Photo by Sharon McCutcheon on Unsplash
“I’m glad I learned about parallelograms instead of how to do taxes. It’s really coming in handy this parallelogram season.” Rebel Circus
I graduated from university with a Bachelor of Commerce Degree but I did not know the first thing about budgeting, banking, debt, investment or tax (at a practical “how to” level) and I had never even heard of superannuation . I did, however, learn about parallelograms at school and I use that a lot too (not)!
We aren’t taught even the basics about money, finance and investment. We are somehow just meant to know it. Given that most of our parents weren’t taught either, we aren’t well equipped for a free and rewarding financial future.
When you do try to learn about money it seems to be written by people who just want to show you how smart they are by using industry jargon and confusing graphs. No wonder we want to just lie down and have a nanna nap.
In this article, I want to just delve into some of the basics of finance and money. Stripping it right back into plain English so you feel confident to make some financial decisions (or at least know the questions to ask when you go for financial advice). It’s by no means a definitive list but it’s a start.
Budgeting and cash flow
I’ve covered this in detail before. Suffice to say, if you don’t have a grip on how much money is coming in and where you are spending it then long term planning is difficult.
Assets and Liabilities
An asset is something of value that will likely go up in value in the future. In financial terms, it’s an economic resource expected to provide a current or future benefit. In practical terms think shares, real estate, cash, bonds, investments…
A liability, on the other hand, decreases in value. Think bank debt, mortgages, credit card debt, taxes owed.
What we commonly refer to as assets may, in fact, be a liability: for example a car or a boat…. When you have to list your assets to the bank they accept these as assets, however, as you probably know… a car rarely goes up in value.
For the record, a store card is not an asset, regardless of how special it might make you feel!
So exactly how do investments work?
Assets can generally be categorised as either a growth asset or a defensive asset.
A defensive asset is generally low risk and less volatile than growth assets. It is generally focussed on providing income to the investor rather than capital growth. Cash, fixed interest and bonds are examples of defensive assets. You put $100 into a term deposit at the bank, and at the end of the term, you get your $100 back plus the interest (income) the bank agreed to pay you.
A defensive asset generally provides a lower rate of return over long periods of time. Whilst they are low risk, they are by no means risk-free. The biggest risk here is interest rates falling (reducing the investor’s income) or inflation going up and the investment not keeping up.
A growth asset, on the other hand, will not only produce income but also grow in value over time. They are generally higher risk (more volatile) than a defensive asset but generally provide a higher expected return. Shares and property are growth assets.
Your investment time frame is important with a growth asset as the longer the investment time frame the lower the overall risk.
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Growth assets have similar characteristics. For example, if you buy a property for $100,000 to rent it out, the rent is paid to you monthly and is referred to as income. Over time, you expect the value of the property to increase and this is what’s referred to as growth. You are taxed on income and growth when you earn it. So for income, that’s annually when you do your tax return, for growth, it’s not until you sell the asset.
Shares (aka stocks or equities) are always seen as scary. “ I don’t understand the share market” is something I hear regularly. But shares work the same as property. it’s just that instead of owning a property you own a small slice of a company. Here’s an example… I might buy shares in Telstra today for $3.50 per share. Every 6 months they will pay me a dividend — that’s my income — when I go to sell the shares I would expect them to have grown in value to be more than the $3.50 I bought them for (growth).
The biggest difference is that there is no price board outside your house telling you it’s current value every few minutes. Share prices move faster than property prices…
It’s the same for a Monet painting… I might buy it for $1million and rent it to a big corporation to hang in their foyer (that’s income) and then sell it in 10 years for $2million… that’s growth.
So if you break it down, the mechanics of most investments are similar. Somehow or another they generate income and growth.
Investment Risk v return
When people think about investing they think it’s risky… what I find is this fear comes because they don’t understand the risks they are facing or the investments they are making. So now you understand how growth and defensive assets work, let’s consider risk.
Risk can be defined as the chance of a loss occurring relative to the expected return of the investment. Or, to say it another way, it’s the uncertainty of getting the returns you expect. It’s generally not about losing all your money, or losing your house, or the shirt off your back…
Generally, the higher the investment risk you take, the higher your return should be… you should be rewarded for the risk you are taking. Also, generally, the longer your investment time frame, the more risk you can take.
If we’re talking about the dream home you’re saving to buy next year then we don’t want to take any risk on the money and we’re going to leave it in the bank. But if you’re in your 20s or 30s and talking about saving for your retirement you can invest fully in growth assets. Sure there will be some ups and downs along the way, but you have time on your side to ride these out.
The biggest risk of investing in all defensive assets is that it doesn’t keep pace with inflation; inflation being the rising cost of goods and services year on year. If you kept your $100 in the bank, in 10 years time that $100 won’t buy you as much as it does today.
Once you start investing in growth assets the difference is in the range of possible returns and the likelihood of a negative return in any given year. Someone invested fully in shares in 2007, for example, was possibly returning 40–50% positive returns… it wasn’t possible to lose money in 2007! However, by 2008 the infamous Global Financial Crisis hit and those same investments were now returning negative 40–50%! However, if you stayed invested you were back to where you started in about 4–5 years.
Managing risk through Diversification
In investment circles, the question of whether to diversify or stay with a single asset class you understand can be hotly contested. My view is that unless you are a sophisticated investor, diversification will reduce investment risk for you.
Diversification is simply not having all your money in one asset class. It’s having your money spread across Australian (home country) Shares, International shares, property and fixed interest. It reduces risk and increases the reliability of outcomes.
Managed funds
How can you get this magical diversification? If you have a lot of money to invest then you can get a diversified investment program by buying assets directly… a share portfolio, a property portfolio, a fixed interest portfolio.
If you don’t have a spare million or two you could consider managed funds. This is where your money is pooled with other investors in what’s called a unit trust. You buy units in the unit trust. Because of the pooled nature, the fund will have millions of investor dollars to achieve the diversification you are seeking. The value of your unit holding is directly related to the value of the underlying assets it owns.
The beauty of a managed fund is you don’t have to make any decisions after your initial decision to invest. You choose the level of risk you are prepared to take and then leave the professional manager to do the rest. You can start with only a few thousand dollars and contribute as little as $100 a month if that’s all you can spare… it’s a good start.
Unless you have a desire to invest in Socially Responsible Investment, I suggest you start by looking at low-cost index managers.
Socially Responsible Investment started out years ago as a way of screening out moral nasties from the investment portfolio — things like alcohol, tobacco, pornography. It then moved to screen out other things like environmental vandalism, poor labour standards or poor corporate governance. Over recent times SRI funds have moved towards not just screening out the bad companies, but actively seeking out companies doing things right or at the forefront of best practice.
These funds are usually a little more expensive than mainstream funds due to the extra layer of research involved, however, they regularly outperform mainstream funds in terms of returns whilst giving back to the planet.
That’s a lot of financial information to wade through. Although there is a lot more I could cover, even my eyes are glazing over, so I’ll leave it there for now.
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