Either way, it's time to take a closer interest in where your wealth is and what it's supposed to be doing for you
If you're just starting out as an investor, there's a lot of information to understand - but that's ok, everything we know we had to learn sometime. Here we cover some of the fundamental issues, such as the different types of asset classes, risk and return, compounding and diversification.
The easiest way of deciding how to invest your money is to look at the pros and cons of the various possibilities and then match them to your needs, expectations and plans over time.
Understanding the different Asset Classes available
There are three obvious ways of investing your money:
- Depositing it into a bank account
- Investing in shares
- Investing in property
You can also invest in commercial property, like office blocks and shopping centres, through purchasing shares in property trusts or specialised managed funds in the share market). For the sake of this article, when you are investing in property (whether domestic or commercial) we shall simply call direct property investment.
If you have superannuation (and today all employees should) you're already an investor, as Superannuation Funds invest in the share market using a variety of investment strategies on behalf of their members.
The 3 Basic Types of Asset Classes
Most investments fit into one of 3 main types or 'asset classes':
- Cash (eg: money in the bank, bank bills} and fixed interest leg government or corporate bonds
- Property (eg: residential, commercial or industrial property trusts)
- Shares (eg: Australian or international shares) also referred to as equities and managed funds
[Note: There are also differing combinations to this mix including the new cryptocurrency of Bitcoin but for our purposes, focuses on the three broad categories first].
These three asset classes can be separated into two board groups:
Cash and fixed interest are generally classified as defensive investments. These investments aim to provide regular income to the investor and the returns are generally stable. In return for this decreased volatility, defensive investments don't usually increase in capital value and their returns are generally lower than growth investments over the medium to long term.
Property and shares are usually classified as growth investments. Growth investments can provide income to the investor as well as an increase in capital value of the investment itself. While these returns may fluctuate over the short term, growth investments have the potential to produce higher returns than defensive investments over the medium to long term.
Start by Understanding how Liquid is the asset?
Investing in Property
It takes time to purchase and if needed, time to sell. You have to find a buyer, perhaps terminate a lease and wait for settlement. If you needed to get all your money out of an investment property overnight, you probably couldn't. Thus direct property is said to be ill-liquid.
Investing in Shares and Managed funds
They can usually be sold quickly on the stock exchange by a stockbroker and thus these types of investments are thus said to be liquid. At the same time, in the past few years, many Australian's who invested in Mortgage Trusts (through the share market) found that their funds were, 'kind of liquid' up to a point, when they wanted to sell some of them, then decidedly 'lumpy' when they wanted to sell all of them and close their investment.
So, make sure you understand the degree of liquidity of the asset(s) you're interested in using to invest with and whether they match your time horizon and personal circumstances.
Start by Understanding Risk
The first thing to remember is all investments have different levels of risks and all investors have different expectations and attitudes towards different levels of risk.
- That's why some investments are clearly not suitable to certain people.
Some people are happy to save their money in a term deposit, whilst others may wish to leverage their abilities through other types of investment. It's about understanding the risk and the possible returns, and making an informed choice based upon your own circumstances.
Be personally accountable for your personal decisions. If you're going to invest, become an educated investor, not a gambler. Do not risk what you cannot afford to lose, make sure you clear plan why you're getting in and an exit plan to help get you out.
Pro tip: Don't outsource your thinking to glossy magazines, slick seminars and the greed of others.
Risk vs Return
All investments can provide a certain level of return to the investor and subject to a certain level of risk. This means that as well as making money on your investments, there's also the chance you could lose money or not make as much as you originally expected to make.
- All investments carry some risk- due to factors such as inflation, taxation, an economic downturn or a drop in a particular market. There are also a range of macro issues that can affect the investment return; for example international issues and government stability and policy.
- There are also a range of macro issues that can affect the investment return; for example international issues and government stability and policy.
As a general rule, the larger the potential investment return, the higher the investment risk and the longer time you need to remain invested to reduce that risk.
Another way of managing investment risk is through diversification. This is the strategy of investing your money across a range of different investments to reduce risk.
The exact mix of investments you choose will depend on:
- your financial objectives
- the amount of time you have available to invest, and
- your personal tolerance for risk
Diversification is important because every type of investment has its own ups and downs. Owning a varied range of investments should help you achieve smoother, more consistent investment returns.
The more ways you diversify, the more you aim to reduce your risk. For example, you can invest:
- across different investment types or asset classes
- fixed interest
- direct property
- domestic or international shares
- in more than one type of fund, and
- more than one fund manager, (when investing in managed funds)
- in more than one investment within each type (eg: invest in several different industries and companies when investing in shares
- inside and outside of the superannuation environment.
We believe that when it comes to investing, the risks of taking a DIY approach are outmatched by the value of having an ongoing relationship with an experienced financial adviser.
The Power of Compounding
Compounding is often described as earning interest on your interest. Each time you earn an income payment from your investment, you can reinvest it to buy more units or shares in the investment.
- This means that these reinvested earnings generate additional earnings, earning you interest on your interest.
Compounding can make a significant difference to the value of your investment over time. To take full advantage of the effect of compounding, think about starting early and leaving your money invested for as long as possible.
Dollar Cost Averaging
Rather than purchasing investments once off or sporadically, you may consider the value of dollar cost averaging over time.
Sometimes referred to as easing your way into the water, its involves establishing a regular investment plan, you can take advantage of 'dollar cost averaging'.
It works like this:
- By investing a set amount at regular intervals, sometimes you end up buying units or shares at a higher price, and other times at a lower price.
The end result is that over time, this spreads out your costs and often insulates you against changes in the value of the assets you are purchasing.