Investing tips

Diversify to reduce risk

Diversification is the simplest way to reduce the overall risk of a portfolio. Different types of investments tend to perform differently to each other depending on the prevailing economic and financial market conditions. So if you invest in a range of investments, in any given year your better performing investments will offset the poorer performing investments and smooth out your overall returns.

It’s important to have the right mix of asset classes to suit your needs as well as good diversification within those asset classes. Asset classes are often classified into growth or defensive investments. Growth investments have a greater potential to grow in value but also greater potential to fall in value. Defensive investments usually maintain more stable values and provide most of their returns in the form of income.

Shares and property are generally considered growth assets and fixed income and cash are considered defensive. Within asset classes there are many variations. For example, within the asset class of shares some companies are considered defensive and some are considered growth. Defensive companies are stable, established businesses with steady, reliable revenue streams, paying a high level of their profits in dividends. Growth companies are those that have high potential to grow the business and profits but may use more of their profits to fund future growth rather than paying dividends to investors.

Whatever an investment is called it’s vital that investors look beyond this to understand exactly the sort of risks an investment entails.

Invest regularly

Investing regularly becomes a habit that can reward you in future. It provides the discipline to allocate money to your investment first before you have the temptation to spend it. You will also benefit from dollar cost averaging. This means that over time you can average out the cost of your investment as its value fluctuates. If you invest the same amount of money every time you will buy more of the investment when its price is down and less when it’s high. This reduces the risk of investing all your money at the wrong time, for example, when values have peaked. Most managed funds allow you to establish a regular savings plan using a direct debit from your bank account.

The following example shows how an investor can benefit from dollar cost averaging by investing regularly. Over a ten month period the price of the investment fluctuates, but by investing regularly it averages out the price they pay for each unit, ensuring they haven’t invested all their money at a peak in prices. This can apply to any investment which has fluctuating values, for example company shares or units in a managed share fund.

The benefit of dollar cost averaging

Monthly investment Investment unit price Number of investment units purchased
$200 $10 20
$200 $9 22
$200 $7 29
$200 $6 33
$200 $6 33
$200 $6 33
$200 $6 33
$200 $7 29
 $200 $9 22   
 $200 $10 20

Total cost of investment = $2,000
Investment value after ten months = $2740
Average of unit price = $7.60
Average price paid for each unit = $7.27

Reinvest income

If you regularly reinvest the income you receive from an investment you will benefit from the power of compounding returns. The longer you do this the more your returns will be generated by your earlier returns. If you invested $1000 which returned income of 8 % pa, that you then reinvested, you would double your money in nine years. After that you would be receiving more returns from your returns than from your original investment.

Gear your investment the easy way

Instead of borrowing money to invest one simple way to gear your investment dollar is through a geared fund. This is where the fund itself borrows money to invest rather than you. Like all gearing this can increase any gains or losses from your investment, but it means you don’t have to use your investment or other assets as security and you don’t have to immediately pay back some of the loan if the value of the investment falls, as required under a margin loan.

Invest in good advice

If you don’t have a clear financial plan or investment strategy then it can be hard to measure your progress and make decisions about your investments. A professional adviser can be invaluable not just for their knowledge and expertise but the fact they can provide you with an objective perspective.

Commitment and discipline pays off

While there are many things to consider when investing, don’t be put off by the complexities and endless options available. Only accept advice and invest in products with risks you understand and are prepared to accept. Then the most important thing is to make a start and be committed and disciplined. Constantly changing your strategy, searching for the next boom investment or the easy way to get rich, is a recipe for disappointment.

What’s next?

  • Learn more about the value of advice
  • Read about how Perpetual invests

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