Investments
Investment Fundamentals
One of the most basic principles of investment but often the most overlooked is that past performance is no indication of future performance. Yesterday’s stars are not necessarily tomorrow’s.
Another investment principle is risk. Every type of investment involves an element of risk. The level of risk dictates the level of return you are likely to achieve over the long term.
What is Risk?
The risk element of any investment refers to the possibility that you might not get back the amount you originally invested. In other words, the greater the risk, the more you stand to gain or lose.
As a general rule, investments with the highest potential returns also carry the highest risk factor. Before investing in any funds, investors are advised to carefully consider what level of risk they are willing to accept.
Managing Risk Through Diversification
What is the optimal way to balance the negativity of risk with the reward of return? The answer is, Diversification.
Diversification simply means that you do not put all of your eggs in one basket. The major benefit of diversifying a portfolio is the potential to increase returns over the long term, by minimising risk and reducing the negative effects of market volatility. Investing globally and spreading risk across a variety of investments are sound diversification strategies. Both can play a part in helping to realise long term financial goals without taking undue risks.
Investing versus Speculation
What is the difference between an investment strategy that is primarily investing and one that is primarily speculating (or perhaps even gambling)?
If you constantly move your money around from investment to investment, trying to time the market in the hope to buy low and sell high, then the only way you will succeed over the long term is by being lucky. This is speculating.
If you leave your money in fixed income investments and hope you will have enough to last you for twenty years after the day that you retire, the only way it will happen is if you get lucky and inflation stops completely on the day that you retire. You are also speculating.
If you have a financial plan that includes a diversified portfolio of both growth and defensive investments, if you realise that shares in particular rise and fall in value but, over the long haul, have demonstrated an ability to earn superior returns compared to bank accounts or government securities, and if you can stay with your plan through fluctuations in market value when your stomach is screaming ‘sell!’, then, congratulations, you are investing
Types of Investments
When diversifying across asset classes you are able to spread your funds to take advantage of capital growth, liquidity and fluctuating markets.
There are two primary methods of investing into these asset sectors - direct or through managed funds.
When diversifying across asset classes you are able to spread your funds to take advantage of capital growth, liquidity and fluctuating markets. This section gives you a brief overview of the four major asset sectors – cash, fixed interest, shares and property – each of which has a different risk profile.
Cash
This covers on-call deposits with banks, building societies and credit unions, or overnight money market investments. These are usually described as liquid assets, meaning that they can be converted to actual cash very quickly.
Pros:
- The capital is safe relative to other asset sectors.
- You have immediate access to your funds.
Cons:
- There is no protection from inflation.
- The returns are highly variable.
- Low returns are expected in the long term.
- Returns are fully taxable
What is Super?
Superannuation is a form of long term savings for retirement. Compulsory and voluntary contributions are made to superannuation funds that provide a concessionally taxed environment within which assets may be accumulated. The tax concessions exist because superannuation is a key part of the Federal Government’s plan to reduce the dependence on the Age Pension.
Types of Funds
Employer fund
A superannuation fund established by an employer for the benefit of the company’s employees.
Industry fund
a superannuation fund to which employers in the same industry (or group of industries) contribute for their employees.
Institutional fund – a superannuation fund offered by providers such as life insurance companies, fund managers and banks, which enables individuals and companies to make contributions to superannuation. For example, Master Trusts and Wrap Accounts.
Self Managed Superannuation Fund (SMSF)
A superannuation fund that has fewer than five members and meets specific requirements. The members are also the trustees of the fund and they have significant responsibilities imposed on them by legislation. Self managed superannuation funds are designed for people who require more control over investment decisions, wish to hold direct investments in superannuation or are seeking a solution to an estate planning issue.
Retirement Income
At retirement superannuation funds may be paid out as a lump sum or an income stream such as a regular pension or annuity. Among the wide range of income streams available are:
Allocated Pensions
An allocated pension is simply an income stream paid regularly from an investment account in the pension recipient’s name. The annual pension level is selected by the pension recipient from a range set by Government regulations. Funds invested in an allocated pension grow tax free and lump sums can be withdrawn at any time to meet capital expenditure requirements. A portion of the regular pension payments may be tax free for the recipient and the portion that is assessable income may be eligible for a 15% tax rebate. Pension payments are made until all of the capital in the account is used up.
Complying Annuities and Pensions
A complying annuity or pension is a guaranteed income stream that complies with certain government standards and is therefore assessed against the higher Pension Reasonable Benefit Limit (RBL). The complying annuity or pension can be payable for life or for a fixed term which is the lesser of 15 years and the recipient’s life expectancy. Once purchased, access to the capital is foregone in exchange for guaranteed income payments and at the end of the term there is no lump sum capital payable.
Immediate Annuities
An immediate annuity is a fixed interest investment that makes income payments monthly, quarterly, half-yearly or yearly over an agreed period.
Glossary
APRA
The Australian Prudential Regulation Authority is a Federal Government agency, which regulates superannuation funds and other bodies in the financial sector, ensuring they operate within the requirements of retirement income legislation.
ASX
The Australian Stock Exchange
BRIC
BRIC is an acronym which refers to the four key emerging economies: Brazil, Russia, India and China.
EPS
Earnings per share
Futures
Contracts that require the delivery of a commodity [of a specified quality and quantity] at a specified price, on a specified future date. Commodity futures are traded on a commodity exchange and are used for both speculation and hedging
Decoupling Theory
The notion that the US is no longer the driver of world economic growth and that Europe and Asia have ‘decoupled’ from the American economic engine.
Deep Value
Deep value investors employ a more extreme version of value investing that is characterised by holding the stocks of companies with extremely low valuation measures. Often these companies are particularly out-of-favour or in industries that are out-of-favour.
Long-Short
A model that can hold both long and short positions [negative positions on the basis the stock will fall in price].
MSCI
Morgan Stanley Capital International: the MSCI provides a number of international tracking indices used for assessing International equity performances.
NAV
Net Asset Value: The valuation of a collective investment based on the market price of securities held in its portfolio
Short Squeeze
When traders, who are short a particular commodity or stock, are forced to simultaneously buy the investment back leading to a sudden jump in the price as demand overpowers supply.
Quantitative Analysis
Quantitative analysis is a form of analysis which uses numbers and ratios derived from a company's financials to assess its prospects.
