Oran Hall | Why investing makes sense
People often ask why they should invest, seeing it as a sure way to lose money, and some believing that certain kinds of investment, buying equities, for example, are gambling. On the other hand, others sound loudly the benefits of investing because of their positive experience.
To invest is to acquire a financial asset to generate a return in the form of income or capital gains or both. The form of income earned depends on the type of asset acquired, so dividends are derived from ordinary shares, interest from bonds, and rent from real estate, but there are other more complex instruments.
Capital appreciation is gained from assets that increase in value and thus generate a profit when sold. Such assets may also generate a loss because they may also depreciate, or lose value. Among such assets are real estate and ordinary shares, also commonly called stocks.
Although it is clear that ordinary shares and real estate generate both income and capital gains, bonds may also generate some capital gains, or loss, depending on whether they are bought for less than their face value or for more.
Investing helps to ensure the present and future financial security of the investor by facilitating the accumulation and growth of wealth and the realisation of goals like getting a good education and having a comfortable retirement. Investing is far superior to saving to achieve these.
Many shy away from investing because they feel they do not have enough to invest, or believe that it is too risky, or that they do not know enough about it.
Investing can be learned over time, and it requires time to acquire the necessary knowledge and skill. Reading appropriate material and listening to and watching relevant programmes, plus talking to experienced investors can help. One does not have to be a genius to invest, and even so-called gurus do not always get it right.
No one has the ability to see exactly what will happen in the future, and it should be recognised that economic cycles, natural disasters, and political developments, for example, can bear significantly on financial markets and thus affect investment portfolios.
Risk is an integral element of investing in that there is no guarantee that actual investment returns will equate to the expected return. This variation of return from what is expected may mean that the return is less, or more, than expected, but it may also mean a negative return, that is, a loss.
In fact, some investment instruments are more risky than others because by nature, their prices vary more than the prices of other instruments. For example, the price of ordinary shares tends to vary more than that of bonds, so they are deemed to be more risky than bonds.
It is interesting to note that although the more risky instruments may cause a loss, they tend to generate much better returns than less risky instruments over the long term as gains tend to outweigh losses over the long term. Additionally, buying opportunities are created when prices decline.
The ability to take risk hinges on many things, for example, age, investment knowledge, the financial resources available, when the invested funds are required, and family responsibilities. Investment strategy, therefore, has to be aligned to the needs and profile of each investor.
Investment strategy also has to align with the psychological make-up of each investor. Some investors are inherently less able than others to take high investment risks, so they should save themselves from worry by focusing on safer instruments and strategies.
A very useful risk-mitigation investment strategy is diversification. This requires investing in several dissimilar types of investment instruments. The amount invested in each is based on the investor’s willingness and ability to take risk, what the funds are needed for, and when they are required, for example.
With this approach, the more risk averse or conservative investors opt for a higher proportion of conservative instruments like bonds and short-term interest-bearing instruments and for less of ordinary shares, for example. Investors with a higher risk profile do the opposite.
The primary benefit of diversification is that as various instruments respond in different ways to the same circumstance, wild fluctuations in investment performance is avoided. Thus, instead of very significant gains sometimes or very significant losses at other times, the portfolio generates moderate returns quite consistently.
There is no way to escape some risk when investing for even bonds do expose investors to risk, for although the investor ultimately receives the nominal sum invested when the instruments mature, its ability to buy the same basket of goods and services it could at the time the investment was made is close to nil. This is due to inflation, which exposes the investor to purchasing power risk.
Investing, ultimately, is a better way than savings to hedge against inflation.
Individuals who do not have the time to manage their own portfolio, have limited funds, have limited knowledge of investment instruments and strategies but who want to build a diversified portfolio, may choose from the wide range of pooled investments – the funds offered by unit trusts and mutual funds operating in the market. Nevertheless, it is still necessary to learn about investments and to get guidance to be able to select suitable funds.
The following will assist you to invest well: do your homework by devoting time to research and observing what happens in the markets, start early, start with the little you have, do not let your money idle, be patient, avoid get-rich-quick schemes, adjust your strategies to changes in your circumstances if necessary, have a long-term view, seek professional guidance from a registered or licensed professional, and focus solely on your portfolio.
Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com