risk, how would you measure it? A proper way would be to measure the interactions of your existing investments versus the investment you would like to add into it. Nobel Laureate Harry Markowitz’s efficient frontier would be one way to assess the suitability. The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.
However, calculating the mean-variance optimisation of your investment portfolio is no simple feat. Another way to check if your new investment is able to reduce your risk is if it can increase diversification, but it might be difficult to ascertain whether you are diversifying properly and defining what are the limits of each sector or country you are investing in as it changes all the time.
Whenever you are faced with the possibility of buying something new, consider these two simple factors: Could it improve your returns or reduce your risk? Getting your asset allocation wrong can be an expensive mistake. Replacing an investment you once believed in with a shiny new product that doesn’t pan out is potentially detrimental to getting the return that you deserve. Constant evaluation and portfolio simulation is something that we do in the background for all investment portfolios. Considerations like suitability, liquidity, returns, and risk are factored and plotted out before the investment is added to the portfolio. After all, everyone’s needs changes over their lifetime and this needs to be carefully measured out.
If you are considering adding new investments to your portfolio or just wish to seek a second opinion, come and have a chat with us.
