Building wealth for the long term

As the grandfather of two very young boys, Bangko Sentral Governor Rafael Buenaventura has rebalanced his personal investment portfolio to provide for their college education in the country and, should they choose, for their graduate studies in the United States.

Buenaventura, who steps down as governor middle of this year, has carefully maintained a portfolio of investments that has been growing steadily over decades and that has taken into consideration such factors as the two-year prescription period after he steps down, during which time he cannot work for any bank or company that has had dealings with the central monetary authority.

Whether they are highly-paid professionals like Buenaventura or the emerging middle class made up of the families of overseas Filipino workers, building wealth is not about cutting corners. Nor does it require genius or connections. Rather, it is about sensible, judicious planning and a commitment to save for the future.

Basically, you work out how much money you will need at a certain point in the future to fund an objective, such as paying for the college education of your children or your grandchildren. Then, you calculate how much money you will have to save and invest to reach this target, taking inflation and the rate of return on your investments into account.

Aside from your financial goals, other factors that come into play when allocating your assets are the size of your assets and income, your age, and your risk appetite or how you feel about taking risks.

Long Term

Long-term investment reduces risk. One way of assessing the risk of an investment is to measure its volatility, which is how much its price fluctuates around the long-term average. Different types of assets have different levels of volatility. Cash, for example, has very low volatility; bonds are a little more volatile; and equities have a much higher volatility.

Traditionally, Filipino investors prefer to keep most or close to 70% of their assets in cash or in assets that can be quickly turned into cash.

Even when interest rates are high–and they are not, at this point in time– cash is an asset class that does not produce high investment returns once inflation is taken into account. "In the past two to three years, with both peso and dollar deposit rates at a very low levels, a US dollar investor may have missed out on the fact that the dollar lost over 20% to 30% of its value against the euro. A peso investor who avoided equities all together would not have gained any from the more than 100% rise in the Philippine Stock Exchange Index in the last two years and would face increasing inflation risks," Citicorp Financial Services and Insurance Brokerage Phils., Inc. head Jess Choa.

Saving Smarter

"A Citibank consumer wealth survey conducted in 2004 showed that Asians must save smarter, not just harder," said Citibank retail business director Raymond Choong, "This also goes for the average Philippine investor."

A key investment concept is asset allocation. This simply means looking at your wealth as a whole–as one big pot–and deciding how to apportion it to achieve the best overall return at an acceptable level of risk.

The main aim of asset allocation is to spread or diversify your investments across asset classes that have a low correlation in order to reduce the volatility of your overall returns. If you invest 100% of your wealth in a single asset, such as a house or the stocks of one company, you are vulnerable to changes in the market. For example, following the 1997 Asian financial crisis, the value of Philippine real estate and stocks dramatically dropped.

Unfortunately, the average Filipino’s investment portfolio would be characterized by:

• a low rate of overall return (because most of it is in cash);

• high currency risk (because all assets are denominated in a single currency, the peso); and

• low diversification (because the risks are not adequately spread out).

Ideally, a professional financial planner could provide advice on how you can apportion your wealth into the different asset groups to achieve your goals.

Generally speaking, the younger you are, the more aggressive your attitude towards risks can be, because your life expectancy is higher and you have a much longer time to ride out market volatility.

A sample portfolio for a 30-something professional with no plans to retire in the next 30 years could have some 35% of his wealth in an aggressive euro-denominated fund specializing in high-growth industries around the world (a long-term investment); another 35% in an education fund (a long-term investment), 20% in cash deposits in the local currency (immediate access); 10% in a premium deposit account to take advantage of foreign exchange movements (for short-term trading), and 5% for local equities (short-term trading).

Of course, a sample portfolio for a 60-year old retiree would be entirely different.

Careful asset allocation encourages investors to focus on overall wealth and not the short-term performance of individual investments. More importantly, it helps one build wealth over the long term.

Real Estate

Real estate is another important asset class for most investors. In many cases, real estate forms the largest percentage of their asset allocation. Real estate, however, present several investment difficulties:

• If you are living in it and don’t want to move, it does not generate any income;

• It requires expenditure on maintenance;

• It usually takes a long time to sell; and

• Its market value fluctuates.

In general, however, purchasing a home to live in makes financial sense, unless rents are very low.

As time passes, you will almost certainly need to rebalance your portfolio by putting more capital or by selling some investments in one asset class and by purchasing more in another. This is either because your investments were not adequately diversified in the first place or because the investments in your portfolio have grown at different rates. After some time, this will cause the asset allocation to change.

By rebalancing your portfolio when necessary to bring it back in line with your asset allocation targets, you keep its risk exposure steady. There is much evidence that a portfolio that is rebalanced is likely to outperform a "buy and hold" portfolio over the long term. This is because when you rebalance, you tend to sell your best performing investment near their highs, avoiding subsequent drops in value.