The process of investing money can be quite tricky. There are many different markets and options to choose from, which can make it quite overwhelming for most. Before a single dollar is invested it is important to know the purpose of the investment other than to “make money”.
Identify your timeframe
A good starting point is to ask yourself how long the money will be invested for. As a general rule of thumb, short time frames should look at safer, more predictable options like cash and term deposits.
They are not the most exciting but they do provide you with liquidity and easy access when you need it. For investments over longer periods (generally greater than 5 years) it may be appropriate to incorporate a level of risk into a portfolio to help enhance the return. Growth or ‘risky’ assets typically include things like shares and property, whose value is less certain the further you look forward into the future. As the term ‘risk’ implies – we hope that these assets will grow to become more valuable over time but there is no guarantee.
Therefore it is generally not recommended to use risky investments (such as shares) to save for short term goals, like that holiday to Europe in 2 years’ time. You could get a rude shock to find your investment has fallen in value when you need it. On the other hand, if your timeframe is longer, the risk of a negative return is less likely. A good example is superannuation, which cannot be touched until retirement.
Know your tolerance to risk
As part of the investment process, we always have our clients complete a risk profile questionnaire to help us determine what sort of investor they are. We often find that there is quite a difference between what people think they are and the investments that they hold. A common example is someone displaying the characteristics of a low risk taker, whilst having an investment portfolio consisting of 100% shares – often all in one company (high risk).
While there is nothing wrong with holding shares – the perception by many who hold them is that they are low risk. It is also common to see share portfolios set up by stockbrokers that have little or no regard for the client’s risk profile.
Diversify, diversify, diversify
We have all heard of the phrase “Don’t put all your eggs in one basket”. In investing terms, this means spreading your money across different asset classes, industries and markets to avoid being exposed in one area. The theory is that if one investment performs poorly another one will do better – or more specifically – choosing investments that have a low correlation with each other.
Diversification should start broadly with an allocation to growth (risky) and defensive assets before diversifying into the different asset classes (shares, property, cash and bonds). Only after the allocation to each asset class has been made should the individual investments be selected. Farmers and small business people are often plagued by the decision to invest everything back into their business or diversify into other areas outside. This is a more complex question that can be answered with the help of someone independent.