Basic Principles of Investing

To start the new year off, I thought I would put something together that explains some of the basics when it comes to investing. Putting some of this stuff into context will hopefully help you when you are making decisions about your own investments, whether it be choosing the right super fund investment option(s), putting some money aside for a holiday or setting up an education fund for children.

Investing at any stage in your life can help grow your wealth or provide an additional income stream. Before you start investing, it is important to identify your financial goals. You may want to save up for a holiday or ensure you have enough for retirement. Once you have defined your financial goals, you can then choose the right investment to suit your budget and lifestyle.

You should divide your goals in three categories, based upon the timeframe required.

Short term goals (1 to 3 years)- examples include buying a new car or saving for a holiday

Medium term goals (3 to 5 years)- might be putting together a deposit for a house, buying a boat, creating an alternate/additional income stream or taking some extended leave from work.

Long term goals (7 years or more)- like setting up a children’s education fund or building a nest-egg for your retirement.

The type of investment vehicle you choose depends on the length of time you will be invested to achieve that goal.

Before you start investing, you should draw up a budget to work out how much you can afford to invest, without having to compromise your lifestyle too much. Draw up a monthly personal budget and note down the income you receive after tax, all your fixed expenses such as regular bills, rent and car/transport expenses, as well as the variable expenses such as entertainment, lunch and grocery expenses. For each category, work out an annual total. Whatever amount you have left over can be put towards your investment, but it is a good idea not to invest all your spare cash, in case of emergencies or extra expenditures that may arise throughout the year.

We have a budget planner on our website. Visit www.youradvicepartners.com.au to check it out.

Risk and Return
It is important to recognise the level of risk you feel comfortable with for different investment types. Some investors are more risk averse and prefer to invest in safe, low-interest cash and bank deposits where the value of their money is unlikely to fall. Other investors may accept that the value of their money may go down over short periods of time, but have the potential to earn a higher return over a longer period of time, if they invest in shares or property.

It is important to remember that losses are always possible, depending on the fluctuations in the share market.

Diversification
Diversification involves spreading your investment over a number of different asset classes (cash, fixed interest, property and shares) to provide more consistent overall returns. It is a good way to reduce the risks associated with investing over short periods of time.

By not having all your money in one type of investment, the high returns you receive from one investment can sometimes offset any poor performance in another asset class.

The Magic of Compound Interest
The sooner you start investing, the better. This is because of the powerful effects of compound interest. For example, if you decide today to invest an initial amount of $1,000, then contribute $100 per month into a managed fund that earns 8% p.a., in 10 years time, you would have $20,071. If you started investing the same amount three years later, you would only have $12,708. This is where the magic of compound interest takes effect. The longer you invest for, the greater the difference in the compound interest, which is why starting to invest now and not waiting is important.

Asset classes
There are four main asset classes you can put your money into. The return you achieve and the level of risk associated is different for each asset class. You can invest in cash, fixed interest (such as bonds), property and shares. To build a balanced portfolio, you can invest in a combination of these asset classes, this method is called diversification.

Cash and fixed interest asset classes are considered ‘defensive’ assets, which means they are designed to defend an investment from losses. These tend to be more popular for short-term or risk averse investors, who prefer safe, more secure investments with some consistency in returns.

Shares and property asset classes are considered ‘growth or aggressive assets’ because they tend to provide overall higher long-term returns but they are considered more volatile (higher risk).

Cash - Cash funds include bank deposits and investments in securities such as treasury notes, with a term of less than one year. Investing in cash via a cash management trust could be good for short-term financial goals such as saving for a holiday or a car, as there is little risk of losing money over short periods of time.

Fixed interest - A fixed interest investment or ‘bond’ is a debt security issued by a corporation or Government in return for cash from an investor. Bonds are the most common form of fixed interest securities. They are agreements to repay a fixed amount of money at a predetermined (maturity) date in the future.

Fixed interest investments are commonly referred to as ‘income-producing’ investments. It is important to understand that interest rate changes can impact the capital value of a bond, therefore they can be riskier than cash, but bonds can potentially offer better returns.

Property - Property investments can include investments in direct property, listed property trusts (LPTs) and other property securities. LPTs invest in a range of residential and commercial property, office buildings, hotels and industrial properties. They are pooled property investments which are broken into units and listed on the stock exchange like shares in a company.

Funds which invest in property securities allow you to take advantage of the benefits of diversification from investing across a range of different property sectors. Property investments have a higher risk than fixed interest investments, but are generally considered to have less risk than shares.

Shares - Shares or stocks are securities representing ownership of a company. When you buy a share in a company, you become a joint owner of the business. When companies distribute profits via dividends, the investor receives part of it.

Shares are generally known to provide the potential for the highest return of all the asset classes over the long term, but a company’s value can rise or fall due to changes in economic and industry conditions and the company’s profitability means they carry the highest risk of loss on your investment.

Direct or Managed Investments
As the name suggests, these are investments where you invest your money directly into that investments. The most common direct investments people make are share and property investments, but may include things like Government Bonds etc.

People with large amounts to invest and who have the expertise and knowledge to choose the right underlying investments for their portfolio and most likely to invest more directly.

A managed fund (or managed investment) is made up of a pool of money which allows a number of people with similar investment goals to individually invest an amount of money into a professionally managed fund. It is the fund managers who decide which underlying assets to purchase.

They allow small investors to not only have their portfolio managed by professional managers but to achieve very good diversification from even a small sum invested.

Managed funds are easy to get started, with many funds only requiring $1,000 as an initial investment to begin investing. They cater for all types of investors from people with as little as $100 to invest per month to those with larger sums to invest.

Gearing Gearing, or borrowing to invest, can be useful in allowing you to borrow and invest more in order to achieve greater investment returns. It makes sense if the investment returns you achieve will exceed the cost of borrowing, but sometimes it can also generate greater losses.

This long-term strategy would suit investors who can cope with higher risks and have income from other sources to service the loan. One of the potential benefits of gearing is the tax effectiveness, where you may be able to deduct interest expenses and ongoing borrowing fees for tax purposes.

Investing for your children’s education and future
School fees can be expensive and if you plan to send your children to an independent or private school, it is a good idea to start saving for their education as early as possible. Depending on the area and type of school, some independent and private school fees can be in excess of $30,000 per year- and that may not even include school books, uniform, extracurricular activities and other necessary items which are usually in addition to the standard tuition fees.

Popular options to invest for a child’s education and future include a cash management trust (CMT), an investment bond or a managed fund. There are a number of providers that offer alternative schemes designed ideally for this type of investment goal. By investing early you can watch your money grow with the magic of compound interest. So by the time your children have reached school age, you should have a nice little nest egg to help cover all the educational costs.

Investing Internationally
When you invest overseas, it gives you access to growing economies, geographic and sector diversification, a better spread of risk and the potential for higher returns over the longer term. The main advantage of investing overseas is access to investments not available in Australia. Some of the world’s largest and most successful companies such as Microsoft, Apple and Coca-Cola are only listed on international stock exchanges.

Buying direct shares in overseas companies can be complex, as well as having currency exchange risks. Some alternatives are to invest internationally through your superannuation fund or a managed fund which invests in international shares and may manage the currency risks.

Next Steps
If you would like to know more about basic principles of personal investment, you can go to our website www.youradvicepartners.com.au

If you want to speak with someone and personal finance strategies, as an EAN member you have a local RI Advice partner who will be more than happy to sit down with you for a no-obligation one-on-one chat about how you can make the most of your money.

Email us on contact@youradvicepartners.com..au or call us on 1300 380 880.
RI Advice Group Pty Limited
ABN 23 001 774 125, AFSL 238429.

The information provided in this document is general information only and does not constitute personal advice. It has been prepared without taking into account any of your individual objectives, financial situation or needs. Before acting on this information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. You should seek personal advice from a qualified financial adviser. The information is current at time of writing but is subject to change.