The calmer waters of interest-bearing investments: their risks and rewards

The interest-bearing investments include:

• cash
• bonds
• the money market securities.

Compared to the roller-coaster ride of equities, interest-bearing investments are like a sea of tranquillity.

The focus of interest-bearing investments is not on the appreciation (increase) of the capital you have invested, but rather on the provision of a steady interest income - often at a fixed rate.

While shares offer you higher returns at a higher risk, interest-bearing investments offer you lower returns at a lower risk, making them a safe haven for many investors.

But this safe asset class is not safe from inflation. 

Interest-bearing investments often do not generate the kind of return that beats inflation, and it is very important to remember that interest income is taxable.  After taking tax into account, the return on interest-bearing investments often struggles to beat the inflation rate.

The reason for this is simple.  Interest-bearing investments are normally money you lend to a bank, government, company or other institution with the undertaking that this exact amount will be paid back after a period of time. 

In return for this, you earn interest.

Since you only get the same amount back after a couple of months or years, that amount is usually worth less as a result of inflation. 

Your only real benefit is the income that you receive.

Interest-bearing investments also hold other risks. 

• This asset class is subject to the ups and downs of the interest rate cycle.  As interest rates increase or decrease, your cash flow can be affected - unless you have a fixed interest rate.
• Furthermore, you should beware of institutions with credit risk.  A high interest rate is not everything:  you must also be sure that your capital will be paid back. 

The so-called junk bond market in America is well known as a market where companies with poor credit ratings offer exceptionally high interest rates.  Sometimes it is better to earn less interest, but know that your money is safe.

Interest-bearing investments do, however, play an important part in an investment portfolio.  Although inflation will still erode the capital value of your investment, these investments do have advantages, including:

• offering you a relatively safe and predictable income.
• offering you less risk and volatility than an investment in equities
• offering diversification in your portfolio in case stock markets collapse
• giving you instant access to cash when you need it.

Investment in Property

Property is one of the main asset classes, the first investment most people make, and usually their biggest asset. 

Investment in property offers the promise of

• an appreciation (or increase) in capital and
• a regular income in the form of rental payments. 

That means that property, like equities, can beat inflation over time.

But you must also be aware that the capital value of your property can depreciate (or decrease) over time, therefore property is a medium- to high-risk investment.

One of the advantages of investment in property is gearing or leverage.  This is the use of debt in the form of mortgage bond finance to 'leverage' you or help you to acquire an asset you would not otherwise be able to afford.

With a little financial help from your banking friends, you will, it is hoped, make a good capital gain on your investment one day.

There are different ways of investing in property. 

• On the one hand, you can simply own your own home in which you live. 
• On the other hand, you can own an investment portfolio of different properites with a view to earning a rental income or capital profit from them. 
• A third way to invest in property is through the stock market.

Your own home

An own home is often the biggest asset in one's investment portfolio. 

For most people, paying off their house takes up most of their earnings.  They are using their mortgage bond to leverage them, possibly with the hope of making a capital gain one day.

Paying off a mortgage on your own home is one of the best investments you can make, and a golden rule to remember is that you should pay off your mortgage bond before you start thinking about investing in other asset classes.

As an own home can be a medium- to high-risk investment,  you should be aware of the following dangers:

• Property is highly illiquid.  This means you do not have immediate access to the value of your property should you need cash (although you could use your mortgage bond facility), and if you decide to sell your house, there is no guarantee that you will be able to do so quickly.
• The value of your house is influenced by many factors over which you have no control, such as political factors and economic and interest rate cycles.

An investment portfolio of properties

Buying a property with a view to letting it and using the rental income to cover your mortgage bond payments (with the mortgage interest often tax-deductibe) while you benefit from the capital appreciation of the property sounds like a great investment strategy.  So why do not more people do it?

The reason is perhaps because there are so many pitfalls in propety investment.  Some of these are:

• Large amounts are required to invest in property.
• Properties need to be managed.  Difficulties include problems with tenants, payments on time, maintenance, etc.  and these must all be factored into your calculations.
• There is a high risk of bad timing in property investment.  Certainly, you can make substantial capital gains, but only if you buy and sell the property at the right time.

Property investing on the stock market

Property investing on the stock market gives the small investor the chance to invest in property in a more liquid way.  You can sell your investment without having to sell a physical property, and you gain access to the propety expertise and scale benefits of large projects.  There are three sectors in the stock market property division in which you can invest, namely:

• property companies,
• property loan stocks, and
• property unit trusts or REITS

You can buy shares or units directly in these entities that own a diversified range of properties.  Each of these will have a different risk profile depending on factors such as

• the age,
• location and
• type of property in which it invests.

These entities normally perform well in a falling interest rate environment, but, as with all property investments, are vulnerable to

• interest rate cycles and
• economic and political change. 

These investments can therefore be fairly volatile and are recommended only for investors with specialised knowledge. 



Additional notes:

The concept of gearing:  This can be explained by the following example.  Say you have put down a deposit of $200,000 to buy a property of $1 million.  Within two years, the property's value increases by 10% to $1.1 million.  This means you have actually used $200,000 to earn $100,000 (i.e. 50% return) with the help of your bank manager!

Beware of property gains tax:  This can reduce the attractiveness of investment property.  Property gains tax can take a significant chunk of your capital gain when you sell property and will make it more difficult for this investment to beat inflation.

How do asset classes fit in with your profile?

From answering the 10 simple questions (reference below), your total score tells you more about yourself.  Three basic profiles emerged and helped set the necessary guidelines for your investment portfolio.

The three basic profiles and their respective investment objectives are:

• You cannot afford to make mistakes: Conservative investment objectives
• You are carefully weighing up your options: Prudent investment objectives
• You want to grow bigger and better: Aggressive investment objectives

Click here to find out what asset classes these respective investors should include in their portfolios.
http://spreadsheets.google.com/pub?key=t5u-KMcEYg81UlomoCgxU9A&output=html

Read also:

What money means to you? Answer 10 simple questions.

http://myinvestingnotes.blogspot.com/2010/01/what-money-means-to-you-answer-10.html

Understand what money means to you: Answer 10 simple questions : Sheet1

http://spreadsheets.google.com/pub?key=tr9oMvjAsDJvkcPgXdd763A&output=html

Equities - high risk

An investment in equities (shares or stocks) means that you have obtained part-ownership in the company whose shares you have bought.  Some companies are listed on a stock exchange, which means that your shares can be traded freely on that stock exchange.

Although equities are a high-risk asset class, they have the best chance of beating inflation over the longer term because of the inherent growth potential of the company in whch you have invested.

For that reason you should keep a SIGNIFICANT  portion of your portfolio in equities.  The basic rule is:  the longer the time until you retire, the more you should invest in equities.


How do I know how much of my portfolio should be in equities?

• Try this general rule of thumb:  multiply the number of years until you retire by two to get to the percentage of your assets that you should keep in equities. 
• For instance, you are 45 years old and have 20 years before retirement.  That means that you should invest 40% of your assets in equity.

Property - moderate to high risk

Property is often the biggest asset in a person's investment portfolio.

Property can keep up with inflation and can be a very effective way of gearing your investment.

This means that by using external financing you can increase the return on your investment.  Debt in the form of a mortgage bond can help you to acquire an asset - and a return on this asset - you would not otherwise be able to afford.

The risk of property, however, is moderate to high. 

Much depends on

• the location of the property and
• the political and economic environment.

One big drawback of this asset class is illiquidity:  the fact that you cannot sell property as quickly as investments in other asset classes. 

For that reason the safest option is to own your own home, but to leave property speculation (a potentially risky business) to the experts.

Bonds - moderate risk

Bonds or gilts can be defined as interest-bearing securities issued by governments or companies in order to borrow money.

In essence, it is an IOU, in which they promise to pay you, the lender,

• interest and
• to pay back your capital sum on a specific date.

This asset class offers a moderate risk. 

• The capital sum that you invest can fluctuate, while
• the interest payments can be higher than on cash.

The 4 major asset classes: the building blocks of any investment plan

Any serious investor should have a basic knowledge of the 4 major asset classes and the risk inherent in each:

• Cash - low risk  (For Savings and Protection)
• Bonds - moderate risk (For Income)
• Property - moderate to high risk (For Growth and Income)
• Equities - high risk (For Growth)

Remember this fundamental rule:

The bigger the risk you take, the greater the possible reward or return (growth on capital) you can expect.

The safer your investment and the smaller the risk you take, the smaller the possibility of a great return.