To understand more about the investment process and how you can choose investments that best meet your financial goals and objectives, you need to understand the relationship between risk and return and the benefits that diversification can offer. It will also help if you have some understanding of the main types of investments available. Investments offered through workplace superannuation schemes fall into four categories – known as asset classes.
Cash (bank term deposits)
A cash fund invests into short-term money market securities such as 90-day bank bills and certificates of deposit.
Returns on cash based funds will typically be in line with or slightly better than what you could achieve in bank term deposits of a similar time frame.
Fixed interest products (bonds and debentures)
Typically, funds investing in fixed interest products will include international bond products and other fixed interest securities not available to ordinary investors.
Returns on fixed interest products should generally be higher than those for cash-based funds but there may be more volatility in your returns.
Property
Funds investing in property will not typically invest in residential property. Instead they will invest in a diversified portfolio of different property sectors including commercial, office, industrial, hotel and others.
Property based funds enable you to invest in a strong and relatively stable market without the difficulties of buying and selling you may encounter with your own residential property.
Shares
An investment in a share fund will include a wide variety of national and/or international shares. Rather than having to pick the best performing shares yourself, the fund will employ experienced, qualified fund managers who know and understand the performance of major companies and who can make the best selection of shares on your behalf.
Returns may be higher than what can be achieved in other forms of investment but there is increased volatility.
Risk
When we look at investments, we need to understand what the term risk means and how it relates to the return gained from each asset class. Many people think of risk as the chance of losing all their money. While this type of risk does exist, it is important to understand that it’s generally limited to those investors who put all their investment funds into a single asset, such as one company, or one property.
The relationship between risk and return
When choosing an investment, the first thing to decide is what’s more important to you – a higher return or less risk? To help you decide what is important to you we have developed a Risk Profiler, click here to check your tolerance to risk.
In the world of investment management, risk is defined as the degree to which the return on an investment varies (or fluctuates) from its normal long-term average. This is referred to as the volatility of the return. Generally speaking, the higher the risk, the higher the return. That is, the higher the return, the more it is likely to vary up and down over short periods of time.
An investment with a high level of cash tends to have a low level of volatility (or unit price fluctuation). For example, cash in the bank (e.g. through a term deposit) is more conservative than other investments and is unlikely to give you a negative return on your money. The other side of this is that cash investments also tend to produce lower returns over the medium to longer term.
On the flip side, investments with a high percentage in shares (or equities) will have a much higher level of volatility over shorter periods of time. Negative returns may be experienced over the shorter term, but over the longer term, you should see this volatility average out to produce generally higher returns. That’s why higher ‘risk’ investments tend to benefit from a longer investment timeframe.
Diversification
Diversification can be a very successful strategy for investors looking to reduce risk and get consistent returns. It’s about spreading your money across a number of different investments – or not putting all your eggs in one basket. If you are not sure you are willing to have such high risk, it may pay to diversify your investments.
Generally speaking, the greater your diversification, the lower your investment risk.
By spreading your money across a variety of asset classes, you can balance the risk against expected returns to suit your attitude to risk. Every asset class has some investment risk associated with it.
How can diversification improve your investment success?
Investing in a diverse range of investments means you take advantage of positive movements in any area while protecting yourself from negative movements in other areas. Diversification can protect you against short-term volatility – when one investment goes down another tends to rise.
Some examples of diversification include investing in different asset classes, investing in different countries or investing with different Investment Managers to take advantage of their different investment style.
Now that you know about asset classes and their risk and the benefits of diversification, use the risk profiler to find out which investment options will best suit your investment needs.