Investing for Dummies - Beginner and not so Beginner Investing

On our Investing for Dummies page we'll get you started on some key basics for every new investor. Although, there are many parameters we cannot influence, an investor can draw on proven theories, strategies, experiences and apply those to new opportunities based on given assumptions. Education is key in understanding what's going on in the financial world so that we can assume the most likely scenarios and turn investment decisions into informed decisions.

For many, making investments or investing has something mystical about it. In fact, even once you've progressed from Investing for Dummies to an advanced or professional investor there are still mystical theories about financial markets out there. In other words, the full extent of knowledge about the driving forces of investment markets and in particular financial markets will stay hidden to most of the investment community due to its complexity.

We have to acknowledge that with investing you're always exposed to some uncertainty because there is no way how we can understand the full picture. Even with the best research information at hand, we still wouldn't know what the future holds and how our investments will perform in financial markets.

Markets are not only driven by economic and business indicators, they're also driven by investor sentiment, irrational behaviour such as fear or natural disasters. They can be an investor's demise or opportunity but it's near impossible to forecast them.

Investing for Dummies comment: It's possible that you find out that you're not successful although you have acquired the necessary knowledge and skills. This is a scenario every investor has to face when starting out. Like with other things in life, we cannot be good at everything we do. It might mean that you haven't found the right investment area yet. Maybe your flair is with currency trading rather than shares. So, don't give up when in doubt! Instead, keep applying your new knowledge and build your experience!

On our Investing for Dummies page we'll look into the fundamental elements that are involved in investing. We look at the basic building blocks of investments that later can be used in more complex structures such as, e.g. in derivatives (derived from the original).

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Setting the investment scene

Let's look at a few prerequisites that a new investor needs to meet before starting on his journey to discover financial freedom. The investor ...

Investing for Dummies comment: If you don't have the time to train yourself up or the discipline to research your opportunities and follow set investment strategies, we suggest you seek the assistance of a financial adviser such as financial planners who prepare well researched strategies and investment options for you.

How to make money?

Let's get into the starting blocks with Investing for Dummies. First, we'll look at the purpose of investing. In brief, we want to make money. As mentioned before, we need seed money to be able to invest. We get this from our savings, money we put aside for a goal at a later time.

The return is the result of investing (or the money we make) over a period of time and can be categorized into two components:

Investing for Dummies example: Let's assume you put $100 into your savings account and keep it there for one year. The bank states that you'll be receiving an interest of 5% per year which equates to $5. This is called INCOME RETURN that the bank pays you for parking your cash with them.

Investing for Dummies example: If you buy $100 of a business (share) and after a year you sell your share for $105 the return again is $5. This is the GROWTH RETURN because the value of your share in the business has risen and is now worth more. In this case, the business doesn't pay you a specified amount on your investment. You just happen to get more for your share at the end of the year when you sell it. It's also called a capital gain.

Some investments may give you income only or growth only or both. As simple as this may sound, never forget to be clear about the kind of return you're offered:

Investing for Dummies comment: Note that returns can also be negative. This is a situation to avoid but might sometimes be necessary temporarily to get to the end result of higher overall returns.

How long does it take?

Returns are usually expressed as a percentage of the investment capital. As mentioned before, time is needed to make a return. Typically, higher returns take longer to crystallize, however, it's possible to achieve high returns in a short period of time too. The issue is that the higher a return is, the more uncertain it is if it can be achieved. Therefore, we need to have time available to let price fluctuations and averages work their way to higher levels.

A return expressed over a period of time is called performance of an investment. Investment fact sheets and research material often indicate how a particular investment or an entire market has performed over a given period of time.

Investing for Dummies example: The following is the performance table of the Vanguard LifeStrategy Growth Fund as at 31st May 2010. This is a managed fund that provides both, income in the form of distributions and capital growth.

These returns are expressed per year (pa) although the actual time period can be less or more than a year. If the total return for 5 years is 3.94% that means that the average annual return for each year was 3.94%.

The bank's compound

Investing for Dummies - interest income

Banks are in the business of taking cash deposits from businesses and individuals and lend it on to other businesses and individuals by way of loans. As we know, mortgages and loans come at a price which is normally expressed in the interest rate which is similar to the one on your savings account except that they're always higher that the interest on savings.

The difference between the interest rate on my savings and what the bank charges for a loan is 2% or $20. This is the profit of the bank.

If you have both, a mortgage and cash savings account, you'll end up getting some income from your savings but paying higher interest on your mortgage with the net effect of more dollars going out than coming in.

It's much more complex than that but the key here is in realizing that this is a main source of profit for the banks.

Compound interest

Generally, mortgage and home loan accounts contain fairly substantial balances. In contrast, what we have in our cash savings account is usually much smaller. Traditional banks not only make money on the difference between the two but heaps more because most of us need a mortgage that is much bigger than our savings.

Interest income, and any ongoing return for that matter, is also exposed to the magic of compound interest. Compound interest is one of the best money making inventions/conventions of all time, and again, makes the banks even richer.

Investing for Dummies example: I borrow $1,000 from the bank at 7%. That's costing me $70 per year. If I decide not to pay that interest cost the bank will add it to my loan balance. In the second year, I now have $1,070 borrowed at 7%. Naturally, the second year is costing me more, i.e. 7% on $1,070 or $74.90 which in turn is added to the balance again making it $1,144.90 at the end of year 2. This then continues year on year.

That way the interest is starting to compound on the initial borrowing amount like a growing snowball rolling down the hill. The loan balance increases by the unpaid interest amount every year. The banks give you investment loans that allow you to capitalize the interest which means nothing else than that you won't have to pay it back. Instead, they add it to the balance like in the example.

Investing for Dummies comment: In everyday situations, this is also used with credit cards. The interest rates on credit cards can be two or three times as high as for mortgage rates. If you don't pay off your credit card regularly, this is more big bucks for the banks!

On the flip side, investors can make good use of compound interest too if they own the cash and have the investment power like the banks do. Then the whole compound interest magic is working into your own pocket.

Investing for Dummies example: Assuming you have $10,000 that you lend to a business (e.g. your own) and receive 7% per year. After ten years, this will result in $19,672 which is almost double the original capital due to compound interest accruing year on year.

Inflation

Investments returns cannot be taken in isolation. They depend on the general market circumstances and there are many influencing factors at play. One such factor is the menace of inflation which is a cost to every investment.

Investing for Dummies example: We all know that $100 today won't buy the same as $100 in ten years' time. Tomorrow's dollars have not the same purchasing power like today's dollars. This is the making of inflation.

Inflation is expressed as a percentage and is measured according to a basket of products and services across different market sectors. It it calculated regularly and is a main indicator based on which the reserve bank of a country makes monetary policy decisions. This allows them to control inflation in a healthy range by way of changing the prevailing cash rate. The cash rate is the basis for all other product related loan rates like the mortgage rate we discussed before. The Reserve Bank of Australia adopts monetary policies to control inflation in a band of about 2.5% to 3.5% which is considered healthy so that the economy is able to grow continuously.

Investing for Dummies example: If the investment return is 7% and inflation is 3%, the real return is only 4%.

Rule of thumb (72)

This Rule of 72 is only an approximate but helpful measure to estimate for how long an investment will have to be in place (in years) before compound interest return will double the value of that investment.

Investing for Dummies example: If you want to find out how long it takes for an investment to double in value if it earns 9% per year, we calculate ...

Therefore the investment will take 8 years to double in value. See also the example we did above for compound interest.

Tax and other costs

Investment returns are also exposed to tax and other costs. Like inflation, investors need to take these into account to be able to determine what the net return of an investment will be.

Investing for Dummies example: If you invest $100,000 in a term deposit with bank A for 3 months, bank A will pay you an annualized interest of 6%. You draw a bank cheque from bank B (which costs $10 ) and go to bank A to open your term deposit account.

At the end of the 3 months you close your term deposit and keep the return of $1,500 (6% x $100,000 divided by 12 months times 3 months). You must pay tax on this income too which is 30%. The following calculation shows how to arrive at the net return.

Investing for Dummies comment: Return ratios are mostly expressed on an annual basis as if you had held your investment for 12 months. This allows for a standardised comparison with returns from other investments.

As we can see in the example above, returns can be heavily impacted by costs and taxes. It is therefore prudent to understand an investment product in detail. While it is important to know potential returns, it's even more important to know all the associated fees and costs involved.

Risk - your friend or your enemy

We invest to make a return but investing doesn't go without risks. Risk or more specifically investment risk is a necessary evil to achieve returns. Without risk there is no return, even when using risk-free investments, they are not waterproof and can also fail.

Investors usually associate risk with a potential loss of their investment. This is the enemy to avoid. However, risk has some very good traits too that makes it your friend.

Investing for Dummies example: You have the choice of investing in cash management trust A that returns 5% per year but risk to making only 3% per year if it's not going as expected. Alternatively, you can invest in infrastructure fund B that returns 10% per year but minus 5% if things go wrong.

The following table shows the potential returns and associated risks of investments A and B.

Investing for Dummies comment: Risk has always an upside and a downside to it. Most people only look at the downside or the potential for loss. In our example, taking a higher risk to invest in fund B will benefit you with getting a higher return. Taking a low risk will result in a lower return. In that sense, risk also translates into opportunity. Risk is always CHANCE (upside) and LOSS (downside) together. Some call it risk and reward which is the same thing.

A measure often used to express investment risk is volatility. Volatility measures the fluctuation in price or return changes. If volatility is high the risk is higher that returns won't be as expected and vice versa. Therefore, volatility is often used as a synonym to risk.

Another measure of risk is the standard deviation or standard error which is usually mathematically calculated for investment securities. It measures how far from the average price any individual price points deviate. It is a way of defining volatility.

A normally distributed return is observed within one standard deviation on either side of the exptected average return. This covers two thirds of statistical probability, i.e. 66.67%. If you want to be more certain statistically you can use two standard deviations on either side of the expected return. This will give you 95% statistical probability.

Investing for Dummies example: Investment B from the previous example has an expected return of 10%. Its standard deviation was calculated at 1.9%. This means that there is a 67% probability that the expected return is going to be between 8.1% (10% - 1.9%) and 11.9% (10% + 1.9%). Or, there is a 95% probability that the expected return is going to be between 6.2% (10% - 2 x 1.9%) and 13.8% (10% + 2 x 1.9%).

You may have noticed in the table above that investment B has a risk of loss of MEDIUM and a risk of higher return (chance) of HIGH. This means that there is more potential on the upside than on the downside. That's why we need to keep the following principles in mind when making investment decisions:

What's your risk attitude

Investors need to be aware of how much risk they can take. The attitude of 'I want everything but risk nothing won't work. If you want higher returns you must be prepared to accept higher risks.

Smart investors and financial planners run a risk profile to analyze how far a person is prepared to go when investing. There are different methods of how a profile can be established. We won't go into these for now but look at one of the questions of a questionnaire based method in the following example.

Investing for Dummies example: A risk profiling questionnaire lists the following multiple choice question: If you made an investment of $100,000 and its value dropped suddenly down to $80,000 what would you do?

There is no right or wrong answer. It also depends on your financial circumstances, the circumstances of the investment itself and the prevailing market situation. However, questions like this help ascertain how far a person would go, how much risk i.e. loss is acceptable for that person and what the general attitude towards taking risks is.

Risk profiles are then translated into investor profiles that determine the investment strategy and the allocation of capital to different asset classes. This leads to:

Investing for Dummies example: In the following table we have listed a few investor profiles that show their allocation to investment asset classes based on the individual's risk attitude i.e. investor profile.

I want a risk free investment!

Who doesn't want that? - It's been widely accepted that a risk free investment is the 90 day government treasury bill which pays the 90 day bank bill rate as a return. The assumption is that this is a risk free investment because it is backed by the government and investors can be certain of the investment return.

However, the developments we experienced throughout the GFC (global financial crisis) have proved that not even governments are infallible. Nevertheless, the 90 day bank bill is a measuring stick against which other investment returns can be compared.

Investing for Dummies example: Okay, after all this you decide to leave your money under the mattress because that's the only way the government can't take it away from you. You also don't want to put it into your savings account because some of the biggest banks in history have collapsed recently. - With this approach you're now confident that you don't have any investment risk left. However, remember inflation that we discussed above. The result is that inflation starts slowly eating into your dollars and time decay will make sure that in the near future you can buy less and less with your savings that you put under the mattress.

Investing for Dummies comment: We'll be looking into types of investments that can be used for investing, talk about investing advice and more advanced investment themes that go with it on our dedicated pages. We'll also look further into combining investment strategies with tax benefits so that we can get the most out of our investment dollars.

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