One of the most popular questions I am asked is "What is the best way to invest so and so amount of money", the amount usually expressed as $1000, $2000 or $10000. Before you can answer questions like this one, you need to create a plan. Please refer to the "Planning Your Investing" article. Once you have established a plan and you are ready to invest, you need to choose the investment vehicle/s which best suit your investment goals.
An investment vehicle is any form of asset that you, as an investor, place your money into with the expectation of gaining a return for your investment.
Investment vehicles can range from fixed interest term deposits, which basically guarantee you a return, through to lottery tickets, for which the chances of a return are very slim. The most widely recognised forms of investment vehicles, along with their benefits and drawbacks, are explained in this article.
Investing in shares means investing in any of the companies or securities listed with the Australian Securities Exchange (ASX). When you own stock, you hold a portion of the net worth, or equity, in a corporation. Shareholders receive dividends, which are part of a company's net profit, and they are entitled to vote at general meetings of the company.
Shares are easily accessible through a broker or a managed fund, and are liquid. There are no management fees (brokerage fees apply), tax concessions are available through the dividend imputation system, and you can reduce risk through diversification. Shares can be used as security for borrowing, and income earned can be re-invested in additional shares without transaction costs, at a discount. Your portfolio can be altered at any time to allow for changing industry or economic trends, and a well constructed portfolio will balance income and capital gain to suit your circumstances. For long-term investors risk is limited and returns are robust, despite the short term fluctuations.
As the share market is at the mercy of market forces of supply and demand, there are no guarantees of return on your investment. The share market can be volatile.
Property investment involves buying real estate directly, or buying property securities, which can be listed on the share market (Listed Property Trusts or A-REITS). Investors can buy units in individual property trusts, or they can put their money into a professionally managed fund that invests in a number of property trusts and direct (real) properties. Investors are entitled to a share of rental income and valuation increases across the range of properties owned by a particular trust. Direct property investment, buying into 'bricks and mortar', is done through a real estate agent, while a broker or investment manager can start you up in property securities.
You can negatively gear your investment to decrease your tax burden. An increase in the market value of units in a trust which is doing well is possible. Good for medium to long-term investors.
Similar to shares, market factors affect property securities so some risk is inevitable. Direct property, or real estate purchases, are long-term investments that are difficult to sell and do not lend themselves easily to diversification.
Fixed Interest / Bonds
Companies and governments, at all levels, borrow money from investors by issuing bonds to pay for their projects. The issuer promises to pay a fixed rate of interest at regular intervals and to repay the face value of the security at maturity. Fixed interest covers investment in things such as government bonds, bank term deposits, finance company debentures, direct bonds, and managed bond funds.
You are promised the return of your principle and interest with fixed interest investments. They are liquid, provide a fixed interest rate, and involve only a minimum trading expense in the form of small brokerage fees. Bonds are considered “debt” to the issuer, and so have priority of payment over shares (equity), and some bonds have tax concessions.
The downside of fixed interest is that the bond issuer may default, or delay your interest payments. Bond value may fluctuate for a number of market related reasons, and there is a liquidity risk, which means that if your money is tied up in bonds, you may not be able to take advantage of rising interest rates.
Putting your money into treasury notes, money market funds, certificates of deposit, bank accepted bills, fixed deposits, building society deposits and cash management trusts are all forms of cash investment. They have historically been short term investments however this is a popular investment during times of uncertainty and when markets are trending downwards.
Cash investments are liquid and are considered the lowest risk investment an investor can undertake. Most cash management funds invest in short-term bank bills which give a steady interest rate, the differences in these funds mainly come down to fees charged.
As risk in this investment is relatively low, so too is the return. There is the danger that the after-tax return on cash may not keep up with the annual inflation rate for high-income earners.
A More Speculative Approach To Investment
Futures and options are referred to as derivatives as they are by-products of a specific financial product such as an ordinary share. The financial product from which the future or option has been derived is called the underlying security or asset.
Investing in futures means entering into a futures contract between a buyer and a seller that requires the delivery of a specific quantity of a specific type of goods, at an agreed price, place and time.
The price, quantity and quality of the commodity is specified at the outset of the futures contract. Futures contracts can be written and traded on any commodity. The law requires that all futures contracts be bought and sold on designated contract markets, commonly known as commodity or futures exchanges. The investor should have a sound knowledge of factors which influence supply and demand for the particular commodity. Most individuals buy and sell futures because they wish to speculate about future price levels of the commodity that underlies a futures contract. Businesses usually buy and sell futures for the opposite reason to hedge their position, that is, eliminate their risk exposure due to changes in the price of a commodity.
The futures market is a highly accessible and liquid market. Contracts are executed immediately by your broker. Leverage magnifies the effects of price movement, which means you can control a large investment for only a small outlay, so potential gains are higher. Futures are used to reduce the risk of fluctuating prices, exchange or interest rates by moving the risk from the producers, lenders or importers to the speculator who is willing to accept them in the hope of profiting from the speculation.
You risk more than the initial amount of money you put in, because selling after the price has substantially fallen means you pay more. Just as leverage magnifies potential gains, it also increases potential losses. This market can change rapidly, so constant surveillance is necessary. It is simply the forces of supply and demand at work that determine the fate of your investment.
Options are contracts between two parties in which one has the right, but not the obligation, to exercise a choice which must be honoured by the other party. Options are used mainly to either hedge or to produce income.
There are two types of options:
The call option : This gives the right, but not the obligation, to buy at a specific rate or price. An option to buy securities at a predetermined price is a call option
The put option : This gives the right, but not the obligation, to sell at a specific rate or price. An option to sell securities at a predetermined price is a put option.
Options are popular as a risk management tool as they can be used to hedge against market movement and interest rate swings. The options buyer carries no market risk, only sacrificing the premium if the decision not to exercise the call option is made. For the option seller, there is no credit risk outstanding once the buyer has paid the premium.
The seller faces a large market risk because they have no control over whether or not the option is exercised. Buyers bear the risk that sellers will not be able to fulfill their obligations under the contract when the time comes. The options buyer pays and possibly loses a substantial premium and faces performance risk.
Currencies/Foreign Exchange (Forex)
The currency of any country is simply another financial asset that is used to purchase goods and services in that particular country. However, people do not limit themselves to just the goods and services produced in their own countries, they buy and sell internationally as well. It is for this reason that the Foreign Exchange exists.
There is no centralised exchange, as there is for the share or futures market, and no fixed opening and closing times, or requirements for participation, other than the informal acceptance of other participants.
Banks do most of the foreign exchange business. Through correspondent relationships with banks in other countries, banks have ready access to foreign currencies. Transactions usually do not involve the physical transfer of currency, but rather a bookkeeping entry. Banks in Australia have foreign currency balances with banks in other countries.
Collectables are tangible items such as stamps, antiques, vintage cars, numismatics (coin), art or more recently basketball swap cards.
Unrealised profits on direct investments in collectables escape the income test, which helps those wanting to limit their income for taxation purposes, or to be eligible for social security benefits. If you get good advice, paintings by well known artists will probably give you a good return on your money.
Although they may have been painstakingly gathered over many years, collections such as coins and stamps are unlikely to make you a lot of money.