Question

Suppose you are an investment adviser at Kowloon East Investment Co., Ltd., a local asset management company. Richard, a wealthy dentist, recently approached you for some advice.

a. During a meeting you suggest that he should invest in around 30 equities drawn from several industries. Richard told you that “I trust my stock-picking ability and believe that I should invest my funds in the four best ideas. Why invest in 30 companies when I can identify the four best projects?” Comment on his statement.

b. You expect the market interest rate to decline in the near future even though the current bond market is not indicating any sign of this change. Which type of bond (e.g., short-term, long-term) would you suggest Richard to purchase to maximize his gains? Would you suggest him to purchase the bond now or wait until the market interest rate actually declines? Why?

Answer 1

Why invest in 30 companies when I can identify the four best projects?” Comment on his statement.

• The Main Reason why i would suggest him to invest in 30 Securities is for Diversify the Risk.

One of the most important principles of investing is to ensure that you have a diversified portfolio. This means ensuring that you spread your capital amongst different investments so that you’re not reliant upon a single investment for all of your returns. The key benefit of diversification is that it helps to minimise risk of capital loss to your investment portfolio.

What are some of the benefits of diversification?

Three key advantages of diversification include:

1. Minimising risk of loss – if one investment performs poorly over a certain period, other investments may perform better over that same period, reducing the potential losses of your investment portfolio from concentrating all your capital under one type of investment.

2. Preserving capital – not all investors are in the accumulation phase of life; some who are close to retirement have goals oriented towards preservation of capital, and diversification can help protect your savings.

3. Generating returns – sometimes investments don’t always perform as expected, by diversifying you’re not merely relying upon one source for income.

What makes a diversified portfolio?

To diversify your portfolio, you need to spread your capital across different asset classes to reduce your overall investment risk. These should include a mix of growth and defensive assets:

• Growth assets include investments such as shares or property and generally provide longer term capital gains, but typically have a higher level of risk than defensive assets.

• Defensive assets include investments such as cash or fixed interest and generally provide a lower return over the long term, but also generally a lower level of volatility and risk than growth assets.

A diversified portfolio means spreading risk by investing:

• across different asset classes such as cash, fixed interest, property, Australian and international shares
• within asset classes such as purchasing shares across different industry sectors
• across different fund managers if investing in managed funds.

Generally, particular investments or asset classes will perform better than others over a specific period depending on a range of factors including:

• current market conditions
• interest rates
• currency markets.

No particular investment consistently outperforms other investments.

For example, during periods of increased sharemarket volatility, your share portfolio may suffer losses. If you also hold investments in other asset classes such as fixed interest or direct property that may perform better over the same period, the returns from these investments can help smooth the returns of your overall investment portfolio.

So, by diversifying your investments, you can achieve smoother, more consistent investment returns over the medium to longer term.

Some other assets to help create a diversified portfolio

Listed investment companies

Listed investment companies (LICs) offer a simple way to spread your investments across a wide range of assets including Australian and international shares, fixed interest, unlisted companies and property. LICs are similar to managed funds, however LICs can be traded on the ASX, so you can buy and sell your investments at any time. Generally, LICs have a lower management expense ratio (MER) than managed funds.

Which type of bond (e.g., short-term, long-term) would you suggest Richard to purchase to maximize his gains? Would you suggest him to purchase the bond now or wait until the market interest rate actually declines? Why?

• As Financial Advisor based on Historically Data i would suggest to invest in Long term Bonds Now.

  Visualizing the 700-Year Decline of Interest Rates

  How far can interest rates fall?

  Currently, many sovereign rates sit in negative territory, and there is an unprecedented $10 trillion in negative-yielding debt. This new interest rate climate has many observers wondering where the bottom truly lies.

  Today’s graphic from Paul Schmelzing, visiting scholar at the Bank of England (BOE), shows how global real interest rates have experienced an average annual decline of -0.0196% (-1.96 basis points) throughout the past eight centuries.

  The Evidence on Falling Rates

  Collecting data from across 78% of total advanced economy GDP over the time frame, Schmelzing shows that real rates* have witnessed a negative historical slope spanning back to the 1300s.

  Displayed across the graph is a series of personal nominal loans made to sovereign establishments, along with their nominal loan rates. Some from the 14th century, for example, had nominal rates of 35%. By contrast, key nominal loan rates had fallen to 6% by the mid 1800s.

  Centennial Averages of Real Long-Term “Safe-Asset”† Rates From 1311-2018

  %	1300s	1400s	1500s	1600s	1700s	1800s	1900s	2000s
  Nominal rate	7.3	11.2	7.8	5.4	4.1	3.5	5.0	3.5
  Inflation	2.2	2.1	1.7	0.8	0.6	0.0	3.1	2.2
  Real rate	5.1	9.1	6.1	4.6	3.5	3.4	2.0	1.3

  *Real rates take inflation into account, and are calculated as follows: nominal rate – inflation = real rate.
  †Safe assets are issued from global financial powers

  Starting in 1311, data from the report shows how average real rates moved from 5.1% in the 1300s down to an average of 2% in the 1900s.

  The average real rate between 2000-2018 stands at 1.3%.

  Current Theories

  Why have interest rates been trending downward for so long?

  Here are the three prevailing theories as to why they’re dropping:

  1. Productivity Growth

  Since 1970, productivity growth has slowed. A nation’s productive capacity is determined by a number of factors, including labor force participation and economic output.

  If total economic output shrinks, real rates will decline too, theory suggests. Lower productivity growth leads to lower wage growth expectations.

  In addition, lower productivity growth means less business investment, therefore a lower demand for capital. This in turn causes the lower interest rates.

  2. Demographics

  Demographics impact interest rates on a number of levels. The aging population—paired with declining fertility levels—result in higher savings rates, longer life expectancies, and lower labor force participation rates.

  In the U.S., baby boomers are retiring at a pace of 10,000 people per day, and other advanced economies are also seeing comparable growth in retirees. Theory suggests that this creates downward pressure on real interest rates, as the number of people in the workforce declines.

  3. Economic Growth

  Dampened economic growth can also have a negative impact on future earnings, pushing down the real interest rate in the process. Since 1961, GDP growth among OECD countries has dropped from 4.3% to 3% in 2018.

  Larry Summers referred to this sloping trend since the 1970s as “secular stagnation” during an International Monetary Fund conference in 2013.

  Secular stagnation occurs when the economy is faced with persistently lagging economic health. One possible way to address a declining interest rate conundrum, Summers has suggested, is through expansionary government spending.

  Bond Yields Declining

  According to the report, another trend has coincided with falling interest rates: declining bond yields.

  Since the 1300s, global nominal bonds yields have dropped from over 14% to around 2%.