Understanding Investments

Understanding investments

A shrewd investor takes the time to appreciate some basic investment principles, develops an understanding of their risk tolerance, and puts in place a plan to achieve their desired goals and outcomes.

There are some tried and tested principles that can be applied to any financial plan. Following these basic principles can vastly improve your chances of achieving financial security even through tough times.

Understanding how investment markets can fluctuate, and being prepared for when share markets take an unexpected downturn, can take patience and a strong resolve. Investors need to keep in mind that historically these unexpected downturns are typically followed by a period of growth that sees investment values return to higher levels over time.

The key element to any investment decision is understanding your appetite around the risks associated with investing, and your tolerance to weather short-term losses, weighed against likely long-term gains.

What is investment risk?

All investments contain an element of risk and it is important for investors to have an understanding and awareness of the risks associated with any investment they may hold or that is being recommended. Past investment results are not necessarily an indication of future performance.

When assessing investment risk we simply define investment risk as;

Over any given period; the probability or likelihood of an investment achieving a lower return then what was expected. Investment risk includes the possibility of losing some or all of the original investment capital.

The trade-off for taking a riskier position is the possible opportunity for a higher return; hence the phrase; “the greater the risk, the higher the potential return should be to compensate the investor for the risk”, however taking higher risks does not always translate into higher returns and investors need to understand that there is no guarantee of this higher return.

Risk to some may mean the possibility of losing a portion of their capital, while for others it may mean the possibility that their investment doesn’t generate sufficient income for them to live on.

Risk vs Return chartInvestors also need to understand the difference between their ‘appetite’ for risk, and their ‘capacity’ for risk. Investors with only a short investment time horizon, such as those contemplating retirement, may not have the capacity to sustain losses from which they are unable to recover in the limited time available before leaving the workforce. Any assessment of risk appetite should be in the context of your objectives and the timeframe in which you wish to achieve your objectives.

An integral part of the ongoing management of investment risk is to have your financial adviser review your risk profile and current situation to assist in making investment decisions. Risk is often referred to as “your ability to sleep at night” – particularly in times of uncertain markets.

To help you get started in understanding a little more about investing we’ve outlined below some key elements to consider when investing.

About Asset Classes

When developing an investment strategy investors will often include assets from a variety of asset classes. An ‘asset class’ is a specific category of investments, such as cash, fixed interest, property, alternative investments and shares.

These investments fall into two broad asset classes – growth and defensive. Investments with little or no growth component but an income component are generally termed defensive assets and those that offer the potential for both income and an increase in capital value are regarded as growth assets.

Growth Assets

Growth assets provide investors with the potential for the longer term capital growth, but have a higher level of risk over defensive assets, especially over short periods. Portfolios with a strong weighting towards growth assets are focused on achieving increased capital growth over the longer term and are used by investors able to accept the increased risk and volatility over the short to medium term. It is because of this volatility that this type of asset is regarded as being of a higher risk.

These types of investments are utilised by investors with longer term investment objectives seeking the opportunity for higher returns over the longer term.

Growth assets have historically experienced periods of great out-performance tempered by periods of underperformance (capital losses). Nonetheless they are regarded as a key driver for long-term capital growth and traditionally have some level of exposure in even the most conservative portfolios.

Growth assets include investments such as Australian shares, international shares and property.

Defensive Assets

Generally defensive assets offer investors a much lower level of risk, but at lower levels of return. Unlike growth assets, defensive assets are focused on regular, often consistent, income with little or no exposure to growth.

These types of investments are suited towards clients with low tolerance to risk or with short-term financial objectives.

Defensive assets include cash, and cash-based products such as fixed interest investments.

Liquidity

A further consideration when developing any investment portfolio is the issue of liquidity. The liquidity of an investment is simply the ability for the investor to readily convert the investments into cash should they ever need to. The more liquid an investment is, the quicker and easier it is to convert to cash. Liquidity also plays an important role in allowing you to take advantage of any new immediate opportunities.

Each asset class, and the underlying investments within each class, will offer different levels of liquidity. Investors need to understand the ramifications of locking large sums of money away for long periods of time. Investments such as bonds, and term deposits, while less volatile, may see the investor locking their money away for at least 2 to 3 years and as long as thirty. Should the need arise to take back these investments before the term has completed, we may see the investor lose some or all of the promised returns as a result of ensuing market changes or penalty clauses.

Diversification

For investors, diversification traditionally means reducing risk by investing in a variety of assets. Asset values do not normally move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its component assets.

Therefore, any risk-averse investor should diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors. Diversification can also be used to increase investment performance; this would be true for instance in the case where an investor is only holding cash based investments. For diversified portfolios there is also an element of active management required.

Diversification is a primary technique for reducing investment risk.

So which assets are right for you?

Every investor is different, and the answer will vary depending on your financial goals, current and future needs, and appetite and capacity for risk verses return. It can also be influenced by other more personal variables. Whether we like it or not many investment decisions have been heavily influenced by emotional needs weighed against traditional investment principles.

To explore your own appetite and capacity for risk, weighed against your current and future financial needs, speak with a Lifespan financial adviser.