Wednesday, 30 July 2014

How Anyone Can Achieve Financial Independence

Why can some professionals making $2 million a year quickly go bankrupt, while someone on an average income can retire and have no financial worries?
The path to achieve financial independence is not a secret. I will share with you a few simple rules.
Most people think wealth is a high income job. Yes, it's easier to amass assets if you have more money coming in each month, but the true secret to increasing your net worth is:
Spend less than you make and use the excess to generate passive income and growth on your money. I repeat, income is not wealth.
What is wealth? Everyone has a different definition depending on their circumstance, however, i personally believe wealth is having a sufficient passive income to maintain your current standard of living. Your total assets (what you own) minus your total liabilities (what you owe) give you a number that is your net worth. I then use a figure of 5% to determine how much passive income could be generated. For example; If a portfolio has a value of $1,000,000 it would be safe to assume a passive income of $50,000 per annum could be maintained.
To acheive financial independence we need to increase our net worth number and start to generate passive income from it (capital gains, income and dividends without requiring any work or labour). If you have a portfolio of private businesses, stocks, bonds, mutual funds, real estate and other cash generators, you could sit by the pool all day. It's also very difficult to wipe out a well-constructed portfolio. 
If you had to stop working right now, how long could you keep up your purchasing pattern for cars, clothing, music lessons, college tuition, video games, etc.? The average person isn't educated in this truth, which is why the more and more they earn, they are left wondering why financial independence and security continue to allude them, always seemingly just out of grasp.
The only way to take advantage of investment opportunities is to have the money to invest until you reach a point where the returns generated on your assets can change your life; e.g., earning a 10% return on $10,000 is only going to net you $1,000 before taxes - not too bad but hardly earth shattering, but the same return on a $1,000,000 portfolio is $100,000 despite requiring roughly the same effort and research.
Amassing wealth and becoming financially independent is a slow process that takes time. You do small things every day such as cut your expenses, generate extra income, and put the money into investment and tax efficient accounts. With time it will build. As each new opportunity appears, you can react on a larger scale than your previous investments. Over time the interest, dividends, and capital gains your money has earned begin to generate their own interest, dividends, and capital gains, and on and on in a virtuous cycle. 
Einstein called compound interest the 8th wonder of the world and it's how $100,000 now can grow to $1,083,471 over 25 years at 10% per annum.
Starting from $0 now, a saving / investment of only $100 per month will be worth $133,789 over 25 years at 10% per annum.
If you have not started yet then the only way you can have more money left over at the end of the month to start investing is to either increase revenue (your income) or decrease expenses. Make a plan, go through your current bank statements and see where you can make changes. Its that simple: 
Increase revenue, cut costs, or both then use the surplus to invest for your future.
Use tax breaks - saving your money in the most tax efficient way is important. Depending on your nationality and country of residence there may be several options available to you to allow you to reduce or eliminate tax on your wealth and/or your income.
So where do you put the money?
I have four simple but key rules when sourcing investments for my private clients (these can vary slightly depending on a clients exact requirements):
- Diversify - Don't put all your eggs in one basket. Buy a mix of assets and buy assets according to a risk level you are comfortable with. Don't know what to buy? Speak to a specialist or read some of my other blog posts as a good starting point.
- Buy Quality - Buy the best quality investments you can afford. If you have the choice of three US Large Cap Equity funds and one has been consistently ranked in the top 10% for returns over the last 5 years. Buy it above the others. If buying property buy the best location you can afford.
- Focus on Income - Try to buy assets and investments that produce income. It can help to lower overall risk and with regular income flowing into your portfolio you can choose how and where to re-invest the income to help diversity and, when ready, can start to use the additional passive income to fund your lifestyle.

- Take a long term view - The value of all investments will fluctuate over time. Have patience and if you have followed the rules above you should develop some nice returns over the long term.
If you follow these basic rules and ideas you should soon see your wealth begin to increase. The only decision you need to make is to start today. The bigger your wealth gets the more i would encourage you to seek professional tax and or investment advice.
Have a great day,
Andrew Lumley-Holmes

Monday, 14 July 2014

Measuring Investment Risk

There are five main indicators of investment risk that apply to the analysis of stocks, bonds and mutual fund portfolios. They are alpha, beta, r-squared, standard deviation and the Sharpe ratio. These statistical measures are historical predictors of investment risk/volatility and are used for assessing the performance of equity, fixed-income and mutual fund investments by comparing them to market benchmarks.


Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its "alpha."

Simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio's return. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%. For investors, the more positive an alpha is, the better it is. 


Beta, also known as the "beta coefficient," is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is calculated using regression analysis, and you can think of it as the tendency of an investment's return to respond to swings in the market. By definition, the market has a beta of 1.0. Individual security and portfolio values are measured according to how they deviate from the market.

A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market, and, correspondingly, a beta of more than 1.0 indicates that the investment's price will be more volatile than the market. For example, if a fund portfolio's beta is 1.2, it's theoretically 20% more volatile than the market.

Conservative investors looking to preserve capital should focus on securities and fund portfolios with low betas, whereas those investors willing to take on more risk in search of higher returns should look for high beta investments. 


R-Squared is a statistical measure that represents the percentage of a fund portfolio's or security's movements that can be explained by movements in a benchmark index. For US fixed-income securities and their corresponding mutual funds, the benchmark is the U.S. Treasury Bill, and, likewise with equities and equity funds, the benchmark is the S&P 500 Index.

R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less would not perform like the index.

Mutual fund investors should avoid actively managed funds with high R-squared ratios, which are generally criticized by analysts as being "closet" index funds. In these cases, why pay the higher fees for so-called professional management when you can get the same or better results from an index fund?

Standard Deviation

Standard deviation measures the dispersion of data from its mean. In plain English, the more that data is spread apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

Sharpe Ratio

Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (U.S. Treasury Bond) from the rate of return for an investment and dividing the result by the investment's standard deviation of its return.

The Sharpe ratio tells investors whether an investment's returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one portfolio or security can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater an investment's Sharpe ratio, the better its risk-adjusted performance. 

The Bottom Line

Many investors tend to focus exclusively on investment return, with little concern for investment risk. The five risk measures we have just discussed can provide some balance to the risk-return equation. The good news for investors is that these indicators are calculated for them and are available on several financial websites, as well as being incorporated into many investment research reports. As useful as these measurements are, keep in mind that when considering a stock, bond or mutual fund investment, volatility risk is just one of the factors you should be considering that can affect the quality of an investment. 

Have a great day,

Andrew Lumley-Holmes

Thursday, 10 July 2014

Equity Fund Types

Let us consider the characteristics of equity mutual funds.
Equity funds invest a key proportion of their assets in individual companies. They purchase shares through the secondary market, though they also buy these through the initial public offerings (IPOs). The NAVs of these funds react directly to the changes in the prices of the equity shares. Equity mutual funds aim to eliminate internal risks by diversifying investments across several stocks.
Following are the different types of equity funds:
Equity diversified funds: These funds invest a large proportion of their corpus in equity shares across different sectors and market capitalisations (blue chips, large-, mid- and small-cap). Their aim is medium- to long-term capital appreciation.
Dividend yield funds: These aim at providing regular income and steady capital appreciation by investing in stocks that have high dividend yields. These funds are relatively less volatile and risky compared with other equity funds.
Sectoral funds: These invest in the companies that belong to a particular sector, such as Pharmaceutical, IT or banking. Such funds do not invest across multiple sectors, so they are less diversified and carry a high company-specific risk (or unsystematic risk) compared with general equity diversified funds.
Mid- and small-cap funds: As the names suggest, mid-cap funds invest in mid-sized companies, while small-cap funds invest in small firms. The companies are classified as large, mid or small on the basis of their market capitalisation. The mid and small companies are expected to grow at a faster rate compared with the bigger ones. Such funds are volatile and risky as their shares are not very liquid in the market.
Equity index funds: Index funds track a specific market index, such as the S&P CNX Nifty or the BSE Sensex, and aim at returns similar to those of the defined index or benchmark. These funds invest in shares that constitute the index and in the same proportion as that of the index. These are exposed to market, or systematic, risks.
Contra funds: These are a variant of equity diversified funds, which identify and invest in stocks that are highly undervalued but have a strong growth potential in the long run. They aim to invest during periods of high market pessimism and derive benefits when the market recognises the stocks' potential. Such funds are useful only for long-term equity investors.

Have a great day,

Andrew Lumley-Holmes

Thursday, 3 July 2014

Understanding Asset Classes

An asset class is a group of securities that have similar financial characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments).
In addition to the three main asset classes, some investment professionals would add real estate and commodities, and possibly other types of investments, to the asset class mix. Whatever the asset class lineup, each one is expected to reflect different risk and return investment characteristics, and will perform differently in any given market environment.
Asset classes and asset class categories are often mixed together. In other words, describing large-cap stocks or short-term bonds asset classes is incorrect. These investment vehicles are asset class categories, and are used for diversification purposes.
Equities - Also called stocks, equities represent shares of ownership in publicly held companies.
  • Historically have outperformed other investments (keep in mind that past performance does not guarantee future results)
  • Most volatile in the short term
  • Returns and principal will fluctuate so that accumulations, when redeemed, may be worth more or less than original cost
Fixed income - Fixed income, or bond investments, generally pay a set rate of interest over a given period, then return the investor’s principal.
  • Set rate of interest
  • More stability than stocks
  • Value fluctuates due to current interest and inflation rates
Money market - Money market investments are relatively safe, liquid short-term investments; examples include: government issued securities, CDs, banker’s acceptances, euros and commercial paper.
  • Less volatile than stocks and bonds
  • Lower potential for growth
  • Short-term investment
Guaranteed - Guaranteed assets with a fixed rate and backed by the claims-paying ability of the issuing insurer.
  • Preserves your principal
  • Provides at least a specified minimum return
Real estate - Your home or investment property, plus shares of funds that invest in commercial real estate.
  • Helps protect future purchasing power as property values and rental income run parallel to inflation
  • Values tend to rise and fall more slowly than stock and bond prices. It is important to keep in mind that the real estate sector is subject to various risks, including fluctuation in underlying property values, expenses and income, and potential environmental liabilities.
Most financial experts agree that some of the most effective investment strategies involve diversifying investments across broad asset classes like stocks and bonds, rather than focusing on specific securities that may or may not turn out to be "winners." Diversification is a technique to help reduce risk. However, there is no guarantee that diversification will protect against a loss of income.
The goal of asset allocation is to create a balanced mix of assets that have the potential to improve returns, while meeting your:
  • Tolerance for risk (market volatility)
  • Goals and investment objectives
  • Preferences for certain types of investments within asset classes
Being diversified across asset classes may help reduce volatility. If you include several asset classes in your long-term portfolio, the upswing of one asset class may help offset the downward movement of another as conditions change.

Have a great day,

Andrew Lumley-Holmes