Benel Lagua l August 12, 2022 l The Manila Times
INTEREST rates are on the rise and inflation is hammering the economy. Given the volatile environment, investors are concerned over how to proceed in building portfolios. Should the process substantially differ from what is followed in normal times?
Let us go back to the basics. An investment is the current commitment of money or other resources in the expectation of reaping future benefits. The investor assembles a portfolio of assets and decides on the best way to allocate funds. A good investment will at least maintain the purchasing power of present resources and hopefully allow growth for future needs.
For the regular investor, the choice boils down to three basic asset categories: cash, bonds and stocks. Sometimes, the investor will delegate the task to financial intermediaries that collect funds from individual investors and invest those in a wide range of securities, pooling assets in the process. These are mutual fund institutions or banks that offer unit investment trust funds (UITFs). Alternative categories usually include real estate and commodities.
For purposes of this discussion, let’s assume the investor will choose among cash, bonds and stocks. In an environment of high interest rates, rising inflation and a world economy affected by a major war in Ukraine, the operative goal is to be well diversified.
Diversification requires the intelligent investor to avoid concentrating wealth or assets in one basket and at the same time choose baskets that do not move in perfect sync with the ups and downs of the economy. In mathematical jargon, assets that are not perfectly correlated. A key determinant of portfolio risk is the extent to which the returns vary in tandem or in opposition. The less perfectly correlated the assets are, the better the diversification effect. The aim is to maintain a return objective while narrowing the risk or variation around the earning goal.
There is a strong temptation given the volatile environment to store hard-earned income in cash or near cash forms. We all need cash, for example, for liquidity in order to assure accessibility and responsiveness to basic and emergency needs. Alas, cash exposes us to inflation and depreciation risk. A year ago today, the peso-dollar exchange rate was around P50-$1. Last month, it breached P56 and is not settling at P55. In terms of value, your peso cash savings have lost 10 percent of its real worth. And then you add up inflation, which reached a three-year high of 6.4 percent in July 2022. The purchasing power of cash has declined by double digits from a year ago.
Thus, one needs to open other investment baskets. Equity placements through stocks have been the favorite for those who take a more aggressive stance. Shareholders are normally rewarded for bearing additional uncertainty about returns. This reward is the equity risk premium, which historically has been attractive.
Between 1900 and 2021, the excess real return of stocks over bonds in America was 4.7 percent on average, according to Credit Suisse‘s Global Investment Returns Yearbook. Aswath Damodoran of NYU estimates the Philippines’ equity risk premium to be 6.12 percent. The stock market has an overall upward trajectory. Long-term investment in the stock market will help contain risk. The concern, however, is that in the short run one can lose money. Timing the market remains a very big challenge.
The third basic outlet is investing through bonds or debt securities. Debt securities are called fixed-income securities because they promise either a fixed stream of income or one determined according to a specified formula. The bond owner (government/treasury or private/corporate) issues a bond to the lender for some amount of cash; the bond is in effect an “IOU.” Uncertainty about cash flow is minimal if the issuer of the security is sufficiently creditworthy. The investor gets regular interest or coupon payments and the return of the principal at some maturity date.
Some people consider bonds a drag in their portfolio. They will not make the investor rich as the returns are capped by the designated interest rate or coupons. But it can help the investor maintain wealth. It will help level out volatility. Many respected conglomerates/corporations in the country recently issued medium-term bonds with interest rates that at least keep up with inflation.
Alternative instruments like commodities and real estate provide additional opportunities but should be viewed against one’s capacity to contain the liquidity and marketability aspects of the investment. These are constraints that will have to be handled within the context and time frame of the individual.
In today’s volatile environment, the key objective must be to make diversification work. The investor must have his assets distributed in various baskets, whether cash, stocks or bonds or through pooling options like mutual funds or UITFs. For the Filipino investor, it also makes sense to take a strong view of currency diversification. The recommendation is not to take the money elsewhere but to avail of opportunities within the Philippines using alternative currencies.
Diversification will help reduce risk but cannot eliminate it. There are risks we cannot diversify away. But by being evenly spread out in our investments, the ups and down will cancel each other out. The aim is to avoid steep declines in value and preserve the worth of savings for the time we need it most.
*** Benel de la Paz Lagua was previously EVP and chief development officer at the Development Bank of the Philippines. He is an active Finex member and an advocate of risk-based lending for SMEs. Today, he is an independent director in progressive banks and in some NGOs. The views expressed here are his own and do not necessarily reflect the opinions of his office or Finex.