The term ‘investing’ is to apply or use money with the intention of obtaining income or profit. Too often investing is confused with speculation. Speculation refers to buying and selling stocks and other assets to take advantage of short term fluctuations in prices to make profits. Speculation is subject to a high degree of uncertainty and risk, that is, taking a gamble to buy low and sell high (but how high is high enough and what if the price drops instead of rising?).
Not all investments are created equal. To understand investments and to subsequently make good investment decisions that meet your needs, it is important to understand these key concepts:
- Income versus growth investments – understanding the type of return each asset class is likely to deliver will help you match your investments with your investment income goals.
- Asset classes – understanding the investment return and risk profile of each asset class will help you match your investments with your investment time horizon.
- Variability in returns (volatility) – an investment concept worthy of consideration when determining your investment strategy.
- Diversification (not placing all of your eggs in the one basket), can reduce volatility and while potentially increasing returns
One of the primary issues to consider is the timeframe of investing, that is, the length of time to hold various classes of assets to obtain the benefit of investing. Investment timeframes are generally described as short term (1-3 years), medium term (3-5 years), and long term (5-7 + years).
Generally, it is recommended to hold cash and fixed interest type investments over the short term, property over the medium term and shares over the long term, due to the varying degrees of volatility (variability in returns) associated with these investments.
As investors are typically risk averse, they will require a higher rate of return before accepting a higher degree of risk; this is referred to as the ‘risk premium’. Accordingly, as potential risk increases, so too does expected return. This relationship is known as the risk/return trade-off.
Portfolio construction is the art of blending investments in various asset classes to produce a return commensurate with the risk/return trade-off the investor is willing to accept. A well-structured portfolio with quality assets will produce the greatest amount of return while taking on the least amount of risk. Diversification within a portfolio helps reduce variability in returns (volatility) and can reduce risk. Asset allocation (diversification), investment timeframe, volatility and risk/return are important considerations in any portfolio’s construction. Sources of diversification within a portfolio can be varied and there is no shortage of investments to choose from – the key is to know the good from the bad.
A Balanced portfolio can adopt the following asset allocation:
||Strategic Asset Allocation %
||Lower SAA %
||Higher SAA %
|Australian Fixed Interest
|International Fixed Interest
|International Listed Property
Investing today is truly a global activity. The internationalisation of investments has forged a global marketplace where the economies of the world increasingly interact with and influence each other. The table above shows the potential benefits that diversification into overseas markets can produce.
The emergence of a global economy has made international investment accessible to all investors and given them the ability to further diversify their portfolio. A properly diversified portfolio now includes different countries as well as different asset classes.
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