Before investing your money, it is important to be aware of some key concepts related to investing.
- Types of investments that can make up a portfolio
- The relationship between risk and return
- Understanding your own risk profile.
What are asset classes?
The four main asset classes are:
- Fixed interest (e.g. government bonds, corporate bonds)
- Property (e.g. office, retail and industrial property)
- Shares (e.g. Australian and International shares).
Asset classes can broadly be separated into ‘defensive’ and ‘growth’ investments.
Cash and fixed interest are generally considered defensive investments. This means:
- they can provide regular income and a stable capital value
- investment returns and values are usually less volatile compared to growth assets, and
- over the medium to long term, returns are generally lower than those of growth investments.
Property and shares are generally considered growth investments which means:
- they can provide growth in the value of your capital and income
- investment returns can fluctuate significantly over short periods although over the medium to long term, returns are potentially higher than those of defensive investments.
Risk and Return
Both ‘defensive’ and ‘growth’ investments have a different expected rate of return, and normally, the higher the expected return, the higher the associated risk.
All investments carry some risk. Some of the risks include:
- the likelihood of not getting the expected return on your investments - including the possibility of losing some or all of your investment
- the risk of volatility - the value of investments and their potential return may rise or fall from time to time due to market fluctuations
- the risk of inflation - if your money earns less than inflation then it loses its real purchasing power.
These risks can generally be managed by assessing the investment you are considering and your own long-term financial situation, needs and objectives.
We would normally expect that the greater your exposure to growth investments, the more likely it is that you will achieve higher long-term returns, but you may also experience greater volatility in the short term.
By spreading your funds across several investments and asset classes, you can reduce the risk in your portfolio so you are not ‘putting all of your eggs in one basket’. This type of investment approach is known as diversification.
Knowing how much to invest in each asset class will depend on your financial situation, needs, objectives, investment time frame and individual risk profile.
Understand your risk profile
Understanding the level of risk that you are comfortable with will help guide your investment decisions. It is generally influenced by factors such as your goals, age, resources and investment timeframe. For example, if you are saving for a round-the-world holiday in the next twelve months, the type of investment options you may be considering will be different to those that are suited to building long-term savings to supplement your super in retirement.
As well as your timeframe, it is important to consider what your appetite for risk is. If you think you would have trouble sleeping at night worrying about your investments taking a downturn in value, you may wish to consider investing in a lower risk option.
You should review your risk profile regularly because most people’s attitude to risk changes throughout their life. For example, as you get closer to retirement, or when children or grandchildren come along.