In the first part of Learn to understand investments I looked at the different investment options. In this second part, I give you a deeper understanding of the asset classes. The key principle is don’t invest in anything you don’t understand. You need to understand how to choose an investment in order to make the right decision.
What factors influence these returns? How likely are they to happen?
To understand what factors influence these returns and you must know how the returns are generated. If you want to know how to choose an investment then you need to see the full picture. There are broad sets of factors that will affect the whole asset class. These same factors can also affect your individual investments inside that asset class.
You must know what factors to look out for. Identify the signs and likelihood of these factors materialising. If you do this then you will be getting a sound understanding of your investment and its performance.
The growth of the world and country specific economies grow the equities market. As the world reduces poverty levels and standards of living rise over time the world improves. This is fundamentally why the equities market over the long term continues to increase in value.
Any negative event can slow down or stop that growth. A pandemic, a war, trade wars and political changes can be negative impacts. These events happen from time to time but are usually short lived. At worst they can last for a few years, but never decades.
These macro factors are not controllable or predictable, so it is not possible to anticipate them. On a micro level there are factors that affect an individual company performance and value.
How to choose an investment in equities requires questions like these
- What industry is the company in? Is it growing or declining? What impacts this industry?
- Does the country or region that the company operates have an impact?
- What is the market demand for the products? Are they unique? What is the competition like?
- Is the company well run? What is the liquidity and financial situation of the company?
Finance IQ has a great article about Knowing a Company before you buy the stock
You can see by all the factors to consider that it is possible to pick winning companies. If you understand the environment, performance, and outlook of the company you will know how to choose an investment. If you pick a winning company, there is no limit to the profit that you can make.
However, if you don’t understand this properly you can choose the wrong equities you can lose too. When this happens the value of the company decreases, and your shares will go below the value that you purchased them. That is where the risk in equities come in. You can win big or loose big.
Bonds pay you back your principle amount plus the interest earned for the period. The asset grows with interest and that interest portion is called the coupon rate. The price of a bond depends on the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time.
The interest rate depends on the credit quality of the bond issuer. If there is a higher risk of the issuer defaulting or not paying back the bond, then the interest rate is higher. If the issuer is very credit worthy, then the coupon rate will be lower. The time to maturity also affects the returns, the longer the time to maturity the greater the interest rate.
You still get your original money paid back even if returns are bad. That’s why bonds are less risky. Normally you get it paid back with an above inflation interest rate. There is a risk that the bond issuer will default but this risk is relatively small especially if you buy bonds from reputable countries or companies.
You can see that bonds will be less risky and equities. There are fewer factors to consider and you are much more certain of your return. Equities returns aren’t guaranteed but bond returns normally are. Understanding how to choose an investment means knowing what risk you want. Compared to equities bonds are significantly less risk but also lower returns.
The property market environment and interest rates affect the property returns. Both the price appreciation and the rental returns are dependent on these factors. If you know how to choose an investment in property you can do well but it is not always simple.
Property investments seem simple, but they are not. They require active management and attract many other costs like rates, maintenance, tenant management, tax etc. These costs will have an impact on the investment returns. It is important to fully understand the costs associated with property.
To understand how to choose an investment in commodities means you need to know how the price will change over time. Commodities can be considered risky as their returns are largely dependent on external factors. These uncertain factors include unusual weather, epidemics, and both natural and man-made disasters. Interestingly though the commodity returns move opposite to stocks. So, in times of crisis they are a store of value and their returns will increase. Its not very complicated just completely uncertain.
Commodities however do not generate any income while you own them. Unlike equities that pay dividends, bonds that pay interest and property that pays rental, comodities pay nothing. They rely purely on their underlying value and the difference between the buying and selling price. Commodities are seen as a store of value.
Interest rate is the only factor that affects cash returns. Larger amounts of cash can earn higher interest rates. Fixed deposits for fixed periods of time will also earn higher interest rates. But the differences are not that large. These interest rates are usually around the inflation rate.
Smaller cash amounts have rates below inflation and larger amounts have rates slightly above. To understand how to choose an investment in cash its all about how much interest you will get vs how accessible your cash is.
Is this investment sound or credible?
Now you can decide what the asset classes are that you understand and want to consider. Deciding how to choose an investment includes understanding where to do it. This very important part of investing is deciding how you are going to make these investments.
Important questions to ask are
- Who is supplying this investment?
- What is their credibility?
- Who is the owner?
You can invest directly into physical property while most others need a third party. It could be via a broker a financial services provider, an investment club or a bank or another company. Besides understanding the investment itself, it is equally important to understand who is supplying this investment.
The credibility and the trust in the supplier are important to guarantee the security of your investment. First check that they are registered under FSCA. To be a finacial services provider in South Africa you must be registered.
They should also have a good name or be backed by someone who does and have a solid track record over several years. This is how many fly by night schemes make their money by attracting people with lucrative returns and then disappearing with all your money.
What are the fees like?
It can be complicated understanding how to choose an investment. This is a service that many financial service providers offer. Be warned this can come at a cost.
You must consider the cost and fees they charge for advising, doing and holding your investments. The older traditional financial service providers can have significant fees of up to 5% of your investment. This will have a real impact on the investment returns that you can generate.
As systems have improved with technology a lot of the newer providers have come up with lower cost models. This is especially true for newer investors just starting out dealing with smaller investments. By understanding how to choose an investment you can save significantly on fees and increase your investment returns.
How I started investing
I have been investing for the last 15 years. However only the last 5 years have been properly focused. My initial investments were in a few companies that I selected, an ETF and a rental property.
Initially, I started out reading some investment books, opened a trading account through my bank and selected some South African companies. The first investments were done with some money that I was not scared to lose. I chose some prominent companies by looking at what I thought were well-run companies in sectors that were growing. The success here was pretty average.
I also invested monthly in Satrix 40 ETF which covered the top 40 companies on the JSE.
How I am choosing my investments
I learned that I was not doing enough research and work to pick individual stocks. I was not prepared to invest the time to do this being more comfortable buying the ETFs regularly. Performance-wise I was actually doing just as well with the ETF alone.
On the property side my plan was to build up a property portfolio. I started with a townhouse that I kept after moving into a bigger house. After owning this property for 12 years I thought I did quite well but it required a lot of effort to maintain. I did an analysis and realised that I would have been no worse off investing in the ETFs with a lot less hassle.
Since then I have finalised my investing plan around early retirement and achieving financial freedom. I have kept my portfolio simple with 3 ETFs and structured it to complement my pension and provident schemes. Another choice is have a 50/50 local and international split for my portfolio.
I use low cost online brokers like Easy Equities and Interactive brokers. Only investing in funds from reputable companies like Satrix, Vanguard and Blackrock.
As I learn more and build up my portfolio I will experiment with more or different asset classes. But I will only do that as I learn and understand the investments themselves and how they can benefit my strategy.
Teach yourself and learn to understand investments. It will help you make the right decisions and find the right advice for you. If you still don’t understand how to choose an investment then consult a professional for some guidance and assistance.