Whether it’s taking a more active interest in our superannuation, starting to build an investment portfolio, or even trying our hands at playing the stock market, we can all benefit by understanding the language and key concepts of investing. Here’s a quick introduction.
There is a huge range of potential investments out there, and these can be grouped together in asset classes that are based on shared characteristics. There are many asset classes, however the major ones that most mainstream investors focus on are shares (or equities), property, fixed interest and cash.
Fixed interest can be high or low risk. At one end of the spectrum are so-called junk bonds, which may offer a high interest rate, but come with a high likelihood that they won’t be repaid. At the other extreme are bonds issued by large and stable governments. These bonds have such a high likelihood that they will deliver the exact return expected by an investor that they are considered, for practical purposes, to be risk-free.
One of the golden rules of investment is that when seeking higher returns, investors must take on a greater degree of risk. As it relates to investment, risk can be thought of as volatility or uncertainty. Quality fixed interest investments provide a high certainty of a particular return. They are low risk, and the returns they offer reflect this. However, for any given share, we don’t know what its price will be in a week, a month or a year. Prices may be volatile, the return is uncertain, so a share is a higher risk investment. However, that risk can be a positive thing – upside risk – which is the potential for the share to generate a higher than expected return.
Asset classes bundle together investments with similar risk and return profiles. By blending these asset classes together in different proportions – a process called asset allocation – investors can construct portfolios that provide levels of risk and return that suit specific needs. Typically, a retiree may want a portfolio that minimises their risk and provides more stable returns. A 30 year old with an investment time horizon of decades may be happy to take more risk, in the knowledge that, over the long term, growth assets (shares and property) have delivered the highest returns.
This blending of different asset classes results in diversification, which is a critical risk management tool. As different asset classes over and under perform at different times, mixing different asset classes lowers the volatility, and hence the risk, of a portfolio.
As far as returns are concerned, studies have shown that over 90% of a portfolio’s performance is determined by the asset allocation. It’s vastly more important than individual investment selection or the timing of purchases and sales.
There are many different indices that track the performance of each asset class and its subclasses. The Australian All Ordinaries Index, for example, follows the fortunes of Australia’s 500 largest companies. The Australian Fixed Income Index Series tracks the performance of higher quality Australian bonds.
Given the importance of asset allocation and the difficulty of picking winning and losing shares or other assets, many investors are content to accept the performance delivered by each asset class. An easy way to achieve this is to invest in index funds. With a small number of these funds, it’s possible to deliver diversification both across and within asset classes, along with any desired asset allocation.
Of course, there’s more to investing than can be conveyed in a short article, but that’s no reason to delay putting the various markets to work. Your licensed financial adviser can help you understand your risk comfort level, and design an investment strategy that’s right for you.
The advice in this newsletter is general in nature and does not take into account your own financial objectives, circumstances or needs. You should consider your own personal situation and requirements before making any decisions. If you have any concerns or questions, please contact us.
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