In general terms, there are four main types of investment, often referred to as asset classes:
• Cash – where you invest money in a building society, bank or other financial institution. Investment options include cash management accounts, and a major benefit of this investment type is liquidity.
• Fixed interest – where you invest in short- or long-term interest rate products that provide a steady income stream. Investment options include bonds, deposits, bank bills and various other types of securities. For more information on fixed-interest products, go to the ASX website: www.asx.com.au.
• Property – where you invest in residential, rural, industrial or commercial property. Depending on your retirement plans and financial objectives, your home may be included in this investment class.
• Shares – where you invest in companies listed on the ASX and other stock exchanges.
Evaluating investment opportunities is easiest if you use a standard set of criteria to measure and compare them. Each investment should be evaluated in the context of your goals and objectives and then the following characteristics (among others) should be considered:
• return on investment
• capital and income security (or risk)
• ease of investment
• liquidity and other market conditions
• minimum investment
• costs
• time frame for performance
• choice and ability to diversify
• taxation.
Return on investment is usually in the form of income (a payment you receive from your investment) or capital growth (where the value of your investment increases over time). Some investments, such as shares or property, may provide both.
Income
Investment income includes amounts such as interest on bank accounts, dividends from shares, rent from a property and distributions from a trust. As well as the amount of income you are likely to receive, you should consider the likely frequency of the payments and the potential for any increases or bonuses. As income from investments is usually subject to income tax at your marginal tax rate, you should always take the income provided after tax into account. Some forms of investment income, such as fully franked dividends, may provide some investors with tax benefits; however, we recommend that you obtain your own taxation advice from a professional adviser before making any investment decisions.
Capital growth
Returns from capital growth can only be realised when you sell an investment for more than the purchase price. The main benefit of capital growth is that it protects you against inflation. Capital growth may occur through rising share and unit trust prices on the sharemarket, increased values in the property market, and/or profit on fixed-interest securities if sold before maturity. Realised capital growth from investments is usually subject to capital gains tax.
Visit the website of the Australian Taxation Office (www.ato.gov.au) for up-to-date information on tax matters.
How secure is your investment capital? Is it possible your investment will be worth less when you wish to sell it? Will you be able to sell it at all if there is a shortage of buyers or if the financial institution you have invested in defaults? By answering these questions you are identifying your risk of capital loss.
In addition to your capital, how secure is the income from your investment? For example, in the case of an investment property, will there always be a tenant to pay rent? This is an important consideration if you are relying on investment income to supplement your income from other sources or to support your lifestyle. In addition, unreliable or fluctuating income may affect the sale price or capital gain of your investment.
When considering capital and income security, it is important to take into account price volatility and the risk/reward equation.
Volatility
Volatility refers to the general tendency of the price of an investment to fluctuate as buyers and sellers enter and leave the market.
Short-term price fluctuations matter less when you invest for the long term and when the price is expected to rise overall during the period of investment. Whereas a three-year investment is usually considered to be short term, a long-term investment can be seven years or more.
If you sold your house on seven different days, you would get a different price each day. In the short term, the sharemarket really isn’t all that different.
The risk/return equation
The risk/return equation balances the possible risk (of loss) against the possible return (or profit) of an investment.
You should only invest as much in high-risk investments as you are prepared to lose. For example, ‘safe’ or low-risk investments such as bank accounts often pay lower rates of interest or offer lower returns, while high-risk investments often provide an opportunity for higher rates of return.
Ease of investment is another important consideration when deciding which asset class to invest in. Look at how hard it is to enter the asset class and what processes you need to go through when you decide to exit. For example, if you know how difficult it can be to find a suitable investment property, negotiate the price and arrange settlement, you will be pleased to find out that establishing an account with a stockbroker is as easy as opening a bank account. Having opened your account, you can buy and sell shares by giving instructions to your stockbroker over the telephone. Alternatively, you can use an online broker. Share prices are listed daily in the major newspapers and may be accessed online. ASX operates from 10 am to 4 pm Eastern Standard Time, Monday to Friday (excluding national holidays).
The ASX trading calendar, market hours and trading phases can be found on the ASX website: www.asx.com.au.
Investments with high liquidity not only make investing easier but, by allowing you to exit your investments easily, provide you with greater access to your money should you need it.
Share prices are determined by the buyers and sellers through the power of supply and demand, and trading may take place instantaneously. There is usually a healthy number of buyers and sellers for shares in most of the major companies. These are known as liquid stocks. However, the Australian market is noted for having a ‘long tail’. This means that liquidity is quite concentrated and can trail off considerably outside the top 200 companies (and sometimes for stocks, within the top 200). You can readily determine how liquid the market for the shares in a particular company are by monitoring how many shares are sold on a daily or weekly basis. Another test of liquidity is how wide the spread is between the bid (the highest price people are prepared to pay) and the offer (the lowest price people are prepared to sell at). When there are lots of buyers and sellers, both sides compete to get their trade done so buyers are prepared to pay more and sellers are prepared to accept less, resulting in a narrowing of the bid/offer spread.
Interest-bearing investments also have a degree of liquidity. Generally speaking, the least liquid asset class is property: investors in this asset class may need to wait for the opportunity to realise any capital gain.
The minimum investment for a particular asset class is another important consideration, as the amount required may prove to be prohibitive for some investors. In the case of share investment, some stockbrokers will accept an initial investment of as little as