Understanding Investing 101

Little boy playing with lego toys

Every now and then it’s good to get back to basics.

To build assets for your long term future, whether inside or outside of Superannuation, it’s important to have a general understanding of how investing works. Additionally it’s valuable to know what your options are and be aware of both the potential risks and returns associated with those options.

How investing works

One of the most important parts of investing for the future is building a mix of high quality diversified assets across the various available asset classes. The mix between these assets class should be determined by:

1) Your risk tolerance (i.e. Conservative, Balanced or Aggressive etc).

2) The time frame funds can be invested for before you need to access them.

3) The returns required to be achieved over time in order to reach your goals.

Asset classes

There are basically four main areas you can invest in:

  • Cash
  • Fixed Interest
  • Shares (Australian & International Shares)
  • Property (Direct property & Listed Property)

Cash and Fixed Interest are considered to be Defensive assets, while Shares and Property are Growth orientated assets.

Cash:

Cash is the catchall term for money in the bank; savings accounts, transaction accounts and term deposits. These cash investments only produce an interest payment and the capital does not rise or fall in value (other than be eroded by inflation). Cash is the most secure of the four main asset classes, but over time provides a much lower return. To June 30 2016, the average return from cash over the last 20 years was 4.9% per annum (source: Vanguard). However of course right now it’s much lower than this.

Fixed Income:

Fixed Income is a general term for Government & Corporate Bonds. This asset class is the next step above cash on the risk & return scale. A government bond involves lending money to the government for a fixed rate of interest for a fixed period of time. The return from Bond investments is mainly via an interest payment. However, importantly, the capital value can either rise or fall depending upon expected future interest rates at any given time. Typically Bond investments are less volatile than property and shares, but give a lower return. They are not without risk though, and during rising interest rate environments can see a short term decline in capital value. To June 30 2016, the average return from Australian Bonds over the last 20 years was 7.0% per annum (source: Vanguard). However as with cash the return is lower than this now due to the current low interest rate environment.

Property: 

Property investing can be residential, commercial or industrial. You can invest directly in property (buy it yourself), or use a property managed fund which will invest on your behalf (and provide greater diversification). The property funds (such as in a superannuation fund) would typically invest in a diversified mix of Listed Property Trusts (such as Westfield, Stockland and Goodman Group).

Whether the property is held directly or via managed fund, the return is a mix of both capital growth as well and an income return via the rental payments. With residential property, typically capital growth over time is higher than income. Commercial property is often the opposite, with the comparatively stronger commercial property rental returns exceeding capital growth over time.

To June 30 2016, the average return from Australian Listed Property over the last 20 years was 8.8% per annum (source: Vanguard). Residential returns over this time have been slightly higher at 10.5% on average over 20 years to 31 Dec 2015 (source: Russell Investments 2016 Long Term Investment report).

Shares:

Share investing can either be via direct shares or a managed fund (greater diversification). Additionally these might be Australian Shares, US Shares, or more broadly International Shares.

With share investing you are able to own a small piece of large companies and share in the future growth of the company along with profit along the way. Like property the return is a mix of both capital growth of the shares and also income return via dividend payments. With Australian Shares dividends quite often are paid with franking credits attached which is effectively a credit for the tax the company has already paid – this tax credit offsets some/all the tax the investor may pay, making dividends from Australian Shares quite a tax effective income stream along with strong prospects for longer term growth.

To June 30 2016, the average return from Australian Shares over the last 20 years was 8.7% per annum, US Shares was 8.2% and broader International Shares was 5.9% (source: Vanguard).

Risk and Asset Allocation

Your asset allocation decisions will play a large part in your long term success or otherwise of your investment holdings. The golden rule is: the higher the potential return, the higher the likely risk.

But what exactly is risk? Risk can be anything from short term fluctuations in returns on your investment, right through to a permanent loss of capital. A more extended definition of risk may be the possibility that an investment will not achieve the expected return over the investment time frame. 

Diversification and allocation across the various asset classes remains a crucial element in protecting against downside risk in the short term whilst providing generally for more consistent returns over the longer term. Typically the various asset classes perform differently at different times. Allocating to solely one asset class and/or picking last year’s winner can be a high risk strategy.

When determining the right mix between asset classes, whilst points 1 & 3 above are important, it’s point 2 – your investment timeframe – which can drive most of your asset allocation decisions. Shares and property can be very volatile in the short term. Additionally individual shares can run the risk of a permanent loss of capital. Hence diversification is crucial. The longer your timeframe, arguably the higher weighting you can have to growth assets, as you have the time frame to ride out the short term volatility and not need to sell growth assets in a falling market. The shorter your timeframe, then a greater weighting should be allocated to defensive assets.

As part of your overall wealth creation strategy, one key piece of advice a financial adviser will give you is what your ratio of growth assets (property and shares) to defensive assets (cash) should be – taking into account your risk tolerance & investment timeframe. Typically they will do some assessment of your risk tolerance and then recommend anything from conservative (80% defensive / 20% growth) to balanced (40% defensive / 60% growth), to assertive (20% defensive / 80% growth) to aggressive (100% growth).

Whether you seek advice or make your own decisions, it important to understand your options along with your risk tolerance. This will help greatly in ensuring that your chosen asset allocation is appropriate over the time frame you are investing for.

Matthew Morrison is the Director of Wealth Advisory at The Practice, a Personal Wealth Advisory & Business Advisory firm based in Parkville, Melbourne. Matt along with The Practice team are committed to and passionate about developing & implementing wealth creation strategies for clients to enable them to Fuel their Family’s Future (while protecting them along the journey).

Matt and The Practice team can be contacted via http://thepractice.com.au or (03) 8888 4000.

Disclaimer – the above views and ideas are general advice only and are purely the opinions of the author. It’s important that you seek professional advice tailored to your needs before taking action regarding your financial future.

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