Learn the basics about how to best invest your money to grow wealth and get your money working for you.
So you want to learn about investing, you’ve come to the right place. This article will introduce you to investing. There is no way it can teach you everything, but what it will do is run you through the basics. Then after that, you will know what you need to look into more. After all, you can’t know what you don’t know. It is all about expanding your knowledge sphere. The size of the sphere is the number of things you know, and the surface of the share is the number of things you know you don’t know much about. Let’s expand your knowledge sphere.
Investing is a way for most people to make some money outside of the normal job. Most people earn money by working- trading their limited amount of time for dollars. Investing allows you to make your money work for you- even when you are sleeping. That is what investing is about.
Investing can help you achieve financial independence over the long term. So it makes sense to learn about it.
An Introduction to Investing
Right off the bat, one of the best known tips for growing a successful long-term investment portfolio is to diversify. Diversification is simply the common saying don’t put all your eggs in one basket. And the reason for this is that if you drop the basket, you break all the eggs. But if you have many baskets with one egg, and you drop that one basket, you only break one egg.
Here are two main reasons you want to diversify your investments;
- Protecting your investment capital, and,
- Ensuring you are able to minimize your risk and maximize your returns
Spreading your investments over different investment vehicles and asset classes makes it more likely that you won’t lose all your investments in one single market turn down. Take the 1985 stock market in NZ. It would have tempted to put all your money into the stock market, after all, the returns were nearly hitting 80% per year.
Those who did invest their money in the stock market in 1985 would have lost a large chunk of their capital in the stock crash of 1986. Where the stock market crashed by 40%. Some lost most of their investments in a single week.
There are man horror stories of people who have had a similar situation. Investing in one assets class, cryptocurrency comes to mind now, can leave you exposed to a large risk of market collapse. And in an unfortunate situation, you may lose a large proportion of your investment.
You may think that you have investments diversity, but you might want to think again. Many people have much of their wealth invested in their homes, which leaves them exposed to market crashes such as the 2008 mortgage crises.
Remember though, diversification doesn’t mean that you won’t experience decreases in the capital. Rather it means that your portfolio can handle it and that you can ride out drops in the market if you choose. If you get caught in a market crash, selling is sometimes the worst things to do as now your loss has been realized. Up until the time you sell the loss in the capital is just on paper.
An Introduction to Risk
Risk can be measured by how volatile an investment is. The volatility of an investment is a measure of how quickly the returns on your investments can change. The more quickly the returns on an asset can change, the riskier it is.
Risk is also linked to timing. If you need to precisely time an investment, it is generally riskier. But if the timing has no real effect on whether or not your investment will produce good returns then the investment is generally less risky.
So let’s take a look at an investment. Say you want to invest $1000 of your hard-earned money into a term deposit with one of the big four Australian banks. You want to invest for 3 to 6 months. The general return now is around 2-3%. These rates don’t change fast, so timing isn’t too important. And the big banks being large institutions you are very likely to get your $1000 back, with the interest payments.
There is a little risk with term deposits, both with losing the value of your capital or having to time when you invest.
On the other hand, let’s say you want to invest $1000 into Genesis Energy shares for 3 to 6 months. There is no way of knowing what your returns will be upfront. So you don’t know how much you will receive back when you go to sell your shares. It could be anywhere between $800 to $1200. No one can tell you for certain how much it will be. So there is a risk in the return on your investment. Secondly, in any given day the share price can go up or down as much as several percent. Then again, it could take years to increase by several percent. So timing is much more important.
There is a greater risk with investing in shares, both with losing the value of your capital, and timing has a greater effect.
The primary goal of any investment portfolio is to diversify and maximize your returns while at the same time minimizing your risk. Two risks that are not often taken into account is inflation risk and the risk of investing itself.
1. Inflation risk
Many investors can understand the concept of inflation risk. Inflation is the rate at which prices of things increases. Have you noticed that over the years the price of petrol or grocery has become more expensive. This is inflation. The buying power of your money is falling, so you need more money to buy the same things.
You need the assets in your portfolio to grow faster than inflation. Otherwise, in real terms, the value of your money won’t be growing, and in rare cases can actually decrease in value. That is not to say that the monetary figure of your portfolio does not increase, rather than the buying power of your money isn’t increasing.
While inflation is minimal today at around 1-2%, there have been periods in our history where it has been much higher. We are currently experiencing a relatively low level of inflation. And we won’t know what inflation will look like in five to ten years time.
The second risk that is not often talked about is the risk of investing itself.
2. Investing Risk
Yes, investing is a risk. Let me explain. Your goal is to maximize your return and minimize your risk. The concept of investment risk is when you miss out on the chance to maximize your return by investing in a certain high return investment because you have already invested your money in another asset which maybe performing worse.
When you invest you are generally locking in you money for a period of time in a given investment vehicle. And changing between can incur some fees or transaction costs, such as real estate fees when selling an investment property.
A well-diversified portfolio will help you against investment risk. At any given time one of the main investment classes, shares, property, bonds and cash, will be performing superiority compare to the others. Therefore to decrease investment risk you should make sure that you have stakes in all three of these investment classes.
Keep in mind, that while you need to spend time determining the right share, or property to invest in, it is consistently shown that it is the diversification over asset class in which you are invested in that protects you from investment risk.
No matter how many stocks you have invested in, if the stock market crashes all your stocks are likely to fall in value, but that would not necessarily mean a fall in the housing market.
3. Timing risk
Timing risk is the risk that you buy an investment at the right time, or worse the wrong time. Timing is important for certain investment classes, and less so for others. The risk comes from buying at the wrong time. It might be buying before a market turn. But it can also be selling at the wrong time. For instance, you might decide to sell an asset because the value has declined for several months. Only to find out later that if you had held, the value would have gone up again.
For shares and index funds the risk of timing can be minimized by the use of dollar-cost averaging. More about that later.
What about Investing Overseas? Let’s face it, New Zealand is a small country not small in size but small in population. There are many cities around the world with more people than the entire New Zealand population, London, New York, and Tokyo. This leads me to another risk that needs to be talked about, which is an economic risk.
4. Economic Risk
Economic risk is the risk which comes from investing all your money in one economy. Even if your investment portfolio is well-diversified over different investment classes, if they are all in the same economy you will still be exposed to economic risk.
Taking about economic risk a step further, we are all exposed already to economic risk. Even if we don’t invest. That is because we are tied to the New Zealand economy through our salary and wages, as well as inflation. Our own success is tied to New Zealand’s success.
Let’s explore some of the economic risks New Zealand faces. New Zealand has several disadvantages compared to other countries economy.
- We are geographically isolated and often left off the map.
- We have a small population base.
- Our economy is highly dependent on primary industry, such as farming and forestry.
- And in the future, our ageing population will have a large burden on our government
So if you are investing for the long term, for longer than 5 years, then investing overseas should be considered. This will help diversify your investment portfolio to another level.
This is not to say that there is an economy without risk. In fact, many other economies face the same risks as New Zealand, especially the burden of ageing populations. But investing in several economies will shield you against one of those economy tanking.
Economic risk is also when there are other economies which are outperforming your own economy. This cause you to miss out on potentially higher returns.
5. Currency Risk
One thing to remember when investing overseas is that you will be exposing yourself to currency risk. When the New Zealand dollar weakens it talks more New Zealand dollars to buy imports, such as cars and goods. This affects consumers, but also affects company and businesses as their products or machinery used to create products has become more expensive.
There is no real way to know exactly which way the currency exchange will go. Even experts don’t fully understand it. There are theories of cycles and waves such as Elliot waves that currency traders use to try an predict the future. But most won’t be much above 50-50 in their pericarditis power.
Still, even being slightly higher than 50-50 can become profitable if you are a disciplined currency trader.
The currency risk looks like this. You invest $1000 NZD in overseas shares. Take the United States as an example, at an exchange rate of 0.50. Your investment is worth $500 USD.
Your shares have increased by 10% and are now worth $550 USD, however, the exchange rate has also risen to 0.60. So converting back to NZ dollars your investment is worth $917.
Currency risk can work both ways if the exchange rate had fallen to 0.40, then your $550 USD investment would be worth $1375.
So as you can see, the risk is hard to quantify as it involves a lot of hindsight.
Risk is hard to quantify and it comes in many forms; inflation risk, investment risk, timing risk, economic risk, and currency risk. These are all external risks to your investments. You must also include the risk of the investment itself- the risk of not getting the returns you were looking for, or worse, not getting back your money at all.
Generally speaking, all investments come with a certain level of risk. Lower risk is commonly associated with a lower potential return, while a higher level of risk is associated with a higher potential return.
Fortunately, all these risks can be minimized with a well-diversified portfolio of investments.
Different Investment Vehicles- What can you Invest In?
So enough scary talk about risk, doom and gloom. Rather, let’s look at different investment vehicles you can use. This is the exciting part of investing, at least it is to me.
Cash, fixed income, property and shares, which are also called shares or stocks are the four main investment classes around the world.
Below is a table summering the characteristics of each investment class
|Time Frame||No Minimum||3 years +||5 years +|
These are generalized characteristics, and do depend on a number of factors, such as the investment duration. But on average they hold true for each class.
Cash is the simplest kind of investment held in a bank savings account. The returns on cash are generally low compared to other more risky investments. But you can withdraw part or all of it at the drop of a hat. That makes cash a very liquid investment. This lends cash to be a good investment vehicle for people with a short term savings goal, or as part of an emergency fund. Cash is not a good investment vehicle for long or medium investments.
To increase the return on your cash you could consider a fixed-term investment with a bank. This is when your money is locked away for a set time. In return for locking this money away, you get paid a higher return. A possible downside to this is that you cannot access your money without being charged a penalty.
2. Fixed Income
A fixed-income investment has a number of names like bonds, fixed interest, or government stocks. It is basically an IOU given by an issuer which is often a government or company. You give them your money for a certain period of time, they promise to pay you a certain interest rate, and then once the time is up they will pay back the initial money.
Often there is a minimum investment size when it comes to buying fixed-income assets. But you can get around this by buying bond funds which have a lower requirement for entry.
Since bonds are held over a certain period it makes them more suited towards medium to long term investors. You won’t be able to access your money until the period is up. Since the IOU is also between you and the issuer, Fixed income investing is not liquid. To get around this, there are several secondary markets where you can sell your bonds if you need to
3. Shares and Equity
A share from a company is basically a right to the share of that company future profits. Companies pay these future profits through dividends payments. You may also gain capital value in the share itself if the company grows.
The price of a company shares is also affected by the activity on the share market. For instance, if everyone is selling their shares for a particular company, the share price is likely to go down. There are more sellers than buyers. The reverse is also true. If there is demand for a companies shares and there are few sellers, the price tends to go up.
Because the price of shares can go up and down they are considered volatile and have a high risk. Shares can make a good long term investment thought.
For many Kiwis, their home is their largest asset which has generally been acquired thought a mortgage. And since people understand how mortgage work, purchasing a rental or investment property comes very naturally.
The downside to owning an investment property is that it does not provide you with much diversification. Since if you already own your home, and add another property, a large proportion of your investments are in the property.
Another option for investing in property is to buy into a property syndicate. A property syndicate pools money together from many investors and purchases investment properties on their behalf.
Cash, Fixed income, Shares, and Property are the main investment vehicles you can use, but there are alternatives. For example, you can invest in commodities such as gold, hedge funds, or even foreign exchange. Generally, these are not discussed because they are not well suited for beginner investors and require a certain level of expertise and ongoing commitments.
So what should your investment portfolio look like?
Unfortunately, I can’t tell you. And that is not because I don’t want to. Rather it is because everyone’s situation, goals, and preferences are different. Some people may want to seek out higher returns and accept higher risk, others might be more conservative.
I can offer a general guide that you can follow that may apply to many people, which depends on your level of risk. Below is a table showing different asset allocation of the different portfolios.
|NZ Fixed Income||70%||36%||7%|
|Investment Time Frame||+5 years||+9 years||+15 years|
A conservative profile is primarily focused on providing a reliable income stream from the capital. It also ensures the protection of the capital value of your investment. It is best suited for people with a low tolerance for risk. If you are reliant on income from your investments you should look at a conservative profile.
A balanced profile is a medium-term investment strategy. It should give you a balance of income and growth, so if that is what you are looking for consider using a balanced approach. If you are saving for retirement and are risk-averse, you might want to look into a balanced profile as well.
High Growth profile
A high growth profile is for long-term growth with low-income generation. Generally, if you have a high time frame and a high tolerance for risk you should seek out a high growth profile of investments. This is well suited towards young people saving for retirement. The returns on a growth portfolio will be volatile as much is allocated, about 90%, into shares and property. Using the profile above will also mean that you are well-diversified across different economies
Now that you have an idea about the risks and different investment option, let’s look at an investment strategy.
Dollar-cost averaging is a name given to an investment technique where you drip feed into an investment. This reduces the timing risk associated with volatile investments such as shares and funds.
Many people avoid shares because the markets move up and down and they don’t want to risk buying in that the wrong time. It is a real fear. Let’s look at how dollar-cost averaging can minimize this.
You set up an automatic regular investment plan of $100 per month. In July, you buy some shares at a cost of $1.00 each. Now you have 100 shares.
In August, you again invest $100. The price of a share has dropped to $0.95. Therefore you buy 105 shares.
In September, the price of shares had fallen further to $0.85, so you buy 118 shares.
However, in November the shares have gone up to $1.05, you purchase 95 shares.
You end up with a total of 418 shares for a price of $0.96 each. If you had bought only in July, or November, you would have had fewer shares at a higher price, if you had bought in August you would have more shares. But because you used dollar-cost averaging, you purchased your shares at an average price and removed any timing risk involved.
This works because when the market falls, you are able to buy more shares, and when the market rises, you buy less. In the end, it all averages out.
You can use dollar-cost averaging in two ways, through regular savings and when you want to make a lump sum investment
If you save and invest on a regular basis, for example, paying yourself first at every paycheck, then you can use dollar-cost averaging. Drip feeding your savings into the stock market or investment fund will take advantage of dollar-cost averaging and smooth out any volatility. If you are in KiwiSaver, you are automatically using dollar-cost averaging, even if you didn’t know about it.
If you have a lump sum of money to invest, rather than try time the markets, you could set up a series of automatic payment. This will minimize the potential risk of a market turn wiping a substantial portion of your investment.
These two cases will protect the value of your investment from volatile markets.
General Guide to Investing
And finally, this entire article is really just an introduction to investing. You’re on the right track!
Reading it will allow you to gain some insight into investing techniques and investment products. But there will always be more to learn. It is more than likely you read something and didn’t quite understand it. This is good. That means you need to do some more research.
That being said, I have a list of several tips for when you are ready to invest.
- Past returns on an investment are by no means a guarantee on future returned- they can only ever be seen as a guide.
- You need to diversify your investment across different asset classes, industries, funds, and even countries.
- Re-invest you divined income and allow the 8th wonder of the world, compound interest, do its thing.
- Generally, the higher the returns on an investment, the higher the risk.
- A large proportion of your investment should generate money, Cash, Shares, Property, avoid over-investing in assets that don’t such as Art.
- Don’t be discouraged by short term volatility, shares will move up and down throughout the day- you should only be concerned with the long term trend.
- When comparing investment make sure the returns you compare are the same. Don’t compare apples to oranges. Some returns are calculated gross and some are calculated net.
- Use dollar-cost averaging for volatile investments, this lowers your risk of timing an investment.
- Investing is a long term endeavour. Don’t check you investment every few days.
- If possible, seek professional advice and independent advice. Be wary of getting rich investment advice from friends and acquaintances.
And here are some general guides into choosing investment vehicles. Keep these in mind and go through them before you purchase into an investment.
- How liquid is the investment, and how liquid do you need the investment to be
- how easy is it to get your money back if you need it
- Are there any entry and exit fees, how do they compare to other similar investments
- Sometimes it isn’t as clear as it should be the fees involved with some investments
- Are there any tax implications you need to understand
- Have you read all the information that has been provided
- What about looking on Reddit or other forums to see what other customers have to say
- Are you comfortable with the company or organisation that you are investing with
- And if you don’t understand anything, or are uncomfortable with anything, don’t invest. Seek independence advice.
And please remember that Passive Income NZ is not a financial adviser and if you are confused about anything you should seek professional advice before making any investment decision. Please read my disclosure for more information. In NZ, Sorted has some useful information to consider when seeking financial advice, or visit the Financial Markets Authority which has more resources to help you out.
Information presented on the Website is intended for informational and entertainment purposes only and is not meant to be taken as financial advice. Some of the links above are affiliate links, meaning, at no additional cost to you, I will earn a commission if you click through. Please note that I only recommend products and services that I have personally used.