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Investing – The big picture Part 1
We have covered a lot of ground up to this point. My original purpose for FIT Wealth was to teach the basics of money and investing to you. However, all of my posts up until this point are so critical to get you to where we are now.
Without a burning desire, setting goals, developing the right habits, increasing your value to the world, understanding the flow of money to you, through you or around you, investing becomes a high-risk activity.
If you want to build an empire, amass a personal fortune, become financially independent or just get yourself into a better financial position, without a strong foundation (everything we have covered so far) the depth and strength of your success (wealth, career or otherwise) will be limited.
By depth I mean how successful you can become, this almost or possibly limitless. And by strength, I mean how impervious to damage you are.
If you have built a ten-million-dollar property portfolio, the depth of your success in this area is impressive. However, if an increase in interest rates of 0.1% could bring your empire down due to the increasing cost of your loans, the strength of your success is low.
What these posts are and what there are not
Just to warn any finance students reading this, the information I am providing will not be of degree standard. I will not be teaching you any trading tricks and tips.
What I want to teach here are just the basics to get you started. I will try to explain things in a manner that is hopefully easy to understand. If it’s not, let me know and I’ll rework it so I’m communicating to you in a more effective manner. Not everyone learns the same way.
If you come across a topic that interests you, go deep dive into it and see where it takes you. Some of these topics can be quite involved and some very complex. But all you need to do is start and have some persistence.
Before you invest
Before you even think about investing, other than your superannuation fund, you need to make sure that your house is in order. By that I mean, are your basic financial needs taken care of?
What is your debt situation like?
If you have high interest loans like credit card debt or a car loan, these are the things you should be paying off first.
A surging share market may make 20% in a year, but this won’t be every year. However, the 20% interest on your credit card will be 20% every year. This type of debt needs to go as soon as possible.
Car loans are usually quite expensive, in the realm of 5 – 10%. This needs to go as well.
Then you need to ensure that you have 3 – 6 months living expenses stashed away in case of serious emergency. If you are still living at home, this is less urgent, but if you rent or have a home loan, this reserve of cash will hopefully get you through to the other side. If you lose your job or get sick you have a level of protection. I will discuss insurance in a later post.
If you ever dip into this emergency account, top it back up as soon as possible. An emergency is not date money for the special girl, needing to get nails done or putting a new muffler on your car to make it louder (and more annoying).
It’s for absolute emergencies and you have no other funds available.
Now, once you have financially steadied yourself and you know how much surplus cash you have to invest, we can begin!
The birds eye view
The way I like/need to work is to see the bigger picture before I get to the detail. This is why I am starting with a high-level view of investing.
But before you invest a cent into any investment, you need to know what your purpose is.
It could be:
- To learn about buying and selling shares.
- To provide a second, third or fourth source of income.
- To set yourself up for the future.
- To eventually create financial freedom.
- To save for a home deposit.
- Insert here any other reason you have for investing.
You may even have different buckets of money for different purposes.
Your “why” for investing is so important because it directly impacts your investing decisions. Get it wrong and it can set you back years.
Imagine you are desperate to save enough for a home deposit. The housing prices continually rise and put it out of reach. You decide to invest in the Australian share market in October 2007 (see chart below). You put your $50,000 into a basket of shares. Unbeknownst to you, the global financial crisis is just about to hit. No one knows how bad this will be. Over the next 18 months your investment goes from $50,000 down to $22,187. And it takes about a decade (excluding dividends) to get you back to where you started.
Yes, it is bad luck but understanding your “why” directs you towards the right investments and more importantly, away from the wrong ones.
Risk vs Reward, I mean Return
One of the first things a financial planner will do is to determine your appetite for risk. This is done through a Risk Profile.
Risk is defined as exposure to danger, harm or loss. Loss is the main concern of the investor.
From the above chart, the general rule is – you need to take on higher levels of risk to achieve higher returns.
Your bank account is a low risk, low potential return investment.
Bitcoin is a high risk and high potential return investment.
Somewhere on that line in the chart above is your happy place.
If you are really unlucky (or have been scammed) you invest in a high risk, low potential return investment like a beach front property in the Maldives (a sad climate change joke – it may be underwater in the near future).
Notice it says, “potential return”. It’s not guaranteed. Therefore, risk is involved. A share investment could turn out to be a high risk, low return investment. For example, you invest in a new technology company with big promises and they manage to just splutter along and fall short of those promises. You accepted high risk and possibly received a negative return. Meaning you lost money.
Why is a Risk Profile important and what does it achieve?
A Risk Profile tells you and the adviser how comfortable you are with the concept of risk. And this will drive the make up of your investment portfolio.
The key question – Will you be able to sleep at night after having made the investment?
For a moment, let’s assume that you looooove Bitcoin.
You want to invest all your savings and borrow on the equity of your house. You now have $300,000 in Bitcoin.
What could happen?
It could skyrocket tomorrow. And you’ve made a fortune.
Governments could outlaw it and create their own tomorrow. Bitcoin is now worthless.
Will you be able to sleep at night or will you worry about every Elon Musk tweet or statement from global governments?
A good night sleep is essential to success and a more enjoyable life.
Sometimes the stress ain’t worth it!
The Risk Profile will ask questions about your investment goals (home deposit, retirement), investment timeline (long or short-term), your tolerance to the swings of the share market (up 10% today, down 30% tomorrow), your understanding of investment concepts (experienced or novice) and your thoughts on risk (opportunity or danger).
Each answer you give is given a point score. Add the points up and the total will correspond to a particular Risk Profile.
Risk Profile categories include (these depend on the financial planner):
- Cash 100%. This is suitable for those with a short timeframe. For example, if you are saving for a home deposit and can’t afford to ride out the highs and lows of the share market.
- Defensive. For investors that are averse to risk. This portfolio might only have 15% exposed to growth assets like shares with the remainder (85%) invested in defensive assets like cash (more on these terms later).
- Conservative. 30% growth assets and 70% defensive.
- Balanced. 50% growth, 50% defensive.
- Growth. 70% growth, 30% defensive.
- High Growth. 85% growth, 15% defensive.
- Total Growth. 100% growth. This is for those with a long timeframe. E.g., 40 years to retirement.
Based on the category you fall into an investment portfolio can be constructed that aligns with your tolerance to risk.
Orange – Growth assets
Teal – Defensive assets
As your portfolio moves from a defensive asset allocation to a more growth-oriented asset allocation you are exposed to higher risk, but greater potential returns.
Asset Allocation: is the process of balancing risk and return in a portfolio by investing across different asset classes.
The different lines in the chart above illustrate the risk/return connection beautifully. The most defensive portfolio presented (the red line) provides the least return and the least volatility (low risk). The High Growth portfolio (the dark blue line) demonstrates the highest return and the highest volatility (high risk). The other portfolios fall somewhere in between. Volatility refers to the speed and/or size of movement in the value of your investments.
The dip in 2020 is due to COVID-19. The market rebounded strongly into 2021. Higher than before the pandemic.
Which one is right for you?
That depends.
Don’t you just love that answer. The problems is that it does!
Your Risk Profile can change throughout life or with the different purposes for your money.
Changes throughout life – In your 20’s, retirement is a long way off so you can afford to take on more risk and ride the rollercoaster of the share market. You may start off as a Total Growth investor. As you get closer to retirement, the stability of your investment for your retirement years becomes a focus and your risk profile decreases to a Growth or Balanced investor.
Different purposes – Your retirement account (superannuation) may be Total Growth due to the long timeframe to retirement, your home deposit may be Cash due to the need for security of those funds and your savings fund for your children’s education may be Balanced as the timeline for requiring the money is only 3-5 years.
When you are in the right risk profile, sleeping at night becomes easier.
The Wrap
In the beginning, if you start investing without knowing all of this, that’s fine. Start off small. If you make a mistake, it won’t be the end of the world.
However, it will become more important to know about your appetite for risk as your asset base builds and becomes more varied.
And it’s definitely important from a superannuation perspective. If you are 20 years old and have a defensive portfolio without even realising it, you can lose out on potentially hundreds of thousands of dollars by retirement.
What is critical, is to have your financial situation strong before investing. Remove bad types of debt and have an emergency cash buffer.
A clear goal for investing will also determine how you invest. Will you have different buckets for different investments?
Understand the risks. A good sleep is important!
Up next …..
Investing – The big picture Part 2 (Asset Classes).
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