Investing is one of the most important tools you can use to improve your financial position.
It’s essentially using your own money to make you more money. It’s available to everyone, and there are only a few main types of investments to understand, yet many people either choose not to invest or don’t know how. Let’s run through the main types of investments that are easily accessible to you and I.
Firstly though, we need to talk about two key fundamental aspects of investing: compound interest and leverage.
Compound interest is the reinvestment of any returns you get from an investment back into the same investment.
For example, if you invest $100 into something that generates a 10% return per year, at the end of the first year you will have $110. That $10 extra will now also earn interest, so at the end of the second year you will have made an $11 return. This ends up having an exponential effect; you’ve probably heard that starting early is important – compound interest is why.
Have a look at this example:
Have a look at these two scenarios both starting with $1,000, adding $500 per year, and 10% interest paid per annum. Total investment of 30 years:
- The interest payments are withdrawn as they are paid yearly. Net result after 30 years: $40,250, of which $24,750 is from interest payments.
- The interest payments are reinvested (compound interest). Net result after 30 years: $90,179, of which $74,679 is from interest payments.
The reinvestment of the interest payments resulted in the generation of an additional $49,929 of income.
If you notice in the graph, most of the benefit is realised in the latter half of the investment term, where it begins to have an exponential effect on the total investment.
Leverage is basically using someone else’s money (i.e. a bank’s) to help you purchase a larger investment. It’s used in many different types of investments, but very commonly used in real estate purchases in the form of home loans.
Leverage can be illustrated simply like this:
- No leverage: if you start with $50,000 and invest in something that returns 10% per annum, after the first year you will have $55,000.
- Net gain of $5,000
- Leverage: if you take your initial $50,000, borrow an additional $200,000 at 5% interest, and invest in something that returns 10% per annum, at the end of the first year you will have:
- Received $25,000 in interest payments.
- Paid $10,000 in interest to the lender of the $200,000, leaving you with a total of $265,000.
- Net gain of $15,000.
You have made an additional $10,000 without having to invest any more of your own money.
Leverage works great when your investment increases in value, however one very important factor to consider is the potential downside; if your investment yields a negative return, the total losses will be higher if you are leveraged. You will still owe the lender the initial amount you borrowed, and also still have to pay interest on the borrowed money. This can get people into serious financial trouble if their investments are leveraged and the investments yield a negative return.
Where to Invest?
Ok, so we know that investing can be good, and compound interest is good. But where should we invest? That depends on a number of things – timeframe of your investment, risk you are willing to take on, initial funds available for investment, among many others. Let’s run through some of the options you have.
This is the most simple and basic way to invest your money (you could argue it’s not even an investment). We’re not talking about literally cash kept at home, but money kept in a bank account earning interest. Cash kept at home will actually decline in value over time due to the cost of living (inflation) going up while your cash just sits there.
Most banks offer high-interest savings accounts where you can deposit your money and earn interest at a particular rate. Typically there will be two rates on offer for a particular account; a base rate and a higher bonus rate that is applicable for an introductory term (first four months for example), or that is applied if certain conditions are met (minimum $1,000 deposit per month with no withdraws for example). Interest is often calculated daily and paid monthly, which means you don’t have to wait until the end of the year to receive interest payments.
A typical interest rate for a bonus saver account will be around 2.50%, however banks vary the rate based on changes to the RBA cash rate.
Shares are essentially a unit of ownership in a company or financial asset. They can be traded in a number of ways, and both public and private companies have ownership in the form of shares.
A publicly listed company is a company which is owned by a number of different people in the general public. These shares in the company are typically traded on a stock exchange (ASX in Australia). This stock exchange provides a market place (i.e. stock market) for people to buy and sell shares. The price of shares in a stock market is set by the people buying and selling – the more people are willing to pay, the higher the price goes. And this is why investing in shares can be so confusing – there are so many different variables that essentially impact human factors that go into buying and selling.
Money is made from shares in two ways:
- Capital growth – shares are bought then sold at a later date for a higher price.
- Dividends – some companies redistribute profits from their business to the owners of the company – the shareholders.
For most investors, capital growth is what would be sought after by investments in shares. And the return can vary dramatically depending on what shares you buy. For example, stable shares in big, established companies (known as ‘blue chip’ shares) are often purchased as part of a relatively lower-risk shares portfolio; however, the potential upside is typically limited. At the opposite spectrum would be speculative stocks – shares in companies that may not even have any positive cash flow, however if their business or idea takes off, the share price can increase by huge amounts. Many times though, the business never takes off and the share price declines to close to nothing.
Therefore, predicting or estimating average returns by investing in the share market is not really possible. To give you some sort of benchmark, the average 12 month return from the All Ordinaries index is 7.35%. However even the returns of the wider market can vary significantly from year to year.
Investing in shares can be a good way of maximising your investment returns, however it’s not easy and needs thorough research and study to do properly.
Managed funds are portfolios of investments that are purchased and managed by a fund manager. People can invest in the fund in exchange for a management fee (among other fees).
There are two main types of managed funds – active and passive. The investments in active funds are bought and sold with the goal of outperforming a comparable index (for example, Australian shares or commercial property). Passive funds are largely comprised of investments that will typically perform similarly to a particular index, such as the ASX 200.
Funds will also be created to fit a particular risk profile or asset class. For example, some funds will be created for the purpose of maximising the return in exchange for additional risk. This fund may include investments in high-growth shares and international property. Other more conservative funds may focus on lower-risk asset classes, such as cash and bonds.
Given there’s so many different types of funds to chose from, it’s hard to provide a meaningful number for average returns. If you’re interested, have a look at this website for the top performing managed funds in various categories.
One of the most common investment strategies that people use is real estate. There are two ways you can make money from real estate – buying for a particular price and selling at a later date for a higher price (capital gains), or renting out the house for a rental income. Typically, a real estate investment strategy will involve purchasing a house with the intent of seeking capital gains, however also renting the house out to receive rental income.
Real estate as an investment usually takes advantage of leverage, allowing people to purchase properties at a far greater price than the money they have available.
In Australia, house prices rose by 6.8% in 2014, and 9.48% in 2013, unadjusted for inflation. As of mid-2015, average rental yield for a house in an Australian capital city is 3.7%.
The risk involved in property investing is largely dependent on your amount of leverage – most issues arise when people borrow too much money to purchase a house, and can’t keep up with the mortgage payments.
Typically offered by banks and credit unions, term deposits are a savings product that allows you to invest your money for a fixed term in exchange for a fixed interest rate over that term.
The risk involved in term deposits is very low – there’s pretty much no risk of losing your money. And the interest rates are comparable to a typical savings account with a bank – actually, term deposit interest rates can range from around 2.50% to 3% interest depending on the term. 3% is higher than most savings accounts, however this sort of interest rate return would typically require a term of 5 years.
The requirement to invest your money for a fixed term is one of the main downsides for term deposits – if you withdraw your money before the term matures, there are often exit penalties applicable.
If you decide a term deposit is best for you, it’s important to shop around, especially if you are already invested in a term deposit that is nearing maturity. You should look at the market and see if you can find a more competitive interest rate – if you don’t, your money might roll over into a new term with the same bank that may be at a lower interest rate that what you can get elsewhere.
Do Your Research
There are many investment options out there, but everyone will have their own set of circumstances and goals. That’s why it’s so important to do your own research and find out what is the best fit for you at the time.