To feel comfortable with making an investment,
individuals should understand some basic concepts of investing.
The following gives a background of the fundamentals.
Risk and Reward
Investment decisions should be based on the concept of risk versus
reward. Generally, greater risk will be offset by the potential
for greater returns. Conversely, the lower the risk the lower
the potential for returns. To measure risk and return, consider
the range of possible outcomes. For example, U.S. Treasury Bonds
guarantee a series of modest returns and the initial investment.
However, a stock may triple in price overnight or it may show
no profit and even become worthless overtime.
Inflation
A principle aim of investing money is to keep ahead of inflation.
Although inflation rates have generally fallen in the past twenty
years, it will always devalue the purchasing power of a unit of
currency. For example, a dollar put into a safe-deposit box in
1980 had approximately only 52 cents worth of purchasing power
in 1997.
Compounding
Starting to invest early can make a huge difference to how much
money is ultimately amassed. For example, two investors each receive
a 10% compound annual return over a 20-year period. The first
investor invests $16,000 for 8 years and then ceases. The second
investor does not contribute for the first 8 years, but then contributes
$24,000 for the next 12 years. At the end of the 12 year period,
the first investor has earned $78,957 (initial investment of $16,000)
whilst the second investor has earned $47,044 (initial investment
of $24,000).
| Year |
Contribution |
Yr-end Value |
Contribution |
Yr-end Value |
| 1 |
$2,000 |
$2,200 |
$0 |
$0 |
| 2 |
$2,000 |
$4,620 |
$0 |
$0 |
| 3 |
$2,000 |
$7,282 |
$0 |
$0 |
| 4 |
$2,000 |
$10,210 |
$0 |
$0 |
| 5 |
$2,000 |
$13,431 |
$0 |
$0 |
| 6 |
$2,000 |
$16,974 |
$0 |
$0 |
| 7 |
$2,000 |
$20,871 |
$0 |
$0 |
| 8 |
$2,000 |
$25,158 |
$0 |
$0 |
| 9 |
$0 |
$27,674 |
$2000 |
$2200 |
| 10 |
$0 |
$30,441 |
$2000 |
$4,620 |
| 11 |
$0 |
$33,485 |
$2,000 |
$7,282 |
| 12 |
$0 |
$36,834 |
$2,000 |
$10,210 |
| 13 |
$0 |
$40,517 |
$2,000 |
$13,431 |
| 14 |
$0 |
$44,569 |
$2,000 |
$16,974 |
| 15 |
$0 |
$49,026 |
$2,000 |
$20,871 |
| 16 |
$0 |
$53,929 |
$2,000 |
$25,158 |
| 17 |
$0 |
$59,322 |
$2,000 |
$29,874 |
| 18 |
$0 |
$65,254 |
$2,000 |
$35,061 |
| 19 |
$0 |
$71,779 |
$2,000 |
$40,767 |
| 20 |
$0 |
$78,957 |
$2,000 |
$47,044 |
Assets
There are many different types of assets in which people can
invest. Different types of assets suit different investment profiles.
These include property, art and coins, stocks, bonds, mutual funds
and bank accounts.
Liquidity
It is important to match the investment to the investment term.
For example, property tends to be semi-liquid, and so are more
suited for medium to long-term investment. Money market funds
and short-term cash deposits are liquid and so could be retrieved
at short notice if required.
Diversification
Diversification of investments helps to reduce the risk of investing
by not ‘putting all your eggs in one basket’. Therefore,
if the value of one type of investment were to fall, the loss
could be reduced by the appreciation or lesser depreciation of
another type of investment. Diversification, or putting different
percentages of an investment into different asset classes, reduces
volatility. Although diversification may forfeit some potential
returns, this could be offset by the lower level of risk.
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