By Sheryl Sutherland*
In my previous column I examined the various asset classes and how they fit in to your investment plan. Picking up where I left off, asset classes can be divided roughly into two groups: growth and income investments.
Firstly growth investments which are purchased in anticipation that they will increase in value over time, although there is no way to predict the rate of growth or the change in value. Shares and real estate are typical growth investments. Growth can also be referred to as capital gain.
Secondly, income investments which usually pay interest. These investments are known as fixed income investments and include bonds or certificates of deposit.
So which should you choose and in which proportion?
Consider the following;
• The longer your time frame the more sense growth investments make as you can ride out possible downturns in your investment.
• Balancing risk, a variety of investments ensures you aren’t as vulnerable to the economic ups and downs.
• Inflation eroding the value of your capital.
Possibly the most important goal in investing is to beat inflation. The ugly truth about inflation is that you need more money every year to pay for the same things. The best solution to this is making investments that are growth oriented.
The higher your real rate of return (what you earn after tax and inflation) the better off you will be. In light of this let’s examine the differences between the growth investments and income investments.
Investing means using money to make money. That happens when: You buy an investment that increase in value, pays you dividends, or earnings – or does both, this is generally a growth investment. You lend money, giving the borrower the right to use it for a specific period of time, and you collect interest, or a percentage of the loan amount, this is an income investments.
Shares are growth investments which give you ownership of a piece of a company.
The advantages of shares are as follows:
• They increase in value over time, usually faster than the rate of inflation.
• They pay dividend income.
• Shares historically provide the best return on investment.
The downside to shares is risk; including the following:
• You may experience volatility, or sharp change in value, especially in the short term.
• Performance can be dependent on company management and overall economy.
• Investment in boom periods can mean paying high prices for shares.
An example of income investments are bonds. You can loan a company money. It pays you back, plus interest. The advantages of bonds are as follows:
• You get regular income from interest payments.
• You get return of principal, or investment amount, at tend of specified term.
• They are usually less volatile than equities, so there’s less risk of losing principal.
The risks of bonds are as follows:
• Income and principal vulnerable to inflation, or loss of value.
• Possibility of losing money if sold before end of investment term.
• Investing when interest rates are low means being locked in to less income for term.
Most of us don’t have enough investment capital to invest directly in shares or bonds so use a fund to do so. KiwiSaver is good example of this, we pool our money with that of other investors and it is managed on our behalf.
The advantages of share funds are as follows:
• They generally increase in value over time and often pay dividend income.
• Funds invest in many securities, which reduces investment risk. The risks of share funds are as follows:
• Performance depends on the quality of fund’s management.
• Even though investment is diversified, there is still market risk.
The advantages of bond funds are as follows:
• They allow more flexibility in price and timing than buying actual bonds.
• They provide regular income, which can be reinvested to increase number of shares.
The risks of bonds funds are as follows:
• They do not assure return of principal, or pay fixed rate of income.
• Their earnings can be vulnerable to inflation and interest rate changes.
So how do you know which is best suited to your investment needs and objectives and how to balance a portfolio?
In her next column Sheryl looks at how to manage risk through diversification.