This is for general information only, and should not be taken
as a recommendation. We recommend you seek professional advice
before making an investment decision.
Introduction
Most people want a comfortable lifestyle now and in retirement and realise that they will need some investments to generate an income to live on in the future. There are many other reasons why investors choose to save or build an investment portfolio, and part of the process of becoming an investor is understanding the basic principles of investment.
Investors need to consider why they are investing, taking into account some, or perhaps all, of the following issues:
- Whether to invest for income or growth
- The risk involved
- The investment time frame
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Investing for Growth
In 1970 a loaf of bread cost $0.21. In 2000 the same loaf of bread cost $2.36. This increase in price is called inflation. Inflation erodes the purchasing power of money over time, and is measured in Australia by the Consumer Price Index (CPI).
Investments
in growth assets help protect the capital value of investments
relative to inflation. Shares are a good example of an asset
that produces both income and growth. Return
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Investing for Income
Many people not only invest to protect the capital value of their investments but also to provide an income stream. Many retirees and other investors will have a lump sum from which they will require a regular income stream. In the past many investors have used cash and fixed interest to achieve this result. However these types of asset classes do not protect the capital value of the investment against inflation.
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Investment Risk
Any investment decision you make will involve some kind of risk. The important point is that you understand the relationship between risk and reward so that you can decide the level of risk you are comfortable with.
Generally the higher amount of risk you are willing to take the higher the potential returns and at the same time the higher potential for losses. Understanding that all investments have risk is not the same as accepting risk. That's why it's important that you understand risk and how to manage it effectively so that your investments can achieve what you want.
The key to managing risk is diversification. This involves spreading your assets across the various investment classes. The term asset allocation refers to the spread of your investments assets across these investment classes namely:
- short term cash deposits
- medium to long term fixed interest investments
- property investments
- share investments
Your asset allocation decision will also largely determine the level of risk associated with your investments and determining the appropriate asset allocation is vital in ensuring your investments meet your risk and return requirements.
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Types of Investments
There are four different investment areas which are detailed below:
Cash
Cash means money placed in a bank account or the short term money market. This is the safest of the four asset classes but is expected to return the least over the long term.
Fixed Interest
Fixed Interest investments are primarily loans to Governments or companies that guarantee the repayment of a fixed amount of money. They are known as bonds (Government, Semi-Government or Corporate), Debentures, or fixed interest securities and can be bought and sold before maturity. Over the long term, fixed interest investments are expected to return more than cash but not as much as shares and property, and because they can be bought and sold, the capital value can fluctuate depending on interest rates at the time the investment is bought or sold.
Property
Property includes residential housing, offices, shopping centres and industrial buildings. Property has elements of growth and income (in the form of rent). This type asset has a higher level of risk than cash or fixed interest, as property values can rise or fall depending on market conditions and interest rates.
Shares
Shares are literally portions of a company that are bought in the marketplace. This means that if you buy some shares, you effectively own part of a company. Share prices can increase or decrease depending on the supply and demand on the market and the outlook for the company.
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Managing Risk
The key to managing risk is diversification. 'Diversification' means spreading your money across a range of investments and it's one of the best ways to reduce volatility and take some of the risk out of investing.
Diversfying
across various asset types allow the high returns from some
asset classes to offset low returns from other asset classes
that may not be performing as well. Diversification can also
reduce the overall risk of a portfolio and maintain the consistency
of the returns.
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Dollar Cost Averaging
"Buy low, sell high" may seem like good advice, but even experienced investors find it impossible to pick when the market will go up or down. Dollar Cost Averaging is an investment technique where a fixed amount of money is invested at regular intervals, usually monthly.
By
investing a set amount on a regular basis regardless of the
share price and market conditions, you buy more shares when
the price is down and fewer shares when the price is high. Therefore
the average price you pay per share can be lower than the average
market price as detailed.
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Borrowing to Invest
Gearing is the term used for borrowing funds for investment. Not only can gearing increase your wealth over the long term but the interest paid may be tax deductible. Gearing carries with it a high level of investment risk, as the more you invest the more you can gain or lose. We believe that gearing suits those with the following investment credentials:
- Those with a secure income
- An investor with a long term investment time frame
- An investor that understands that gearing carries additional
risk
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