Learn about investing
Investing is simply the process of putting your money to work to generate more money, in the form of income paid to you or an increase in your investment capital.
There are many types of investment structures you can use including managed funds, superannuation, shares publicly traded on stock exchanges and income bonds issued by governments or corporations.
Key investment principles
There are a number of key investment principles that have stood the test of time and are essential for all investors to understand.
The benefit of compounding returns
This is the ability to earn returns on your returns that have been reinvested. Over time this has a snowball effect and over many years you can end up earning more of your returns from the reinvested returns than from your original investment.
Risk and return are always linked
The link between risk and return is the most fundamental rule of investing. To potentially achieve higher returns, you must be prepared to accept higher risks. All investing involves risk and there are different types of risk, such as losing part or all of your money, not receiving the return you were expecting, or not being able to access your money when you need it. Another risk for many people is actually being unwilling to accept the risks and invest in the type of assets required to achieve their investment goals.
Diversify to reduce your risk
Spreading your money across a number of different investments and/or asset classes is known as diversification and is the simplest way to reduce risk. For example, investing in ten different companies carries a lower overall risk than investing in one, particularly if they are in different industries or countries. Different types of investments perform differently under various market conditions – so whatever your investment goals, appropriate diversification is very important.
Values can be volatile
The value of an investment may fluctuate to varying degrees. For example, the value of a stock tends to fluctuate greatly, while low-risk fixed income investments have historically been more stable. The greater the potential return, usually the greater the volatility, and therefore potential loss if you need to access your investment when its value may be down. One simple strategy to mitigate the effects of volatility is to invest regularly and benefit from dollar cost averaging.
Time in the market
All investments need to be considered in the context of time. Some investments such as term deposits can only be accessed at the end of the specified period. Time is also important with more volatile investments such as shares, both in terms of entering and exiting the investment. The more volatile the investment, the greater the time required to "ride out" any possible downturns in the investment's value and maximise long-term returns.
Gearing can increase gain and losses
Gearing is investing using borrowed money. This has the potential to increase returns as well as losses. Borrowing money costs money, so to be worthwhile the total return (income and capital gain) needs to exceed the cost of borrowing the money and outweigh the risks of "losing" the borrowed money that you will still have to pay back.
Understanding Asset Classes
Each asset class has different characteristics, in terms of their structure, potential returns and risks. It's important to understand these characteristics so you can choose the investments that best suit your purpose.
A share is a part ownership of a company. You are literally buying a share in the company. You may receive dividends paid from the company's profits and if the company's profits and prospects grow, so will the value of your shares. Companies have limited liability which means you have no personal liability for the company's debts and obligations. Equally, you have no guarantee of the return of your capital or income from your investment in the company.
This is an investment that promises a particular return and the return of your capital, usually over a specified period. The level of return is compensation for the risk you take. The risk is the issuing organization's ability to pay back the promised return. Government and corporate bonds are examples of fixed income investments.
The most important thing to remember with fixed income investments are that any "guarantee" depends on the issuer's ability to pay and the quality of any underlying assets backing the investment.
Like shares, many fixed income investments can be traded on markets and their value can fluctuate depending on the perceived risk of the issuing organization, as well as prevailing interest rates and outlook.
Investing in buildings used for offices, industry, retail and residential can provide regular income as well as capital gains. Investing in property companies and trusts listed on stock exchanges effectively means investing in existing buildings, developing buildings, and managing the properties and related services for the businesses that lease them.
Similar to property, investing in infrastructure such as roads, rail, seaports, airports and pipelines can provide regular income as well as capital gains. Similar to many property companies, infrastructure trusts and companies are often listed on public stock exchanges. Infrastructure usually requires large amounts of initial development capital with income returns generated over the long term.
Ways to boost your investment
Diversify to reduce risk
Diversification is the simplest way to reduce the overall risk of a portfolio. Different types of investments tend to perform differently to each other depending on the prevailing economic and financial market conditions. So if you invest in a range of investments, in any given year your better performing investments will offset the poorer performing investments and smooth out your overall returns.
It's important to have the right mix of asset classes to suit your needs as well as good diversification within those asset classes. Asset classes are often classified into growth or defensive investments. Growth investments have a greater potential to grow in value but also greater potential to fall in value. Defensive investments usually maintain more stable values and provide most of their returns in the form of income.
Shares and property are generally considered growth assets and fixed income and cash are considered defensive. Within asset classes there are many variations. For example, within the asset class of shares some companies are considered defensive and some are considered growth. Defensive companies are stable, established businesses with steady, reliable revenue streams, paying a high level of their profits in dividends. Growth companies are those that have high potential to grow the business and profits but may use more of their profits to fund future growth rather than paying dividends to investors.
Whatever an investment is called it’s vital that investors look beyond this to understand exactly the sort of risks an investment entails.
Investing regularly becomes a habit that can reward you in future. It provides the discipline to allocate money to your investment first before you have the temptation to spend it. You will also benefit from dollar cost averaging. This means that over time you can average out the cost of your investment as its value fluctuates. If you invest the same amount of money every time you will buy more of the investment when its price is down and less when it's high. This reduces the risk of investing all your money at the wrong time, for example, when values have peaked. Most managed funds allow you to establish a regular savings plan using a direct debit from your bank account.
If you regularly reinvest the income you receive from an investment you will benefit from the power of compounding returns. The longer you do this the more your returns will be generated by your earlier returns. If you invested $1000 which returned income of 8 % pa, that you then reinvested, you would double your money in nine years. After that you would be receiving more returns from your returns than from your original investment.
Gear your investment the easy way
Instead of borrowing money to invest one simple way to gear your investment dollar is through a geared fund. This is where the fund itself borrows money to invest rather than you. Like all gearing this can increase any gains or losses from your investment, but it means you don't have to use your investment or other assets as security and you don't have to immediately pay back some of the loan if the value of the investment falls, as required under a margin loan.
Invest in good advice
If you don't have a clear financial plan or investment strategy then it can be hard to measure your progress and make decisions about your investments. A professional adviser can be invaluable not just for their knowledge and expertise but the fact they can provide you with an objective perspective.
Commitment and discipline pays off
While there are many things to consider when investing, don't be put off by the complexities and endless options available. Only accept advice and invest in products with risks you understand and are prepared to accept. Then the most important thing is to make a start and be committed and disciplined. Constantly changing your strategy, searching for the next boom investment or the easy way to get rich, is a recipe for disappointment.