Investment Basics

If you’re just starting out as an investor, there’s a lot of information to understand. Christian has put together this article which covers the fundamentals, such as the different asset classes, risk and return, compounding and diversification

Understanding the different asset classes

Most investments fit into one of four main categories or ‘asset classes’:
These four asset classes can be separated into two broad groups.

Defensive investments

Cash and fixed interest are generally classified as defensive investments. Defensive investments aim to provide regular income and returns are generally stable. In return for this decreased volatility, defensive investments do not usually grow in capital value and returns are generally lower than growth investments over the medium to long term.

Growth investments
Property and shares are usually classified as growth investments. Growth investments can provide income as well as an increase in capital value. While returns may fluctuate over the short term, growth investments have the potential to produce higher returns than defensive investments over the medium to long term.

Risk vs return

All investments provide a certain level of return and are subject to a certain level of risk. This means that as well as making money on your investments, there’s also the chance you could lose money or not make as much as you expected. All investments carry some risk – due to factors such as inflation, taxation, an economic downturn or a drop in a particular market. As a general rule, the larger the potential investment return, the higher the investment risk and the longer you need to remain invested to reduce that risk. The amount of risk involved with an investment can be managed by matching it appropriately with the length of time you have available to invest and your tolerance towards fluctuations in returns.

Diversification
Another way of managing investment risk is through diversification. This is the strategy of investing your money across a range of different investments to reduce risk. The exact mix of investments you choose will depend on:
Diversification is important because every type of investment has its ups and downs. Owning a diverse range of investments should help you achieve smoother, more consistent investment returns.

The more ways you diversify, the more you can reduce your risk. For example, you can invest:
The power of compounding
Compounding is often described as ‘earning interest on your interest’. Each time you earn a dividend, distribution or income payment from your investment, you reinvest it to buy more units or shares. In turn, these reinvested earnings generate additional earnings. Compounding can make a huge difference to the value of your investment over time. To take full advantage of the effect of compounding, think about starting early and leaving your money invested for as long as possible.

Dollar cost averaging
By implementing a regular investment plan you will be able to take advantage of ‘dollar cost averaging’. When you invest a set amount at regular intervals, sometimes you will purchase units or shares at a higher price, and sometimes at a lower price. Over time, this spreads out your costs and insulates you against changes in the value of the assets you are purchasing.

Think in years, not days
When markets unexpectedly fall in value, some investors are tempted to sell up and buy back in later. Initially this may seem a sensible approach, but on closer examination it can be a risky strategy. As the chart shows, if you had mistimed movements in the Australian sharemarket and weren’t invested in the 10 best Performing days over the 10 year period to 31 December 2010, your average annual return would have slipped from 8.66% pa to 3.87% pa. If you had just missed the best 20 days, your return would have slumped to just 0.2% pa. Missing the best 30 days in that period would have delivered a negative return of minus 2.75%. This highlights the risk of moving in and out of the market hoping to take advantage of short term fluctuations. A less risky strategy would be to focus on your long term investment goals and consider staying fully invested. Remember, it’s time in the market, not timing the market that determines your wealth.