The higher the return, the higher the risk. This is an important investment principle. Managing the level of risk is what investing is all about. There is no investment without some risk, including putting money in the bank. Always check the potential risks when quoted returns are unusually high.
The variety of investment products available can be very confusing. However, it becomes easier to understand if you think of investment products under three main categories:
- income producing investments
- capital growth producing investments
- investments producing both income and capital growth.
As you read on, these categories will be explained. Despite the wide variety of investment products available, they derive from three basic types:
- interest bearing products
- shares
- property.
Keep this in mind as you read about the individual products described later in this booklet. Before you invest in a particular product, you should think about the following guidelines.
1. Decide on your investment needs
Do you want your investments to earn income or capital growth?
Be realistic in your expectations of how much income you will get from your available capital. You may need to use up some of your capital, as well as its earnings, to meet your living expenses.
Income producing investments pay you a regular income. They can:
- preserve your capital and pay only income,
- provide the return of your capital through the income, or
- provide an income but your asset value can rise and fall depending on what is happening in the investment markets.
Products that preserve your capital are considered to have lower risk because the number of dollars invested remains the same, unless you withdraw funds, but there is no potential for capital growth.
The majority of products that return your capital through the income are commonly known as income stream products (see pages 61 – 68). These are usually managed investment products and their value may increase or decrease depending on the movement in value of the underlying investments and markets. This is reflected by changes in the unit price.
There are managed investments that do not return your capital, preserving the number of units you have in the investment. Any capital growth can be converted to income by cashing in some of your units. Sometimes this can be complicated, have tax implications and incur fees. Managed investments have the potential for capital growth but they can be more volatile and may need to be held for at least five years.
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2. Invest for the right length of time
Do you need emergency money, longer-term investment money, or both?
Before you choose your investments, work out when you will need the money. If you need regular extra income to pay your bills, consider income producing investments, or combined income and growth products.
The investments you choose should depend on how long you want to invest your money. Money you need for short-term expenses and emergencies should be placed in more secure, readily accessible savings accounts.
If you are prepared to invest your money for a longer term, for example more than five years, and are prepared to accept some short-term losses in exchange for expected overall long-term gains, you may want to consider growth investments. Remember— a loss is not made on an investment until the units or shares are sold.
3. Use quality investments
Does the company—and its products—have a reliable track record?
Wise investors invest in companies with reliable reputations that have been established over time. It may be better to earn a lower return but know that your money is more secure. Investing in a less reputable company may give you a higher return, but you risk losing your money. Past performance does not predict future returns.
Most funds offer no guarantees about income or capital because they depend on market conditions. Carefully check any guarantees that are offered to see exactly what they cover. Remember—guarantees are only as good as the company providing them. Satisfy yourself that the investment is reputable by asking questions and carefully reading all the information provided.
4. Diversify or spread your investments
Are you varying your investments to reduce the risk?
Check how long it takes for your money to be returned if you decide to cash in an investment early. Find out what costs or potential losses there are. Ask if your investments have early withdrawal penalties or tax implications.
Diversification aims to reduce the risks by investing money in a range of companies or products and by ensuring it is available at different times; that is, not putting all your eggs in one basket.
You may want to spread your money with several different institutions, with various investment types and across different markets, such as cash, fixed interest, shares and property.
If you are investing in fixed interest investments, it may be wise to spread your money so that you have different maturity dates. This reduces some of the risk if interest rates change. It can also provide you with income on a more regular basis. While you should always spread your risk over several investments, having many small investments may involve a lot of supervision, and the returns may be lower. Further, investing in similar types of products with different companies may not necessarily reduce your risk.
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5. Balance the risks and returns
What level of risk are you willing to take for the returns involved?
Decide how much income you need to meet your planned lifestyle. Assess how much risk you are prepared to take. Don’t just chase the highest return.
Risk refers to the chance or possibility of loss, or not getting the return you expected. Risk levels can vary with:
- the performance of the economy
- movements in interest rates
- the expertise of those managing the company or fund
- currency exchange rate movements between countries.
Many investors who have been attracted by promises of high returns have lost money by not carefully assessing the risk. Investing safely means not investing in a product just because everyone else is. When the interest rate being offered is unusually high, always check the risks involved. If a return looks too good to be true, it probably is.
You should consider not only the risk of losing some or all of your money, but also the risk of not getting the returns you expected. To minimise your risks in these areas, your best investment may be more secure accounts such as savings accounts and term deposits.
If you have already retired you may not be able to replace any losses. Therefore you may prefer to settle for a lower, but steadier, return rather than to risk your life savings on an expectation of greater returns. If you are a younger investor, you should consider growth on your investments. Remember—growth means some level of risk.
6. Manage your debts
How much debt can you afford?
If you have loans or credit cards, make sure you can afford them and control your spending on them. If you are retired or about to retire, think carefully about taking on debt. When you are no longer working, debts can be much harder to repay. Pay off all your loans if you can. Exceptions to this rule may include loans with low interest rates such as Defence Service Home Loans.
If you are retired and get a social security or Veterans’ Affairs pension, you may find it difficult to get loans from financial institutions. You may consider keeping credit cards and loan facilities open to cover emergencies, although controlling how much you spend on them is important.
Home Equity Conversion loans are different from other types of loans in that the loan repayments can be deferred—they can be paid from your estate. (See ‘Your home as an asset’).
7. Take advantage of compounding earnings
How does compound interest work?
Interest earned on most investments can either be paid to you to spend, or it can be reinvested. When you reinvest the interest earned, that interest earns more interest. This is called compound interest.
Compounding interest helps your investments grow faster. Reinvestment of share dividends or distributions from managed investments compounds the number of shares or units held.
If you compound the interest, tax is still assessable on the interest earned each year. Depending on your circumstances, you may need to set aside money to pay the tax.
Leaving your money in a superannuation fund until your final retirement, or contributing more money earlier in life, is a very effective way to compound returns.
Comparing the effect of compounding
Say you invest $10 000 in an interest bearing account for 10 years and earn 5 per cent interest per year.
- With no compounding: at the end of 10 years you would still have your original $10 000. You would have earned $5 000 in interest, giving you $500 each year to spend.
- With compounding: at the end of 10 years your original $10 000 would have grown to $16 289. You would have earned $6 289 in interest, although this would not have allowed any spending money. By compounding your money, this investment would have earned you an extra $1 289 over 10 years.