Don’t invest in anything you don’t understand is good advice. Learn how to understand investments before you hand out your money. Don’t ignore this or you will be lured in by fantastic sounding returns. If you don’t understand how those returns are generated, then you don’t understand the investment.
People are not born knowing about investments. A handful will study the topic, but most people learn from experience by trial and error. Cut through the fancy terms and jargon.
Just take myself I am learning as I go along. I like to understand things and make up my own mind about whether it is good or bad. Rather read up and find out the information for yourself. Have your own interpretation rather than rely on someone else’s. Use advice and expert opinions to improve your understanding but not to make your decisions.
The basics of financial literacy are critical to understand. This post just scratches the surface of what to consider and help you learn how to understand investments. It is the absolute basics that will help you start off. For a bit more detail another easy to understand guide to investing is Investopedia.
Why must you invest?
Investing is something that everyone should be doing. The main reason is that we need to save and invest money for the future for when we can’t or do not want to work anymore.
You want to multiply your money. By choosing the right types of investments you are able to increase the value of your money and even generate ongoing income from these investments. There are my types of investments and many options
There are many investment options available. They are all different but the process of understanding them, comparing them, and choosing them are remarkably similar.
Think of them as different types of vehicles from a tractor to an expensive sports car. They all have engines and wheels and move forward and backwards but the purpose, speed comfort, reliability etc are different.
Investments are similar in that they all use your money to generate a profit. But the speed, complexity, risk, and size of return can vary.
What are the general asset classes and how do they work in principle?
When you invest you will be buying an asset. An asset is something that has value, and you will be wanting this asset to increase in value over time. That is the purpose of investing to generate a profit. I will cover the broad categories of assets called asset classes.
Cars are not assets because they require maintenance, eventually fall apart. But critically they lose their value over time. They are a liability not an asset.
Instead we can think of asset classes as vehicles that carry your money. For fun lets compare them to cars for a moment. What types of cars or vehicles would they be? What purpose, behaviour and performance would they have?
Equities would be a sports car, flashy and capable of incredible speeds but you need to know how to drive otherwise you will have an accident.
Equities or stocks are shares in companies. The purpose of companies is to grow and generate profits. By doing this they create value and become more valuable. If you own shares you can benefit from this growth and share in the profit if they pay dividends.
Bonds are like a bus, reliable and predictable, on a designated route and expected to arrive at a certain time.
Bonds are interest bearing assets because they are effectively loans with a fixed or variable interest rate. They are issued by governments and large corporates who need to borrow money for growth. Buy buying a bond you are lending your money. You are guaranteed a return payment of your money plus the interest earned over that period.
Property is like an old car, very familiar, looks great, requires a lot of attention and usually performs but sometimes not.
Property is easy to understand for most people. It can be residential, commercial, or industrial property. This is a tangible asset that you can see and touch.
Commodities are a different vehicle like a motor bike, they can change speed quickly, some people love them some hate them and are useful when you cant use the sports car.
Commodities like gold, oil, coffee, or beef are also an asset class. Gold is the most popular and common one. These are interchangeable with other goods of the same type. Commodities are a store of value and their prices move opposite to the stock price.
Cash is like a tractor the slowest of all but very dependable, been around forever and used to do the dirty work.
Cash as in money in your bank account or money in a bag. We all know cash but don’t realise that it is also an asset class.
There are many variations of these asset classes but essentially every asset that you come across should be able to fit into one of these main categories.
How are the returns generated?
Understanding this goes to the heart of learning to understand investments. You can start to decide if this investment is worth it or not when you understand how the returns are generated .
The returns are dependent on the cost price that you pay, the event or time that passes and the price that you sell the asset at. You also need to consider any costs incurred during this whole process like transactional fees, commissions, taxes etc.
It is the part that happens between when you buy and sell the investment that you need to understand.
Equities increase in value as companies generate more profit over time. All companies want to make bigger profits and grow bigger. As this happens, they become more valuable and then their share price increases. Most companies also share their profit in the from of dividends several times per year. So, this investment can increase in value as well as generate an income.
Identifying which companies in which sectors in which regions will grow or be the most profitable lies at the heart of understanding equities. The more you can understand about the industry and the way the company is run the better your understanding of that equity.
Picking individual companies is complicated and you need to have the time and ability to do this analysis to truly understand the company.
Equity ETFs are a relatively new kid on the block like the SUV they are easier to drive, comfortable, versatile and perfect for long journeys.
But equities are also available in ETFs (exchange traded funds). These are essentially funds made up of a group of equities in a basket. This can make it a bit easier to understand and less volatile. Overall, most companies increase in value over time, some by a lot and some by a little or nothing at all. So, if you have a basket of companies as an ETF then your return is generated from the average return of the long term.
Bonds are simple as their return is based on an interest rate and the return is paid back as interest. The money is usually tied up for a period of years and the interest rates are higher than what you would get at banks. These returns are a commitment from the lender and are guaranteed as long as the lender can pay the money back.
Property, Commodites and Cash Returns
Property returns are generated by the property increasing in value and rental returns
Commodity returns are determined by their value at the time. This depends on demand and supply. Low supply equals high prices and high supply low prices.
Cash returns are purely derived from interest earned on the cash. The interest rate is dictated by the central bank interest rate decisions. Returns are also dependent on the inflation rate which will erode the value of cash.
How easy or quick is it for you to get in or out of this investment.
This is important for when you want to access or exit this investment when you want to use the cash or to take the profit or to stop a loss. The investment may have a lot of value but can you realise this value when you want to.
The ideal is an investment that you can access and convert to cash quickly. This gives you flexibility and guarantees that you get close to the current value.
This is important for you to learn to understand investments. and is called the liquidity of the investment. This means how easy is it for you to get access to your investment if you wanted to buy or sell it to convert to cash.
If an asset is liquid it means that it can be bought or sold quickly. The difference between the buying and selling price is called a spread. Ideally you want this to be narrow.
Assets that can be bought and sold on public stock exchanges like equities, bonds, and commodities are liquid. Within a few minutes or hour or two you can buy and sell these assets.
If you are not able to do this quickly and easily then the asset would be referred to as being illiquid. Property, cars, jewellery, collectable art, antiques, or private company interests on the other hand are illiquid. These assets take time to sell especially if you want to recover the full value. Illiquid assets would have a very wide spread.
Learn How to understand investments continued
This had been an introduction to asset classes and a start to learn to understand investments. In part 2 I will cover the the following important questions
- What factors influence the returns? How likely are they to happen?
- Who is supplying this investment? Who is the owner? What is their credibility?
- My approach to investing
Normally I would tell you not to take any of this as advice and consult a professional financial advisor for that. But this time I will say, go out and do it yourself. Teach yourself and learn how to understand investments. It will help you make the right decisions and find the right advice for you.