OZ Financial Planning

Investing ABCs

The right investment for you depends very much on your personal circumstances including the reason for investing, your tolerance of risk and your timeframe of investment. Investing and all of its jargon can be daunting to most and sometimes all too hard to know where to begin. An understanding of a few key points is crucial to achieving your objectives and helping you to sleep at night without unnecessary worry about where your investments are headed.

When developing your investment strategy to achieve your goals you should consider the following:

• Your personal and financial goals;

• The level of risk you feel comfortable with;

• The target return you require to achieve your personal and financial goals; and

• The required asset allocated to achieve this required return

We now explore some basic investment concepts to help you better understand the basics of investing.

Asset Allocation

Asset allocation refers to allocation of your portfolio to the different asset classes — cash, fixed interest, property, Australian shares and international shares. Your adviser will consider your risk profile among other things to determine the optimum asset allocation for you. Generally the more risk you are prepared to take will result in a greater allocation to shares and property, whilst those investors that are risk adverse will see a lower allocation to these investments.

Risk & Volatility

What does risk mean to you? This could be the risk of losing your money or the risk of not individuals. What is risky for one investor is not necessarily risky for another investor.

Volatility or risk merely refers to the shorter ups and downs in the value of an investment. Although there can be other risks associated with your investment.

Every type of investment has its own likely pattern of returns, likelihood of a negative return, expected income and growth and taxation. All investments involve some degree of risk, not just the risk of losing value, but that you will earn less than expected. Some investments such as cash deposits and term deposits show little volatility, whereas growth investments, such as shares are generally more volatile, but generally deliver superior returns over the longer term.

Saving versus Investing

Saving is generally considered a short term action, whereby you may allocate a set amount each week or pay period to a separate bank account, such as a high yielding savings account. Savings can often be discretionary, whereby the amount will vary depending on your other expenses at the time and may often be dipped into if the need arises. The income from such high yielding accounts is fully taxable at your marginal tax rate.

Investing is a more disciplined and planned approach with a conscious decision to set objectives, determine strategy and allocate resources and income accordingly to achieve these objectives. Investing is usually considered long term and typically toward retirement funding or general long term wealth creation.

The risk of outliving your money

Whilst cash and fixed interest investments are less volatile in the short term, these investments held over the longer term could deliver a lower than expected return compared to ‘more volatile’ alternatives such as shares and property. The risk here is that you will not achieve your goals. It maybe that you do not have the retirement nest egg that you thought you would have and may result in a lower level of retirement income than anticipated.

Minimising the volatility of your investments

Three golden rules to minimising the volatility of your investments are:

• Diversification;

• Investing for the longer term; and;

• Investing only in quality assets.

Diversification

Diversification is commonly associated with the phrase “don’t put all your eggs in the one basket”. For instance do not invest 100% into Australian shares, as by doing so you are totally exposed to the risk and fall entirely of the Australian share market. By adding in investments from other asset classes, such as cash, fixed interest, property and international shares, you will experience the rise and falls of a number of different markets, rather than just being exposed to the perils and risks of one market. This allows you to offset the poor performance of one market with the better performance of another market, or asset class, as asset classes generally perform differently at any given point in time.

Investing for the long term

In the whole scheme of things, volatility should have little impact on long term returns. Volatility is inherently associated with the share market in the short term. However, in the long term, volatility is less and less as you ride out the market cycle of 5 to 7 years. Returns are typically superior over the long term from those assets that are inherently more volatile in the short term.

Time in the market, not timing the market

An example of staying in the market for the long term and trying not to pick the best time to enter and leave a market is the 1987 stock market crash. Many investors sold out of the market hastily incurring a loss of around 30% virtually overnight, however, those investors that stayed with the market, adhering to their long term strategy would have generated around 11% return per year for the next ten years.

Many investors will chase last year’s best performing asset class in an attempt to beat the market. However, history suggests that this is virtually impossible. No one investment consistently outperforms all others from year to year. In fact the best performing asset can be vastly different from one year to the next. The reason for this is economic, political and international conditions change and all asset classes respond differently. This further enhances the case for diversification.

Investing in quality assets

Investing in those assets that have sound management principles and structures are less susceptible to volatility, company default and poor return resulting from internal company issues. These investments usually have reliable income streams and often recover faster from market downturns than less quality assets and may outperform given certain market conditions.

In Summary

We often need to be reminded that in periods of market volatility and southward returns we are often distracted from focussing on the long term bigger picture. Typically those investments which are likely to generate superior long term returns are more likely to be associated with higher short term volatility.