Money and its growth: Part II

For those who DO seek higher returns, then well, as mentioned, their only hope to reduce risk and keep high returns is through knowledge. Hence come in the whole arcane art and science of fundamental and technical analysis in stocks and forex and commodities in general. Yet in equity investment, even without resorting to financial quantum physics, it may well pay for people to find out one simple fact: while individual stocks may fluctuate from heaven to oblivion, the GENERAL trend of the stocks for a growing economy is upwards. If you trace the whole US stock market for the post 1945 period, the trend is clearly a hill-like climb upwards which beats inflation significantly.

There is nothing esoteric or mysterious about this. Stock prices trace the net income (profits) of a company. Generally speaking, assuming healthy cash flow, growing net income over time, translates eventually into growing stock prices. In a growing economy, most publicly listed companies do grow their profits, notwithstanding spectacular annihilations here and there. A very simple and very safe (by equity standards) investment strategy is simply then to throw your money into index funds. These mutual funds buy every single stock in a major index, i.e. a list of certain stocks. These may be things like the S&P (Standard and Poor) listing of large capitalisation (500 of them), mid cap or small cap companies. The risk level and returns level are also typically lowest for large cap and highest for small caps. These indexes generally out-perform the overall stock market, which already outperform inflation.

The one big concern about such index funds is currency fluctuations (Singapore also has an index, but I suspect its gains are not very spectacular given our lack-luster GLCs). The falling US dollar for instance can do vast damage to your S&P fund investment. Again, in this era of vast American current account and budget deficits, cautious investors may want to look towards European indexes (though the concerns there are lower net-income growth). If only European companies just grow faster, or America clean up its finances, THEN investment will be so much more a cup of tea. Or for that matter, I look forward to the day when China has a reliable enough financial accounting system, or also India for that matter.

To return to the topic, it is important to know that most stock investors get burnt up because they treat the stock market like 4-D or Toto and keep on hoping for 'the right pick'. I have nothing against the 'right pick'--if properly done. After all Warren Buffett and all famous entreprenuers got rich by making the Right Pick (Dell picked his own company to put in his initial $1000, Buffett picked Coca Cola, Washington Post, Geico and others). But unlike the lottery, stocks of good profitable companies do not generally fly upwards overnight and allow you to collect your 'winnings' immediately. They take time to grow their profits consistently over many years, and their stock prices naturally gravitate with their performance. But instead, many amateur stock investors simply fly from flower to flower extracting what little nectar there is. Soon they stumble onto a Venus flytrap and that is the end of them.

The requirement for doing right picks is thus a very large dose of discipline and patience to wait for your pick to blossom. In addition, few actually have the patience to do the extensive research needed to build up a personal selection of stocks. This entail looking at company financial statements for the past years (meaning a modicum of accounting knowledge), researching into management and market trends (which is in turn conditioned by forex, political and technological trends). A normal college graduate should be able to perform all these, but risks remain (though if you diversify by buying 4-5 reliable stock ( a mixture of high risk small caps and low risk big caps may be a good idea) that you are confident of, you should expect general overall growth). The good thing about this investment strategy (as compared to an index fund) is of course you may actually pick a Microsoft, Dell or a Wal-Mart in their earlier stages (this is especially true for small-cap stocks) and see your investment increase by a hundred times or more. It is rare, but perfectly possible. Alternatively you may pick 3 Enrons. Higher risks, higher returns, remember?

Another high risk, high returns proposition is the ill-understood world of forex trading. In the past foreign exchange trading belongs firmly in the world of high finance. Millions of dollars are needed to profit from tiny forex fluctuations. But today, there are brokers who allow small-time investors to buy on extreme margin (on debt). That is it allows you to command $100 or so by investing $1 (you borrow the other $99). It is a very high risk proposition and such margin trading can only be considered speculation and not investment.

For small investors, the main type of forex investment you should consider is simply to factor in the indirect effects of forex trends on your other investments. For instance, buy European or bonds stocks to buy in on the Euro's long term rise. Or for that matter, put a little money into renminbi bank deposits to gain on the currency's eventual rise (assuming the Chinese government holds together). Some banks also offer forex-linked accounts that allow you to bet on the long term trends of some currency pairs. Generally speaking, the advice for all forex investments is the same for equities: research, research, research--forex trends are linked to certain economic and political conditions that must be known.

Final word

All in all, perhaps the best overall strategy for the average joe is probably not to merely put in loads of funds into either high risk or low risk asset classes. That is, do not put in 90% of your money into stocks and 10% into cash and bonds, or vice versa, but balance it out to create middling risks with middling returns. A Businessweek article has recommended a conservative allocation of 60% to stocks, 20% to bonds, and 20% to cash for an retirement account. Obviously you can vary the proportion to suit your own risk acceptance. Also remember even within stocks you can diversify between large, mid and small cap stocks to spread risk.

So there, some ramblings about money and its growth. Will welcome your comments.