Investing explained

Whether it is taking a more active interest in our superannuation, starting to build an investment portfolio, or even trying our hands at playing the stock market, we can all benefit by understanding the language and key concepts of investing.

There is a huge range of potential investments out there, and these can be grouped together in asset classes that are based on shared characteristics.

There are many asset classes, however the major ones that most mainstream investors focus on are shares, property, fixed interest and cash.

Shares

Shares give investors part ownership in specific companies.

The share market sets the value of each share and prices can fluctuate significantly, even from day to day.

This price volatility means that, relative to other asset classes, shares are higher risk, particularly in the short term.

However, investors expect to be rewarded for taking on this risk by the potential for shares to deliver higher long-term gains than the other asset classes.

Property

Property also provides investors with full or partial ownership of growth assets.

Income is received in the form of rent, and property can also provide capital growth.

As property can, at times, fall in value, it is considered a medium to high-risk asset class.

Fixed interest

Fixed interest refers to investment in government or corporate bonds.

Bonds are a type of loan, and each bond has a maturity date – the date the loan is repaid; a maturity value – the amount returned at the maturity date; a coupon rate and a market value.

The coupon rate is fixed for the life of the bond, hence the term ‘fixed interest’, but the market value can fluctuate depending on movements in interest rates.

Cash

Cash covers bank accounts and term deposits.

Returns are in the form of interest payments, and cash is generally considered to be a low-risk asset class. Why are asset classes important? One of the golden rules of investment is that when seeking higher returns, investors must take on a greater degree of risk.

Quality fixed-interest investments provide a high certainty of a particular return.

They are low risk and the returns they offer reflect this.

However, for any given share, we don’t know what its price will be in a week, a month or a year.

Prices might be volatile, the return is uncertain, so a share is a higherrisk investment. However, that risk can be a positive thing – upside risk – which is the potential for the share to generate a higher than expected return.

Asset classes bundle together investments with similar risk and return profiles.

By blending these asset classes together in different proportions – a process called asset allocation – investors can construct portfolios that provide levels of risk and return that suit specific needs.

This blending of different asset classes results in diversification, which is a critical risk management tool.

As different asset classes over and under perform at different times, mixing different asset classes lowers the volatility, and hence the risk, of a portfolio.

As far as returns are concerned, studies have shown more than 90 percent of a portfolio’s performance is determined by the asset allocation.

It’s vastly more important than individual investment selection or the timing of purchases and sales.

Of course, there is more to investing than can be conveyed in a short article, but that’s no reason to delay putting the various markets to work.

Your licensed financial adviser can help you understand your risk comfort level and design an investment strategy that’s right for you.

• The information provided in this article is general in nature only and does not constitute personal financial advice.