The ramifications of poor financial understanding, literacy, and decision-making can be lasting which is why being educated and informed is of the utmost importance. If you’re a novice looking to establish a portfolio or a seasoned professional diversifying your mix, here are five critical questions to ask before embarking on your first or next investing journey.
What is the full cost of the investment?
If I told you index funds routinely outperformed Australian active funds, would you believe me? That’s what S&P Dow Jones Indices found, and the numbers are staggering. The SPIVA Australia Scorecard states, “Over the 10-year period ending June 30… more than 70% of Australian equity general, Australian bond, and A-REIT funds underperformed their respective benchmarks on an absolute basis.” Someone’s nest is being feathered and if you’re beholden to an actively-managed investment manager, it may not be yours.
The implication is obvious: what are the ongoing costs versus the return? Do transaction costs and taxes add to the cost of holding the investment? How many layers of fees are imbedded in the investment? Is the cost of your portfolio, including your advisor, providing good value? These questions only but scratch the surface when attempting to weight the investment scales.
Don’t get caught looking at just potential returns, investigate the costs.
What is the expected time commitment?
“A stitch in time saves nine” is a proverb that suggests a timely effort now will prevent more work in the future. Time itself, is an investment. How much time are you prepared to allocate to your portfolio? Depending on the study, it takes anywhere between 4,000 to 10,000 hours of deliberate practice to acquire elite sporting expertise. You know what also takes up time?
Re-entering the job market because you’ve exhausted your savings and retirement funds.
Before beginning your investing journey, consider if you understand how the stock market operates. This is your stitch in time moment. Google returns 1.9 billion results for the query “how does the stock market work?” Never forget, investing is a form of competition. Not only are you competing with well-researched and resourced professionals but also, the market itself. How much time can you commit to researching your selections? Is your idea of monitoring the performance of your portfolio a few throwaway minutes here or informed and engaged time there? Are you disciplined enough to execute a minimise losses-take profits strategy or do you prefer abdicating this responsibility to a trusted advisor?
Everything worthwhile is worth your time.
Is the investment simple or complex?
Albert Einstein famously said, “If you can't explain it to a six-year-old, you don't understand it yourself.” Words of caution when contemplating potential investments. The first port of call is understanding complexity— the investment’s level of sophistication. Collateralised debt obligations, forex, futures, options, hybrid securities, stapled securities and so on and so forth. If you can’t explain their sophistication or properly describe these investment classes to a six-year old, is it wise to commit your money?
Understanding complexity is one thing, realising what you’re getting into another. For instance, are you investing in a property or lending money to a property developer? Does the investment have internal gearing that may magnify the potential for losses or gains? Are fees imbedded in the investment (e.g. an investment property may require fees to the land owner, builder, real estate agent, mortgage broker, and your advisor)? How liquid is the investment and when needed, how quickly and easily can you redeem your investment?
Before committing, know what you’re getting into and how quickly you can get out.
Is the investment portfolio diversified?
How many times have you heard “don’t put all your eggs in one basket”? Diversification guards against investment risk and reduces volatility. Spreading your portfolio across a range of equities, fixed interest, property and infrastructure, alternatives, and cash, leaves you less exposed to a single economic event meaning in the event of a catastrophe, a diversified portfolio can absorb losses and minimise financial damage. It’s a hedge against a worse case scenario.
The amount invested in each asset class depends on a range of factors. Is income or growth more important? Is capital preservation paramount? How quickly do you need access to your capital? What are taxation implications of the income or capital gains? What are the ramifications of hedged or unhedged currency movements? Establish your goals then diversify accordingly.
Diversify, diversify, diversify.
What is the appetite for risk/risk tolerance?
Picture a grandfather with his teenage grandson standing on top of a 6-metre vertical ramp. If you were given the choice to pick who is more likely to go over the edge on a skateboard and potentially, experience a tremendous rush of endorphins or stand pat and reduce his exposure to potential harm, what would your answer be? Naturally, most people would answer the grandson is more willing to go over the edge and thus, has a greater appetite for risk.
Investing comes down to the amount of financial risk you are willing to bear to generate a potential return. A person’s appetite for risk is a function of a number of factors: age - generally speaking, as we grow older, we become more conservative realising the amount of time available to accumulate or replace lost capital is diminishing, experiences with investing, level of sophistication with investment types, cultural background, upbringing, and personality type.
Establish your willingness to stomach violent swings in the value of your investments then strategise accordingly.
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Sources - Luk, P., SPIVA australia scorecard