By Paul Clitheroe,
Money Magazine, September 2007
Six of the best
1. Invest in something you understand
In both life and investing, the simple things are often the best. Most successful companies have a fundamentally simple product.
It's not terribly hard to get a good grasp of how a business like, say, Woolworths works. I think a pretty good test of whether an investment is complicated and, more to the point, if you understand it, is how well you can explain it to someone else. As the famous investor Warren Buffett has said, "If you don't understand it, don't buy it."
2. Consider mainstream assets first
Most mainstream investments fall into one of three categories: cash (which includes fixed-interest securities), property and shares.
These three investment classes are generally a more proven way of generating wealth. Broadly speaking, they can be classified as income investments (cash and interest-bearing securities) and growth investments (property and shares).
Managed investment funds, strictly speaking, are not a separate asset class. They pool their unit holders' funds and invest the money in other underlying assets, such as cash, property or shares. We'll look at these two main types: "income" assets and "growth" assets.
Income assets
Income assets, also known as "conservative" assets, are generally lower in risk. They include term deposits, cash management trusts and other interest-bearing securities and they usually pay investors a specified income on a regular basis.
However, there are downsides. In keeping with the classic investment principle that risk equals return, the lower-risk nature of most income assets means their average returns are normally lower than the average returns from higher-risk growth assets, such as shares and property.
Another important characteristic of income assets is the way they are taxed. To put it simply, your income asset's earnings are taxed fully at your marginal rate (the highest rate of tax you pay). Growth assets — shares and property — attract some tax relief.
Finally there are the matters of capital growth and inflation. Assuming you hold your income assets until maturity, they offer no capital growth and are also subject to erosion by inflation. Despite these negatives, income assets offer security and regular income and therefore have a place in most investment portfolios.
Some income assets, most notably debentures used to finance property developments, are very high-risk, despite presenting themselves as low-risk. There have been serious company failures in this area with investors losing a lot of money, such as the collapse of Fincorp in 2007, Westpoint in 2006 and, in 1990, Estate Mortgage and the Pyramid Building Society.
Growth assets
Growth assets include property, shares, both international and Australian, and units in managed funds that invest in these assets.
These investments offer ongoing income in the form of rent, dividends and distributions, but they also offer capital growth and some tax breaks. It's important to remember that these investments carry more risk.
The capital growth is by no means guaranteed and while there will be periods when the market goes gangbusters (a "bull'" market), there will also be periods when the market dips (a "bear" market).
You need to be able to withstand a fall in the value of your investment.
Shares and property can also be good sources of ongoing income and, unlike income assets, the return on growth assets can be more tax-effective.
Dividends offer franking credits to offset the income tax you pay and property can give you depreciation and other allowances that can be claimed as a tax deduction. An important point to bear in mind about growth assets is that their stated returns usually include both capital growth and ongoing income, but the capital growth is only accessible if you sell the asset.
Property
Aim for the best-located real estate your money can buy. I reckon it's important to pick a property and a location that will appeal to the ageing baby boomers who make up an increasing proportion of our population.
As the population ages, the baby boomers (people born between 1945 and the mid-1960s) will increasingly move from their homes in the suburbs to smaller dwellings, such as townhouses, closer to the city or to coastal retirement enclaves.
Generally, the dwellings will need to be low-maintenance with little or no garden, made of good-quality materials, well positioned and close to all amenities. Something that fits those parameters is more likely to show stronger price and rental growth than other types of properties.
Shares
In addition to monitoring a share's performance on the Australian Stock Exchange (ASX), things you should look for in a publicly listed company include:
* whether or not the underlying business is a good one;
* whether the management team is experienced, with a good track record;
* whether the product has good growth potential.
A company's annual report provides a lot of information but can be a bit overwhelming — sometimes running to a few hundred pages. This is when the advice of a competent financial planner can be useful. Alternatively, the ASX runs courses designed to give investors a better understanding of shares (13 12 79 or www.asx.com.au).
3. Risk equals return
Taking excessive risk in looking for a big return is the number-one reason investors lose their money. They get too greedy — and investment salespeople know this. Now, I'm not saying risk is to be avoided. If you take no risk, you get no return. Everything has some risk, but you must be aware of risk. The real trick is to consider how much risk you can manage and to invest accordingly.
A young person just entering the workforce, for example, may be prepared to invest heavily in an international managed share fund. Sure, this is risky and international markets have copped a hiding over the past few years. However, with a 20-year view, this strategy could give our young investor the highest return over the decades.
At my age (51 as I write this seventh edition), I would not invest all my money in international share markets because of the high risk. However, I have been more than willing to invest some of my super money in this area — because I won't be touching it for a few years yet. Having paid off my mortgage, my main plan at this stage is to build up my super and a portfolio of other investments, such as Australian shares and some investment property. As I age, my attitude to risk will change. I'll be more concerned with protecting my wealth, not growing it, so I will gradually switch to lower-risk investments such as cash, fixed interest and blue-chip shares.
4. Invest on merit
It could be a free music CD if you buy units in a particular managed fund, a bonus deposit for opening a new savings account, even a year's worth of home insurance for taking out a new home loan. These offers may be all above board, but in some cases they may encourage investors to choose a long-term investment vehicle based on a short-term gain. It pays to stay focused on the fundamentals.
When it comes to investing, don't be baffled by big talk, broad statements or bad gimmicks. Focus on the important stuff — what the company aims to achieve, what it invests in, who runs it, what the fees are and what its long-term performance has been.
5. Diversify
In broad terms, I recommend you have a plan to create three pools of wealth — your home, your superannuation and other investments. This strategy gives you exposure to property (your home), shares and fixed interest (through your super) and other investments you buy yourself. It also gives you diversification from a taxation and legislative perspective.
Super is a highly regulated area and the main reason I would not rely solely on super is another type of risk — the risk of the legislation changing, (and it has changed a great deal). How you diversify depends upon your age, income, family and so on. For example, with a share portfolio, you should diversify by choosing different sectors within the market. You might invest in the following areas:
* Banking and finance
* Building and construction
* Media
* Health
* Resources
Inside, say, the banking and finance sector, you might further diversify by choosing several shares such as Westpac, National Australia Bank and a smaller bank, such as St George.
6. Don't try to 'time' the market
Good market timing is all about buying at the bottom and selling at the top and being a "market timer" means trying to do just that. But no market timer I know consistently gets their timing right year after year, as no one has yet worked out how to read the future.
I'm not saying you shouldn't use research to guide you to better investment areas. But when it comes down to it, determining how much risk you can live with and then buying investments that suit your risk profile and monitoring these is a better strategy than regularly switching from one investment area to another.
For the complete story see Money Magazine's September 2007 issue.
http://money.ninemsn.com.au/article.aspx?id=294907
Key points
"If you don't understand it, don't buy it."
Income assets, also known as "conservative" assets, are generally lower in risk
Dividends offer franking credits to offset the income tax you pay
