It is great that many people are now searching for good financial advice. With past generations, the typical financial advice passed down from parents to children was: buy a home, pay it off as quickly as possible and then – if you are really good at managing your money – buy an investment property.
Unfortunately, there are still a lot of people who think this is the safest and smartest way of increasing their wealth. Banks are still encouraging their mortgagees to pay off their homes “in only 8 years!”. There are even investment books that herald how quickly you can pay off your mortgage. Just follow these steps. But it’s the wrong long-term investment strategy. It always was and still is today.
Why? Because, firstly, you have broken the first and most important rule of investing: Don’t put all your eggs in one basket. Good investors understand and apply the rules of diversification. What happens if the property market falls? What happens if interest rates rise? Good investors know that residential property is the lowest performing category in the property sector. And then of course, there are all the problems associated with maintaining good tenancies and avoiding cashflow problems.
So what are the basics of sound, practical and realistic investing? Risk, return and timeframes.
RISK
All investments incur varying amounts of risk. This is caused by many factors: inflation, economic downturns, interest rate changes, movements in the market, wrong market timing, not diversifying your portfolio, borrowing risks or simply choosing the wrong investments.
However the good news is – risk can be managed. Good financial planning always includes planning for risk. The steps include:
1 Determining your risk profile
2 Understanding the risk levels of each investment asset class
3 Determining your timeframes
4 Creating a solid overall plan
5 Reviewing your plan at regular intervals
RETURN
There is an old, yet generally true saying in investing: The greater the return, the higher the risk – or loss of your investment. However, when you establish a calculated plan that allows for risk management, you can plan for the level of risk involved.
There is also many factors to be considered in the relationship between risk and return: The higher the short-term risk, the greater potential return in the long term. That is why assets such as shares, which may wildly fluctuate in the short-term, predictably outperformed other asset classes in the long term.
So, what constitutes return? When we talk about return on your investment we refer to the increase (or decrease – negative return) you receive from that investment. This arises from two sources: distributions (from either interest income or dividends paid) or capital growth of the asset.
TIMEFRAMES
Once you have an understanding of the relationships between risk and returns on investments, you can see how important it is to plan, set and maintain the right timeframes.
The timeframe is the essential glue that holds the financial plan together. Get them wrong and your whole plan falls apart. Get them right and your plan should purr along nicely, with only the minimum review.
THE 8TH WONDER OF THE WORLD
John D. Rockerfeller called Compound Interest the 8th Wonder of the World and for good reason too. Compound interest refers to the cumulative effect of re-investing the interest or returns that you receive on your investment. Interest is then paid on both the original sum invested and the accumulated interest. This has a major impact on the growth of your investments.
For example, if you invested 20,000 and received 10% interest per annum – not compounded – in 20 years you have the original $20,000 plus $40,000 in interest, equalled to a total of $60,000 at the end of the 15 year period. However, if you used the same scenario but compounded your interest, i.e. reinvested it back into the investment, you would have over $146,500.
Also, the more you add to your investments over that period of time, the greater your investment will grow. For example, if you added an additional $200 per month, you will have doubled that amount to $298,000.
When investing, it is therefore critical to the growth of your principle sum to ensure that the returns from your investment are compounded and, if possible, keep adding additional payments as you go. This, of course, is easier when you are within your working years. Later when you retire, you will be expecting to live off the returns from your investment and, therefore, the compounding effect will lose its effect.
Also, it is important to point out that the longer you invest and the sooner you start has a profound effect on the total sum you will have to retire on. A regular saving plan that quickly converts your savings into investments is the best strategy to follow, particularly for newcomers and novices to the investment scene, or for those who do not have a lot of cash reserves to start with.
