Investment Basics

Before you start
Investing is a big decision, and getting started can often be the hardest part. Here we take a look at some of the basic elements of investing and the things you should know before you begin.

Set a goal
Before you even start investing, you need to have a goal. What is it that you want to achieve, and when do you want to achieve it?

Your goal might include saving for a home, a child's education, retirement or simply the peace of mind that comes with financial security. Whatever the goal, knowing how much time you have to achieve it is very important since this will determine the best type of investment to help you get there.

Generally, your goal will fall into one of three timeframes:

  1. 1. Short-term - up to 1 year
  2. 2. Medium-term - 1 to 5 years
  3. 3. Long-term - 5 years or more

It's important also to remember that the earlier you start investing, the better off you will be.  That's because you not only have more time to accumulate wealth, but you also benefit fromwhat's known as compound interest.

Compound interest is the concept of adding accumulated interest to the principal, whereby you begin to earn interest on interest.

Asset classes explained
We've all heard the term 'asset class', but what does it really mean?

Assets generally fall into one of two categories - 'defensive' or 'growth'. Defensive assets tend to be income-producing and are usually suited to short-term investors or those who prefer safer investments with more consistent returns. Examples of defensive assets are bonds and cash.

Growth assets tend to be higher risk / higher return assets and are usually suited to long-term investors who are willing to endure the peaks and troughs associated with their investment. Examples of growth assets are shares and property.

Below we take a closer look at each of the main asset classes.

- Cash
Cash is a stable investment that provides steady returns. While the chance of losing money is remote, the returns tend to be the lowest of all asset classes.

Examples: bank deposits and short-term money market securities.

- Fixed interest
Over the long-term, fixed interest tends to provide better returns than cash, but lower returns than property and shares.

Examples: securities such as bonds and debentures.

- Property
Over the long-term, property tends to earn more than fixed interest or cash, but less than shares. You can invest in property either 'directly' by purchasing real estate or 'indirectly' by investing in a fund such as a property trust that uses pooled investor funds to purchase real estate.

Examples: industrial, retail and commercial real estate.

- Alternative assets
Over the long-term, alternative investments tend to earn more than property, fixed interest or cash but fluctuate in value more in the short-term, so they carry a medium to high level of risk.

Examples: infrastructure projects such as roads and airports, gold and art.

- Shares
Shares tend to earn the highest returns over the long-term but are more likely to fluctuate in the short-term, which makes shares a higher risk investment.

Examples: units of ownership in any company listed on the Australian Stock Exchange.

Asset allocation
Asset allocation refers to the distribution, or weighting, of each asset class within your investment portfolio. For most people, their investment portfolio will include a mix of defensive and growth assets, though others will invest entirely in one or the other.

Asset allocation is usually determined based on the level of risk you are willing to take. For example, if you are a conservative investor, you might invest 70% of your money in cash and bonds and 30% in shares and property. However, if you are an aggressive investor, you might invest 70% of your money in shares and property and 30% in cash and bonds.

Risk vs Return
Different investors have different risk tolerances, i.e. the level of risk that we're prepared to take.

When determining which investments are best for you, you need to consider your own investment timeframe. That's because each asset class has a unique time horizon. For example, if your time horizon is one year, you might consider a cash investment, such as a term deposit. However, if your time horizon is five years or more, you might consider investing in shares.

As an investor, you aim to get the highest return possible at a level of risk you feel most comfortable with. To that end, you need to consider how tolerant you are of market fluctuations and the probability that your investment returns may not meet expectations. Remember, some investments will even lose money.

Income vs Growth
The type of investment you need depends on whether you require capital growth for the future, income from your investment for now or a combination of both.

Some people, such as retirees or those with short investment timeframes, may choose to receive an income from their investment. Income is generated from the interest and dividends earned from the investment. Bonds and cash are examples of income-producing investments and they generally provide stable and regular returns.

Growth assets, such as shares and property, generally suit people who want to invest for five years or more. These types of assets grow your capital with moderate levels of income over time. Investors wanting to generate wealth over the long-term should consider placing a greater portion of their investment into growth assets. While growth assets can be volatile over shorter timeframes, they have historically produced greater returns than income assets.

Understanding volatility
Investment markets move up and down. They can vary from providing strong returns year after year to a sudden drop, which can be quite alarming for some investors.

There are many factors that drive market movements. In fact, over the last twenty years or so there have been at least ten major events that have had a significant impact on the direction of Australian and global investment markets, starting with the Wall Street Crash back in October of 1987.

However, markets do tend to recover with time, as the graph below shows.


 

It's important to remember that having an investment plan and sticking to your goal can help minimise the impact of market volatility and keep your investments on track.

Investment strategies
There are a number of simple investment strategies that you can use to help build your investment portfolio. Some strategies help you to increase your investment more quickly, while others may be more tax-effective or can reduce the impact of market fluctuations.

Diversification
All investments contain an element of risk. These risk characteristics are not always the same for each investment, meaning that what may affect the value of one investment may not affect another.

By spreading your portfolio across different investments, or diversifying your investments, you can reduce the effect of one investment on the performance of your overall portfolio.

Diversification ensures that your investment dollar is spread across a range of investments in line with your investment objectives. And by balancing your portfolio across a range of investments, you give yourself the opportunity to maximise your returns whilst minimising your risk.

For further information on Investment Basics please refer to the Optimum Investment Guide