By Leigh Köhler, 25 July 2014
We often do not know whether we have planned sufficiently and set enough aside to offer us peace of mind. My major life event was the recent birth of my first child - saving and investing suddenly became very real to me again. Thoughts of school fees, university fees, and her wedding day, all raced around in mind. I need to secure her future and ensure that she is taken care of. This article looks at the basics of investing, to remind me (and all of us) of the importance of preparing for life’s major events.
The first thing to realise is that saving is different from investing. Saving for a new car is very different from investing to achieve a long-term goal, like retirement. Saving involves putting money aside, typically into a money market fund, fixed deposit account or even just your bank account. Saving is therefore relatively safe, with neither the risk of making a substantial loss nor opportunity of making a large profit. Savings accounts and other low risk options are a great choice for an emergency fund and short-term goals. However, they are not the best choice for goals with a longer timeframe. That is because the return they provide is relatively low, usually less than the rate of inflation. If the return is less than the rate of inflation, it essentially means you are losing money over time. Today we are faced with interest rates that are lower than inflation; therefore saving your money by putting it under your mattress, into your bank account, or money market fund will more than likely result in negative real returns – so generally, impressive returns are probably not likely through saving.
Investing, on the other hand, can help you to not only create wealth, but preserve wealth as well. By taking an appropriate level of risk you may have the opportunity to earn potentially higher long-term returns. Investing is simply the act of putting your money in a financial vehicle with the goal of making a return, so you are basically making your money work for you. Successful investing requires both commitment and a plan.
When you start a journey, you usually know at least two things - where you’re starting from and where you want to go to. Most of us use a GPS device or perhaps even a roadmap to help us get to our destination and there is absolutely no difference when it comes to investing. Therefore the second thing to remember is that you should work with a financial roadmap and devise a financial plan. Working with a qualified and trusted financial adviser is critical when it comes to planning your financial affairs and particularly when it comes to investing. There is no guarantee that you’ll make money from your investments. But if you and your intermediary develop a plan based on your individual needs and risk profile and follow through with it, you should be able to gain financial security over the years and enjoy the benefits of managing your money.
To be successful at most things in life, planning and discipline are key, and investing is no different. You'll first need to determine your current financial position - how much do you owe and how much money do you have to invest? It is important to live within your means and decide how much you will set aside for investing before you start to develop your plan.
Then list your goals. Do you want a car, a university education for your children, or a comfortable retirement? Once you know what you want, when you want it, and how much it costs, you and your adviser can figure out how much you’ll need to save and/or invest. Once you have a plan, you have to be disciplined when it comes to the implementation stage. To be disciplined, basically means to keep market movements in perspective, recognising the potential impact of risk and sticking to your plan by regularly reviewing your portfolio.
The next thing you need to know is how long you want to invest. Your investment time-frame provides a framework for deciding which investments to choose. Generally the longer your investment time frame is, the more you should be exposed to riskier assets like property and equities. People have different goals at different stages of their lives. For example, if you are retired, you may simply want to maximise the amount of income you receive. Whatever your goals and your time-frame for investing, it is important to remember that markets go up and down – because that’s what they do - and sometimes a market downturn can last for months or more. But over the years, investors who adopt a long-term approach to investing tend to come out ahead of those who try to time the market. Whatever your financial goals may be, one of the best ways for you to reach them is to invest over a long period of time. That’s because the effects of compounding the returns you receive from your investments over time can be significant. In fact, compounding is considered as one of the main drivers of long-term investment returns. Compounding happens as you re-invest your returns, then re-invest the returns on those returns.
You should be thinking about whether you are investing for the purposes of income or growth. Investments are generally divided into income assets and growth assets. One of the key investment decisions you need to make during the planning stage is whether you require income, growth or a bit of both from your investments.
Growth assets – predominantly equity and property (although property has elements of both growth and income) - are designed to provide most of their returns in the form of capital growth over time. Over the longer term, these assets can help to protect against inflation. Therefore, investors with a longer investment time-frame tend to invest in a higher proportion of growth assets. Growth assets tend to have more volatile returns over the shorter term, but they have the potential to produce higher returns over the longer term.
Income assets on the other hand provide returns in the form of income and include cash, bonds, property and certain equities. Income assets tend to provide more stable, but often lower returns relative to growth assets. If your primary need is for income you may benefit from holding a higher proportion of income assets.
How much risk are you willing to take? Your ability to take on risk is key to finding out what works for you. When investing, the higher the potential return, the higher the risk. There’s no such thing as a high return, risk-free investment. If you want higher returns, you have to be prepared to accept the risks that go along with them. Your tolerance for risk may depend on what is more important to you - keeping your money safe or seeking higher growth – and when you need the money.
One of the ways to define risk is the likelihood that an investment’s actual return will differ from expectations. A number of specific risks can affect your investments. As part of developing your investment plan you should understand the potential risks.
One of the cornerstones of investing is diversification. With a diversified portfolio of investments, returns from better performing investments can help offset those that underperform. Diversification alone does not ensure you will make a profit, nor protect you fully against losses in a declining market. But it can reduce the risk of experiencing a serious loss of wealth as the result of being over-committed to a single investment.
Spreading your portfolio across a range of investments is one of the best ways to reduce risk and protect against sudden falls in any particular market, sector or asset class. Diversification helps you to spread your potential risk by investing in a mix of investments. That way, when some of your investments are under-performing, other investments can carry the load and help to even out the ups and downs in your portfolio.
Major life events are usually catalysts for action and often lead us to focus on our physical, mental, spiritual or financial health. My major life event led me to focus on my financial affairs. Some may argue that being in control of this part of your life often helps you achieve balance in the rest of your life. But whatever the personal impact may be, the importance of investing cannot be ignored. It can be complicated, but there are simple truths that form the foundation of getting it right. Understanding the difference between saving and investing; working with a financial roadmap and devising a financial plan; defining your investment time-frame and investing for the long term; knowing whether you want income or growth or both; understanding the risks; and diversifying your investment - are basic, yet crucial considerations when it comes to investing. So be more conscientious about your financial affairs, take some time out to chat with your financial adviser, and invest appropriately (and invest enough), so that when you are confronted by a major life event, you are fully prepared for it.