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The (Very) Basics of Investing

‘The basics of investing’ is a topic that has spawned thousands of books and articles, yet it is an area which remains loosely understood by the great majority of us. It is sometimes portrayed as an area of great complexity, but central to any investment decision are a number of easy to understand concepts.

Firstly, it is important to set out your investment goals, i.e. what is the objective of the investment. Analysing the investment objectives will help determine the most suitable types of asset for reaching this goal. Consideration must then be given to the following;

  • Risk: Is inextricably linked to return and generally the more risk with a particular investment, the greater the return expected. The majority of investors consider themselves to be somewhere in the middle of the risk spectrum i.e. between risk averse and risk taker. It is really only through experience that many establish what tolerance for risk they have. (See broader section on risk and return on the next page).
  • Expected return: Investors will generally expect to get the best returns they can, for a given level of risk. On the basis of long-term historic performance figures, the returns for each asset class will differ. You need to consider what level of risk you are prepared to take in order to achieve a return objective. If the return objective is set too high, then the level of risk required to achieve the return may in turn be too high. The key is to be realistic. Proper expectations with respect to risk and return can only be assessed in conjunction with a qualified investment adviser.
  • Time: Before investing you should be clear about the time horizon for which the investment is being made. Certain investments (e.g. stock market investments) are not suitable over the short-term. Often the investment objective will determine the duration e.g. investing for education on behalf of young children is long term, whereas investing for a deposit on a house would typically be more short term.
  • Access: A requirement for short-term access to funds would steer you in the direction of liquid investments like deposits (which offer greater access). Some investments offer unrestricted access to funds while others can be relatively illiquid. The requirement for an income is also an important consideration, which would fall into this category. The investment goals established at the outset will determine the need for access.
  • Charges / terms and conditions: The investment decision should have been made before consideration is given to charges, terms and conditions. Nonetheless it is relevant to any decision on investment, but emphasis should be on value for money rather than paying particular attention to price or charges in isolation.

Taxation is a key consideration, but does not override any of the criteria just discussed. Criteria relating to access or time horizon will differ in circumstances where a person is investing within a pension structure.

Risk & Return

An old Wall Street saying, “You can either sleep well, or eat well”, is a colourful idea to constantly remind people that greater investment return comes only with exposure to greater risk. Higher return usually necessitates higher risk. It is important to be careful that you are realistic in seeking an appropriate balance between the two. Attitudes or preferences for risk vary considerably. First, you must establish what your attitude to risk is. Then this must be combined with information about your goals, objectives and time horizon to formulate a plan which is suitable to your individual needs. This is achieved by going through a detailed financial analysis with an Investment adviser.

Financial Analysis

The process of establishing attitude to risk can be fairly subjective, but an investment recommendation cannot be appropriate or robust without some attempt at assessing risk tolerance. Investment advisers go through a process called a ‘fact-find’ before advising clients, which is important in defining the investment characteristics of a person and relating this to an investment proposal. In some circumstances it may recommend against investing where there are large outstanding debts, in favour of debt restructuring.

Diversification

Diversification and risk are linked in the sense that appropriate diversification controls or reduces risk. Effective diversification means that some of your assets will be under performing all of the time. The least effective investment strategy is attempting to allocate funds between asset classes to catch the cycle of performance. Diversification is simply an investment approach based upon allocating your investments across a multiple of asset classes. Though recommended the world over, it is sometimes followed with indifference. Don’t ignore this most basic tenet of investment.

There are many levels to diversification; diversification of asset type, industry, geography, even diversification of time horizon. Financial security is not achieved through avoidance of all risk; this is impossible – as every investment decision involves an element of risk. It is achieved through appropriate diversification.

Re-balancing is a critical aspect to achieving successful diversification. The so-called ‘free lunch’ that diversification provides, the potential to increase the return of a portfolio without increasing risk, goes hand in hand with rebalancing. You should consider the frequency with which you will re-balance your portfolio before starting out with an investment.

Compounding and cost averaging

Compounding refers to the process by which a portfolio grows and achieves growth on growth. It is a very powerful force. The longer the time frame, the more growth on growth your portfolio enjoys. It is important to start saving early to reap the greatest benefits from compounding.

When investing a portfolio with risky assets (as inevitably a diversified investor will be) you ideally want to buy when prices seem attractive and sell when they become expensive. Given the difficulties with predicting where we are in this cycle, you can achieve this timing benefit by regularly committing money to a portfolio. This is referred to as Euro Cost averaging. Cost averaging works well in the sense that it reduces the potential for emotions to get in the way of a rational investment plan. Investing is inevitably emotional, so if you engage in a policy of investing regularly, rather than committing a lump sum all in one go, the chances that an investment plan gets de-railed are reduced.

Investing in the stock market

The stock market can be a source of great confusion. Jargon is often used, and it both confuses people and adds to the illusion that it is a complex area, understood by few.

At its simplest, an equity or share - represents an investors ownership in a “share” of the profits, losses, and assets of a company. The return to an investor/shareholder in a company (in exchange for the provision of “equity”) is through income received through dividends, and /or through an appreciation in the price of the company’s shares.

Investment in the stock market can take place via direct investment in the shares of companies quoted on a stock exchange or can take place indirectly through pooled funds.

Generally speaking it is recommended that an investor have a considerably long time horizon if considering investments in shares. At a minimum, seven to ten years is required to be able to endure the potential for the stock markets’ gyrations.

Investing in the Fixed Interest

Fixed interest investments, often referred to as Bonds are essentially a form of debt, like a loan. Governments and large corporations use bonds to raise money for capital expenditure. The investors or those who purchase the bonds are the lenders. The investors/lenders receive payment for the loan usually in the form of an income and at maturity they receive back the amount they invested/loaned.

The bond is structured on three basic principles:

  1. A fixed amount is invested (lent) to the issuer.
  2. An annual or semi-annual interest raid is paid by the borrower (Government or Corporate)
  3. At maturity the original capital is returned with the final interest rate payment. With a return to be paid to the investor

Fixed interest investments are a low risk investment and used as part of a diversified portfolio to reduce risk. As a consequence, the returns on fixed interest investments are usually meagre, in exchange for what is usually a low volatility asset.

Property investments

Investing in property usually takes place via commercial property market, rather than the residential market.

Commercial property, in the form of office buildings, retail shops and industrial warehouses is available to retail investors through unit-linked funds from insurance companies. Investors receive rent from tenants and also receive the potential for capital gains through the appreciation in the value of the property assets. Property is a cumbersome, illiquid asset and investors should be prepared to invest over a long period of time. Notwithstanding the poor performance of Irish property in the last five years, returns to investors’ can be significant if bought with a firm eye on the price.

Capital protected products

In the current era of low interest rates many people with funds surplus to their immediate requirements are seeking investment products which have the potential to generate higher returns than standard deposits. However, many of these potential investors do not wish to or are not in a position to risk any loss to their capital. Traditionally the “With Profits” products were the investment option which many such investors availed of.

A basic guaranteed fund usually offers 100% capital protection and a fixed percentage of the increase, if any, of the capital value of a particular index over generally a five-year period. In the worst case scenario the investor receives back their original capital without any growth. In the best case scenario the investor receives back their original capital and a potentially unlimited return, linked to the growth in a stock market index. In practice many of these products end up producing returns which are in line with or behind what is available on deposit.

Alternative investments

When referring to alternatives these days, one could be making reference to Wine, Art, or any number of exotic investment which is not considered mainstream. Generally though, alternative investments, as far as pension and investment is concerned, usually refers to Hedge funds or absolute return funds.

Although seen as a relatively new phenomenon, hedge funds have been in existence, albeit in a small way, since 1949. Hedge funds have more recently attracted investors disappointed by the poor and often negative returns from managed funds. Some hedge funds can promise positive returns even when stockmarkets are falling. To do this the hedge fund manager uses techniques such as selling stock they don’t own with a view to buying back the stock at a later date, hopefully at a lower price. This is called going short of a stock and if the right stocks are chosen there are substantial gains to be made in a falling market. The tool kit available to the hedge fund manager is extensive and expands the possibilities for profit and risk management.

Notwithstanding the use of financial instruments which may appear to be high risk (i.e. derivatives), hedge funds or absolute return funds can provide a return in excess of cash with low volatility.

Cash as an investment

All types of assets are considered investments, even cash. A decision to invest in cash represents a decision to not invest in other assets, which is a legitimate investment decision. Cash while low risk in terms of the volatility of the returns suffers from the risk that inflation may erode the returns and you may lose real value on your investment. Cash is also subject to credit risk in terms of the credit standing of the institution with whom your money is deposited. It is recommended that all investors’ keep at least a small allocation to cash as part of a diversified portfolio. In the event that attractive investment opportunities arise, investors’ with cash in their portfolio’s are in the best position to avail of these opportunities.

Conclusion

We all desire high returns, with as little risk as possible. Unfortunately this is not compatible with the way in which investment markets work. As an investor you are in control of one of the most important variables in terms of investment return – your own saving behaviour. The greatest influence on investment return is likely to be a person’s saving behaviour. There is no investment strategy that will make up for an inability to save. Start early, save regularly, be diversified and re-balance often.

 

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