Investing 101: Making Sense of Investment Terms

by Dominique Schuh

When it comes to investing, it can be a minefield for both the amateur investor and the professional alike. But one point to remember is that not all investments are created equal, and those that suit you the best may depend on your stage in life, and how comfortable you are in taking on risk.

Here are a few fundamentals to consider:

1. Assets can be divided between roughly two categories: "defensive" and "growth".
The defensive side of things provides a buffer for you and has less volatility (up and down movement) and is generally associated with investments such as cash, term deposits and bonds. This is the safe stuff and has a lower associated risk, as well as a lower return. The "growth" side of things is made up of property, Australian and international shares, and commodities. The return from these types of assets generally comes from two areas – the increase in the value of the investment as well as the income they generate through dividends or rent.

2. Risk and return are related
Evidence from investors and academics points to one undeniable conclusion: returns come from risk. Investment rewards are rarely accomplished without taking a risk, but not all risks carry a reliable reward. Everything we have learned about expected returns in the share markets can be summarised in three dimensions:

a) Shares are riskier than bonds. In turn, they offer higher expected returns as a reward.
b) Small companies have higher expected returns than large companies. This makes sense because small companies are more of an unknown quantity.
c) Lower priced 'value' shares offer higher expected returns than higher priced 'growth' shares. A value share is one that is out of favour for one reason or another. The level of exposure to these areas will determine the risk and reward for an investor.

3. Diversification reduces investment risk
Investing without diversification is exposing yourself to unnecessary risk. Avoidable risks are holding too few shares, speculating on specific industry sectors or countries and following the predictions of others. These are risks that don't provide a reliable reward.

By spreading your investments across different types of asset classes you can build a total portfolio for all conditions. This is because while one asset class is performing poorly, another may be doing well. This is not to say diversification is complete protection, but it is insulation to reduce volatility. We hope you have found some useful tips in this week's "Money in Life" series. Remember not to leave these items to the last minute and also know that we're only an email or phone call away if you would like to seek advice on any of the above.