Investing

Making the move from saver to investor is your first step on the road to building wealth. It’s only by putting your money to work that you can really get ahead.

How do people become wealthy? Some people inherit money, some people build their own business and some have a lucky break – but for most of us building wealth is about astute, well-researched investment backed by sound advice. Even starting with limited resources, it’s possible to realise your financial goals.

But first you need to know a few things about yourself: What are you investing for? What do you want to achieve and when? How willing – and able – are you to accept risk?

Once you have a reasonably clear idea on those issues, you can start looking at your investment options.

There are five basic categories of investments or asset classes: Australian shares, international shares, property, fixed interest and cash.

Each has characteristics that suit some types of investor better than others. Some assets provide income, while others have the potential for capital growth; some are riskier than others; some offer tax benefits as well as an investment return.

What are your goals?

Are you looking to invest for the short to medium term, maybe to buy a car or fund your children’s education? Or are you hoping to build wealth for your retirement? Perhaps you want to generate a regular income now.

What are your specific targets? It might be a certain level of income in retirement or enough money to meet private school fees. Once you know this, you can work backwards to establish what you need to do to achieve your goal.

This will involve balancing risk and return. An important rule of thumb is: the higher the risk, the higher the potential return (and vice versa).

If your financial target is high but the amount of time you have is short, you’ll have to consider whether you should take on more risk in the hope of a higher return – or perhaps revisit your financial goals.

The longer your investment time horizon, the more risks you can afford to take to achieve your goals. In 10 years’ time a slump on today’s sharemarket won’t mean much to your ultimate return – but if you’re looking to cash in your investments in the short term you’ll have to bear in mind that you may not have enough time to recover from any losses.

Appetite for risk

Once you’ve established your goals, you need to consider what type of investor you are. Everyone’s different – age, investing experience, financial resources and personality type all come into play when determining your risk profile.

Are you a cautious investor with little appetite for risk, or someone with the time and money – and inclination – to take on more risk in the hope of achieving higher returns? Have you owned shares before or are you a first-time investor? Are you comfortable borrowing money? How would you react if you experienced a low or negative return in any one year?

Assessing what sort of investor you are is important. While you want to maximise your returns, you don’t want to take on a degree of risk outside your safety zone. By the same token, in thinking these issues through you may come to realise that you are an overly cautious investor and that you can safely step up a notch.

The five basic asset classes can be placed in an investment risk pyramid, with cash-type or secure investments such as cash management trusts, savings accounts and government bonds forming a solid and safe foundation; medium-risk assets such as property, shares and corporate bonds taking a more modest share in the middle; and more speculative investments such as collectables, options, futures, and alternative investments like hedge funds the smallest part at the peak.

Income versus growth

The type of investments you choose will also depend on whether you want capital growth (that is, for your assets to appreciate over time) or an income now – or a combination of the two.

If you want to receive income on a regular basis there’s no point in investing in speculative shares that don’t pay dividends. You need to invest in assets that generate interest, rent or dividends. Property trusts, fixed-interest securities or shares with a strong dividend yield would be better options for your investment portfolio.

If you don’t require an income from your assets, high-yielding shares are not for you – especially as you could lose a large part of that dividend income in tax. In this case, you can afford to have a broader focus on equities and capital growth. Shares might account for 60 to 70 per cent of your growth portfolio.

Diversification

Having all your eggs in the equities basket – or in fixed income or in property, for that matter – is unwise.

Holding a diverse range of assets is important because it spreads your risk by reducing your dependence on the performance of one particular asset class – a positive performance in one area will offset periods of weakness in other investments.

As well as diversifying across asset classes, you can diversify within each asset class – spreading your risk even further. Within Australian shares, for example, instead of just focusing on banking stocks you could also invest in resources stocks or infrastructure assets. As well as big blue-chip stocks you could look at “small-cap” investments in smaller businesses with lower market capitalisations.

You’ll need to rebalance your portfolio now and then. You may start out with 30 per cent in shares, 30 per cent in property, 30 per cent in fixed interest and 10 per cent in cash, say. But a year down the track, with the sharemarket booming, you might end up with 40 per cent in shares, 25 per cent in property, 20 per cent in fixed interest and 15 per cent in cash – weightings that no longer sit comfortably with your overall strategy. It may be time to sell some shares and divert the profits into property and fixed interest.

The right vehicle

Now you’ve found the right investments, it’s time to consider the right investment vehicle. There are four possible investment structures, each with its pros and cons:

• You can buy the investments in your own name, in your partner’s name, or both;
• You can invest via a self-managed superannuation fund;
• You can use a company structure; or
• You can set up a family trust.

Generally, it pays to invest in the name of the person with the lowest rate of personal income tax but capital gains tax considerations can also come into play.

Power investing

Gearing involves borrowing money to invest. It allows you to increase your investment and therefore potentially your return. On the downside, it also magnifies your losses if the investment doesn’t pay off.

Margin lending is an increasingly popular gearing strategy. Just as a property investor puts down a deposit on a house and borrows the rest, margin lending allows investors to buy a portfolio of shares or managed funds with as little as a 20 per cent deposit.

The negative side is that when the value of the shares falls below a certain point, a margin call is made requiring the borrower to restore their loan-to-valuation level – generally within 24 hours. Borrowers can do this in one of three ways: by coming up with more cash, by selling some shares – and, if margin calls are being made, it’s probably not a great time to sell – or by contributing additional shares to top up their equity.

Fail to act and the lender may invoke their right to sell shares without consulting you.

That’s why it pays to borrow conservatively – say, for only half the shares in the portfolio (50 per cent gearing) – and to regularly review your ability to meet interest payments and any margin calls.

Home equity loans – borrowing against the equity in your house – geared share funds and instalment warrants are other ways of boosting your available investment funds.

Superannuation

Of course, another effective way of accumulating wealth is super, which qualifies for attractive tax breaks.

On the down side, super is heavily regulated, the rules tend to change, and your money is tied up until retirement age. Younger investors may want to keep some of their money in more liquid assets that are more easily accessed.

Seeking advice

If all this sounds a bit complicated or like a lot of work, it’s probably time to talk to a financial adviser. Financial planners can help you set some financial goals and create a plan to get there. They can guide you through the tax maze – or put you in touch with a tax planner who will.

But make sure you speak to a licensed adviser, and be aware that some advisers receive commissions on the financial products they recommend – an adviser who charges a consultation fee, instead of relying on commissions, may be more likely to offer truly independent advice.

Finally, don’t be taken for a ride …

The Australian Securities and Investments Commission is fond of saying that “if it sounds too good to be true, it probably is”. Its MoneySmart website will help you sniff out scams and get-rich schemes.

The bottom line is: do your research. Is the person offering the investment licensed and authorised to give advice? If there’s a prospectus, read it. Don’t be carried away by the spiel of a slick salesperson.