What is investing? Investing basics for beginners

Investing involves acquiring assets that appreciate in value over time and yield returns through income or capital gains. In a broader context, investing can also encompass allocating resources to enhance personal or societal well-being. However, in finance, it primarily refers to purchasing securities, real estate, or other valuable assets to generate capital gains or income.

Australians demonstrate a strong inclination towards investing, with approximately 2.2 million individuals, accounting for 20% of taxpayers, owning investment properties in 2020-21, as per ATO data. Additionally, a Savvy survey indicates that roughly 15% of Australians have investments in shares, with up to $5,000 allocated to this asset class.

Understanding the Mechanics of Investing

Investing functions on the principle of purchasing assets at a lower price and selling them at a higher price, yielding a profit known as a capital gain. This profit is realized through selling assets when their value appreciates over time. Here are three scenarios illustrating appreciation:

• Stocks may appreciate due to a company's introduction of a successful product, leading to increased sales, higher revenues, and consequently, a rise in stock value.
• Commodities like gold might appreciate as the US dollar depreciates, driving up demand for the commodity.
• Real estate, such as a home or apartment, may appreciate due to property renovations or the neighborhood becoming more desirable.

Apart from capital gains and appreciation, investing involves holding assets that generate income. Income investing focuses on acquiring assets that generate cash flow over time without the need for selling. For instance, dividend-paying stocks provide investors with regular income from dividends, which can be reinvested to benefit from compounding interest.

Types of Investments Explained

Investments are broadly categorized into four main asset classes: stocks, bonds, commodities, and real estate. Additionally, there are investment funds like managed funds and exchange-traded funds (ETFs) that offer diversified exposure across these asset classes. Here's an overview of each:

Bonds: Bonds enable investors to lend money to companies or governments in exchange for fixed interest payments over a specified period. They are often considered "fixed income" investments due to their predictable returns. While bonds are generally less risky than stocks, investors should be cautious of bonds issued by entities with poor credit ratings, as they may have a higher risk of default.

Stocks: Companies issue stock to raise capital for business operations. Purchasing shares of stock grants partial ownership in the company, allowing investors to participate in its gains and losses. Some stocks also offer dividends, which are periodic payments from the company's profits. However, stocks entail higher risk due to the absence of guaranteed returns and the potential for companies to go bankrupt.

Real Estate: Real estate investments involve purchasing properties or real estate-related assets. Real estate can offer steady income through rental payments and the potential for property appreciation over time. However, real estate investments require substantial capital and may involve ongoing maintenance costs.

Commodities: Commodities include physical goods like gold, oil, and agricultural products. Investing in commodities can provide diversification and protection against inflation, but prices can be volatile.

Investors should carefully consider their risk tolerance, investment goals, and time horizon when selecting investments from these asset classes. Additionally, thorough research and diversification across different types of investments can help manage risk and maximize returns.

Managed Funds and ETFs: Managed funds and Exchange-Traded Funds (ETFs) invest in stocks, bonds, and commodities following specific strategies. Both offer diversification benefits by pooling investments into hundreds or thousands of assets. Managed funds, actively managed by investment professionals, aim to outperform benchmark indexes but typically incur higher fees. Conversely, ETFs passively track benchmark indexes, resulting in lower costs and often delivering returns in line with market averages.

Commodities: Commodities comprise agricultural products, energy products, metals, including precious metals, serving as raw materials for various industries. Their prices fluctuate based on market demand; for instance, adverse weather conditions like floods impacting wheat supply can lead to price increases due to scarcity.

Investing in commodities typically involves trading futures and options contracts rather than physically holding quantities of commodities like oil, wheat, or gold. This method is preferred over direct ownership due to its complexity and higher risk, making it suitable for experienced investors.

Real Estate: Real estate investment involves purchasing homes, buildings, or land, with varying levels of risk influenced by economic cycles, stock availability, and urban development trends. While property investment can yield wealth accumulation and tax benefits, success requires financial resources and patience. Alternatively, investing in Real Estate Investment Trusts (REITs) offers indirect exposure to real estate income, often providing higher dividends than stocks.

Beginning Your Investment Journey

Starting to invest is straightforward and doesn't require a large sum of money. To begin, determine the type of beginner investment account that suits your needs:

• Consider a robo-advisor if you have limited funds and prefer a hands-off approach. These automated platforms create diversified portfolios tailored to your risk tolerance and financial objectives.
• Opt for an online brokerage account if you prefer hands-on research and selecting individual investments. For beginners, managed funds and ETFs offer easy diversification.
• If you seek professional guidance with a hands-off approach, consult a financial advisor specializing in assisting new investors. They can help you select and manage investments based on your goals.

Regardless of your chosen method, remember that investing is a long-term commitment, and consistent investment is key to maximizing returns. Stick to your investment strategy through market fluctuations to achieve optimal results over time.

Understanding Risk and Investing

Investments entail varying degrees of risk, with higher risk potentially yielding faster returns but also carrying a greater chance of financial loss. Conversely, lower risk investments offer slower profit accumulation but ensure a safer investment.

Assessing one's risk tolerance is crucial in investment decisions. A higher risk tolerance indicates comfort with short-term fluctuations in investment value for the prospect of long-term gains, while a lower risk tolerance suggests a preference for a more stable rate of return.

Financial advisors typically advise taking on more risk for long-term objectives, such as retirement planning, where there is ample time to recover from market downturns.

For instance, although the ASX200 has encountered various short-term downturns, it has delivered average annual returns of approximately 13% since 1900. However, needing funds during these downturns could result in losses. Therefore, considering investment timeline and overall financial position is essential.

Risk and Diversification

Regardless of risk tolerance, diversification is a fundamental strategy for risk management. Diversifying investments across various asset classes mitigates the impact of losses in one area with gains in another, ensuring a well-rounded investment portfolio.

For instance, if stock markets perform well, certain segments of the bond market may experience declines. Concentrating investments solely in bonds could lead to losses. However, diversification across bonds and stocks can help minimize losses.

By holding a diversified portfolio comprising investments in different companies and asset classes, investors can offset losses in one sector with gains in another, thus maintaining steady and secure portfolio growth over time.

Commence Investing Early, Maintain Consistent Investments

Successful investors often accumulate wealth systematically by making regular investments, such as through payroll deductions or automatic savings account transfers, advises Jess Emery, a representative for Vanguard Funds in the US.

Consistent investing allows you to capitalize on market fluctuations. By investing a fixed amount over time, you acquire fewer shares when prices are high and more shares when prices are low. This practice, known as dollar-cost averaging, can potentially reduce the average cost per share over time. However, dollar-cost averaging relies on the willingness to continue investing during market downturns, according to Emery.

Additionally, it's essential to understand that all investments carry inherent risks, although calculated risks can yield rewards.

Moreover, avoid making hasty decisions to sell investments during market downturns. Predicting when stock values will rebound is challenging, and significant market gains have often followed substantial losses.

Prioritize investing in yourself as the foundation of good investment practice. Educate yourself about the optimal superannuation fund, establish emergency savings, and devise a plan for managing student loan debt. With these essential financial steps in place, you can embark on your investment journey confidently, leveraging your current funds to secure your future.