Why do I need to invest?
In this article AMP Financial Services explains the principles of investment, plus it gives sample asset allocations for different types of investors.
Saturday, November 6th 1999, 12:00AM
Why do I need to invest
The importance of investing for retirement is very simple - you will need to produce an income from your investments for the rest of your life. You will also want to protect your assets and lifestyle from being eaten away by tax and inflation. You may also want to increase the value of your assets.
What is not normally known is exactly how long your investments will need to last. Will you outlive your investments?
Because of healthier lifestyles and advances in medicine, we are living longer.
What is my life expectancy?
The current life expectancy of New Zealanders is approximately:
|
Current Age |
Male |
Female |
|
50 |
28 years |
32 years |
|
55 |
23 years |
27 years |
|
60 |
19 years |
23 years |
|
65 |
15 years |
19 years |
|
70 |
12 years |
15 years |
|
80 |
7 years |
9 years |
Source: NZ Life Tables 1995-97
As you can see, there can be a lot more living to be done in retirement!
You should note that these are average life expectancies, meaning that many people will live beyond these years. In many cases, people will live well into their 90s. The important question is: "Can you afford to live that long?" You and your financial adviser need to consider this when drawing up your financial plan.
How much money will I need?
When you are retired, you still need to invest. Only now, you want to make sure your money grows as well as providing you with income to live on.
It is difficult to give a ball park figure on how much money you will need. This is because it is dependent upon many factors, your goals, how you are investing at the moment, your family situation and when you joined your superannuation fund, etc.
It is probably safe to say that most people in retirement need 50 - 75% of their pre-retirement income.
However, you should also keep in mind what inflation can do to your investments as rising prices reduce the buying power of your money. As you will have your money invested for a long time, you should ensure it will still be working for you in 20 or 30 years time.
Your financial adviser can help you work out how much money you will need in retirement and how much income your investments can reasonably be expected to generate.
What do I need to know before I invest?
There are some basic principles to consider when deciding how to invest your money.
1. All investments have an element of risk
When you invest you are making a series of important decisions. Balancing the risk and return of each investment decision is an extremely important part of investing. In general, the higher the return, the higher the risk.
Your first reaction may be to think that risk has something to do with losing money. However, there are many more ways to "lose money" that you may not be aware of. And not all of them are within your control.
For example, all of the following factors can be called ‘risks’ for investments:
- inflation (which eats away at your spending power)
- a general downturn or recession in the New Zealand or world economy (which may take a number of years to reverse!)
- a drop in one of the investment markets, such as the property market (which may take some time to recover)
- tax (which reduces your income)
No investment can avoid all of these risks. The key is to employ strategies that work together to reduce the risks when you invest.
One strategy which professional fund managers use to reduce risk is called ‘diversification’. The easiest way to understand diversification is the old adage of "don’t put all your eggs in one basket".
If you spread your money around you will reduce your dependence on any one investment. This may help protect you from the highs and lows of individual investment markets (volatility). If one of your investments is not doing well, you still have others that may perform better.
2. Match your investments with your goals
It is very important to match your investments with the amount of time you intend to invest.
If you only intend to invest for a short period, less than three years for example, selecting less volatile investments, such as cash and fixed interest may be suitable for you.
However, when you invest for the longer term, you will have time to ride out any short-term fluctuations. Longer-term investments (such as property and shares) may be more suitable as they are more likely to keep pace with inflation and grow in value over time.
3. Find out all about your investments
You should only ever invest if you understand your investments and can sleep at night knowing they are working for you. Investment for security in retirement should not be a gamble - you should have a clear strategy. If you are looking at past returns from an investment, keep in mind that the past cannot guarantee future profits or income. Weigh up each investment opportunity on current information and how each investment fits together to create your plan (your portfolio of investments).
Make sure you have access to as much information as possible before you decide to invest. Your financial adviser is there to help explain how investment markets work and what combination of investments will be most suitable for your own situation.
4. Use discipline and flexibility
When you have decided what your financial plan is and the investments you want to make, stick with them. It is very easy to get carried away with the mood of the markets. If you are comfortable with your long-term strategy, the best way to ensure it succeeds is to follow it through.
On the other hand, if you find your investments are not doing as well as you hoped, be flexible. Reassess your situation, talk to your adviser and decide on a new course of action together.
What are my investment options?
Most people are aware of term deposits and investment properties as possible investments. However, there are many other investments that may be more suitable for your situation.
Broadly speaking, there are four main areas of investment available. These areas are called "asset classes". They are:
1. Cash
2. Fixed interest
3. Property
4. Shares (also referred to as equities)
1. Cash
‘Cash’ refers to investments such as bank deposits and cash management trusts. Cash is the most secure asset type and the risk of losing your capital is minimal. Another advantage of cash is that it is easier to withdraw in an emergency because it is highly liquid. So you should always keep some of your money in cash investments.
This high level of security does come at a price however.
Long-term cash returns are relatively low compared to other asset classes. Generally, a cash investment will not grow in value over time, so its value is gradually reduced by inflation.
2. Fixed interest
Fixed interest investments (sometimes referred to as securities) include government bonds, debentures, mortgage trusts and fixed term deposits. You invest your money for a set length of time at a fixed rate of interest. At the end of the term you are guaranteed to get your money back. This guarantee is made by the institution with which you have invested.
A disadvantage of fixed interest investments is that your money is not easily accessible (for example, if you are buying bonds directly). There is an active secondary trading market for some fixed interest investments, however, where buyers and sellers trade investments. Some fixed interest investments can be sold before they mature. This will offer some liquidity of funds for investors.
If you sell your investment early, or invest in a fixed interest trust where the manager buys and sells securities before their term ends, it is also possible to lose money with fixed interest investments. This is an added risk, although the return is usually slightly higher than that of cash.
3. Property
In addition to residential property, this asset class includes industrial, commercial, retail and rural property. Property should be viewed as a longer-term growth investment. This means that while a property investment can provide you with rental income, it may also increase in value over time. Capital growth provides a good way to protect your investment against inflation.
However, property is not always as rosy as you might imagine. You should also carefully consider the negatives. Firstly, if you need access to your money, it can be a long and complicated process to arrange a sale. You may only be able to buy one property which may not give you enough diversification.
Also, the property market is very sensitive to changes in the economy. And, if your property is vacant for any length of time, this will affect your income stream.
An alternative to having property investments in your own right is pooling your money with other investors and investing in a property trust. Problems like easy access to your investments and lack of diversification are usually reduced by making an investment in a quality property trust. Investing in a property trust is not without risk. You may wish to discuss property trusts with your adviser.
4. Shares
When you buy a share you are buying a stake in a company. As a shareholder you will share in the profits and future growth of that company. Generally, shares are an excellent long-term investment, usually offering investors an income stream as well as the potential for capital growth. Investors can receive a regular income payment when the benefits of company profits are distributed to shareholders as dividends.
Of course, the higher potential returns mean that shares are not without risk. They are definitely not suitable as a short-term investment, as prices can fluctuate from day to day. The fortunes of companies can quickly change depending on management changes, economic news and world events.
An alternative to having share investments in your own right is pooling your money with others and investing in a share trust. A share trust usually invests in many different companies which will give you diversification with your share investment and may also be easier for you to administer. A share trust is not without risk and you may wish to discuss share trusts with your adviser.
Other investments
There are other types of investments available. Some are highly speculative, such as new product ventures, while others may be more secure. As a general rule it is best to only invest in something you understand. If adequate information is not available, you are unsure of what the risks are or no-one can clearly explain the investment to you, it is unlikely that you will feel comfortable with it for long.
What investments are best for me?
The investments that will suit you depend on the type of person you are and how long you are investing for. You and your adviser will need to work out how to structure your investments so you feel comfortable and to ensure your financial plan meets your long-term needs and goals. This is often referred to as the "sleep test" - having investments that allow you to sleep at night knowing that your money is working for you.
Remember that investing involves a relationship between risk and return and you will need to determine your individual ‘risk profile’.
As a basic guide, you may be able to identify yourself with one of the following broad groups of investor types.
The Conservative Investor
The Conservative Investor seeks security. Protection of capital always takes precedence over the prospect of the highest possible returns. The main risk with this style of investment is inflation eroding the purchasing power of capital. This type of investor typically has 75% interest bearing investments and 25% growth investments.
The Moderately Conservative Investor
The Moderately Conservative Investor dislikes undue short term risk. They seek good returns but the risks must be minimal. They are not too concerned about tax and inflation.
This type of investor typically has 50% interest bearing investments and 50% growth investments.
The Balanced Investor
The Balanced Investor looks to gain from a portfolio made up of a combination of investments. Calculated risks are acceptable and strategies taking account of tax and inflation are favourably considered. This type of investor typically has 25% interest bearing investments and 75% growth investments.
The Moderately Aggressive Investor
The Moderately Aggressive Investor is seeking a portfolio more around capital growth than a regular income strategy. This profile requires a long term outlook. This type of investor typically has 15% interest bearing investments and 85% growth investments.
The Aggressive Investor
The Aggressive Investor accepts higher short term risk, higher volatility and higher gearing in the interest of potentially higher returns. Most appropriate for investors with at least a 10 year time frame. What is your life expectancy? This type of investor typically has 100% growth investments apart from emergency funds and short term expenditure.
How can I access these investments?
Having decided on which asset classes you would like to invest in, you must then choose the method of investment. There are two broad methods.
1. Direct Investments
Direct investments are where you select the investments you wish to make - perhaps some shares and government bonds - and buy them direct from the market yourself. You are responsible for the decisions that are made about the investments, and you must keep track of how your investments are performing.
Effective direct investing involves many considerations including:
- Having time, expertise and research material at hand to make decisions.
- Understanding the costs involved.
- Reviewing your investments.
- Measuring your investments’ performance.
- Knowing the right time to alter the investments in your portfolio.
- Assessing whether these investments are tax effective.
- Managing the cashflow of any investment.
2. Managed Investments
If the hands-on direct approach does not appeal to you, you may like to consider managed investments. Managed investments are offered by investment managers, such as AMP Asset Management. When you invest in a managed investment your money is pooled with the money of other investors. Qualified investment managers then keep a close eye on the markets and the economy. The investment manager and other skilled professionals do a lot of the hard work for you!
Managed investments are an effective way to access a diverse range of investments for a minimal amount of money. You can also have access to investment opportunities you may not have been able to make by yourself. For example, with around $2,000 you can invest in commercial property or international shares.
Some benefits of managed investments are:
- Professional funds management.
- Access to a choice of investment options.
- Diversification across investment sectors.
- Clear reporting and regular statements.
- Consolidation of cashflow.
- Ability to reinvest or take nominated amounts of regular income from your investments.
I’ve heard you have to pay fees to invest
No matter how you choose to invest, there are fees to pay. The size of the fee depends on the manner in which you have invested and the type of investment you have made.
When you purchase investments directly, you may have to pay sales commission and/or brokerage. If you are investing in shares for example, brokerage fees are charged when you buy and also when you sell. If you are buying and selling property, you may have to pay estate agent fees, bank fees, solicitor fees, etc.
If you choose to invest in a managed investment, there is usually an entry fee. There are also ongoing administration fees that the investment manager deducts from the money in the fund before declaring the returns. The level of these fees depends on the fund, the investment manager and the type of investment options you have chosen.
In all cases, make sure you are fully aware of all the costs involved in the investment before you commit to it.
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