Investing 101 for Millennials
If any of the following statements depict your current situation, this article serves little value to you, and you can go straight to the conclusion.
- You just moved your assets from hedge funds into family offices
- You work closely with your financial advisor to balance and diversify your portfolio
- You work with your trusted robo-advisor and invest passively in ETFs
- You are not interested in making risk-adjusted returns and are content with growing your wealth at the deposit rate
- You have negative cash flow and spend more than you make
If you are still with me, we are in the same boat! Here is a discussion on the risk and reward profiles for some of the more common asset classes.
Equities
Recommend portfolio weight: Mid — High; expected annual return: 5–10%
One can invest in a company’s equity by purchasing shares of a company. Though there are various classes of shares, the scope of this discussion is limited to common shares. Shareholders own a piece of a company, and they have the opportunity to participate in the company’s success via capital gains and dividend distributions. The shareholders come together to elect the Board of Directors, whom the CEO is ultimately responsible to.
Value vs Growth
Before calling your broker and placing an order for a particular stock, it’s important to understand the rationale behind subjecting yourself to unsystematic risk and the potential rewards that come with it. For value investors, they seek out undervalued stocks with the expectation that the stock will appreciate to its intrinsic value in the future. On the contrary, growth investors invest in high growth stocks with a focus on capital appreciation.
Cyclical vs Defensive
It’s also worthwhile noting the difference between cyclical and defensive stocks. Cyclical stocks have a higher risk return profile due to its high correlation with the broad economy and business cycle. On the contrary, defensive stocks are not as correlated with the broad economy and business cycle, and their yields typically remain stable throughout the gyrations of the economy.
Only by understanding the sources of returns and acknowledging that chance plays a larger-than-expected role that an investor can detach himself from the market emotionally and execute his strategy objectively.
Bonds
Recommended portfolio weight: Low — Mid; expected annual return: 1–5%
Though they don’t get as much spotlight as their equity counter part, the size of the bond market significantly surpasses the size of stock markets. Some estimates put the size of the global bond markets to be over $100 trillion compared the to $64 trillion estimate for the global stock market.
Bonds are debt. The lender provides some form of financing with an understanding that the borrower will repay the debt with interest over a set period. Bonds are rated by credit agencies, and low yield bonds are less risky compared to high yield bonds. A debtor is deemed investment grade (low yield) if it can pay back the debt with interest. Conversely, junk (high yield) bonds have a lesser likelihood to be repaid, and they demand a higher yield to compensate for the higher risk.
Cash / Money Market Securities
Recommend portfolio weight: Low — Mid
Investors most often overlook the importance of cash securities. Cash securities provide liquidity and decrease the portfolio volatility. More importantly, having sufficient cash securities is like having enough ammunition such that when the next opportunity arises, the investor can move capital with relative ease for a clinical execution.
Alternative Investments
Recommended portfolio weight: Low — Mid
Alternative investments are complements to traditional investments as they offer significant diversification benefits and are typically uncorrelated with the traditional investments. However, they are most often illiquid and are more complex to price. Here are some of the typical alternative investments.
Real Estate
Direct investments in real estate require a substantial upfront capital, and the real estate market is relatively illiquid compared to the traditional markets of stocks and bonds. Though there’s the benefit of providing rental income and psychological stability, it comes with the cost of high due diligence and information that’s not readily available and accessible.
As an alternative to the relatively illiquid and high transactional cost of direct investment in real estates, there’s a market for indirect real estate investments where investors can own portions of real estate via real estate investment trusts (REITs) that trade on the public exchanges.
Private Equity
Similar to real estate investments, private equity investment requires a high level of due diligence and is geared towards sophisticated and accredited investors. There are two platforms where one can own a portion of a private company; one via the company’s direct stock offering (usually through options), and the other via an angel investor/venture capital. The former requires an established relationship with the private company either through working for them or through friends and family, and investments in venture capital funds are typically limited to high net worth individuals or institutional investors.
Derivatives
Derivatives, as its name suggests, is a derivative of the underlying security. The size of the derivative market is estimated to be more than $1200 trillion, which is multiple times the size of the world stock and bond market combined. Derivatives are either used for hedging purposes or as a speculative strategy. During the period leading up to the financial crisis of 2008–09, credit default swaps (CDS) gained widespread interest, and it played a role in the collapse of Lehman Brothers and the world economy. It also made hedge fund manager — John Paulson billions of dollars.
Crypto Currencies
Crypto currencies have been around for a while, and they have a very niche user base. There are well-established exchanges to obtain your crypto currency of choice, whether it’s Bitcoin, Ether, Litecoin, etc. However, what is of interest is the recent success of initial coin offerings (ICO). As ICO gains more traction, it is inevitable that some form of crypto currency will be included in a savvy millennial’s arsenal.
While we might never discover the real identity of Satoshi Nakamoto, the technology behind crypto currencies is now being scrutinized carefully with a possibility of becoming mainstream shortly.
Conclusion
We all have different investment goals. While some of us strive for the highest risk-adjusted return, others might set their sights on impact investing, and it requires a level of self-discovery and knowledge of the various financial products to find an investment fit.
Author’s note
Please consult a licensed financial advisor if you are interested in investing in the financial products mentioned.