Whether you follow a Warren Buffett-style buy and hold approach, or adopt technical analysis, learning how to invest and devising an investment plan will not only help you crystallise your short and long-term financial goals and objectives, but also dramatically improve your ability to achieve them.
It can be incredibly empowering to comprehensively review your current financial position, and if you do, you’re more likely to develop an investment plan that’s custom made for your specific requirements.
Understand your current financial situation
Before devising an investment plan, it’s imperative to have an accurate picture of your cash flow, including income, regular outgoings – especially discretionary spending – and your capacity to save/invest surplus money.
"Do not save what is left after spending, but spend what is left after saving", is a handy piece of advice from Buffett, the world's most successful investor.
Remember, all good investment plans will have one aim in common, wealth accumulation over time.
Based on the "principle of compounding returns", an investment earning 10% annually doubles every 7.2 years.
The right investment plan for you will depend on a myriad of factors – most importantly your age, earnings and existing assets – which have a direct bearing on both your investment time-horizon, and risk/reward profile.
While cautious investors would also like above average returns, their need for wealth preservation is greater than that of more aggressive investors who can afford to take bigger risks in pursuit of higher gains.
Balance & diversification can dial down risk
As a prudent investor looking for both capital growth and income, you’ll want to diversify your exposure to key asset classes like shares, cash, property and fixed interest.
If like most investors, you have a moderate tolerance for investment risk, and are investing for long-term wealth creation, it’s important to balance your investments to avoid over-exposure to any single asset class.
That’s because investment markets, whether in shares, property or cash, typically run in cycles (like the broader economy).
So by offsetting better performance from one asset class against worse performing assets, you can smooth out your returns.
While many macroeconomic and industry-specific factors influence a company’s earnings performance, Australia’s falling cash rate environment – which is bad news for fixed interest investors – is typically good for listed stocks as the cost of (corporate) borrowing becomes more affordable.
Economic/macro indicators drive market sentiment
As an informed investor, it’s equally important to understand primary economic indicators and how they will impact different sectors of the economy.
You’ll get a good insight into any trends developing within the economy by monitoring key pieces of data like gross domestic product (GDP), interest rates, unemployment, inflation, the Australian dollar, the balance of payments and the current account deficit.
These overall trends will fashion the market sentiment dished out to the asset classes you’re most likely to invest in.
So by keeping abreast of the global and local economy, you’ll be better positioned to actively review and tweak your investment portfolio in light of those sectors that will either benefit or suffer going forward.
Instead of putting all your (investment) eggs in one basket, as a balanced investor you’ll typically divide your portfolio between cash, fixed interest, shares and property.
Exactly how much of your portfolio is allocated to each asset class should directly reflect economic conditions and investment prospects, plus your requirement for investment-generated (or passive) income.
Also consider how quickly you may need to convert investments back into cash (liquidity requirements).
For example, with cash rates now falling, investors who previously parked in fixed income are showing an increasing interest in equities.
However, during the Global Financial Crisis (GFC) and COVID the portfolios of most investors were seriously overweighted towards cash, with many spooked into sidelining the share market altogether.
Ironically, this decision resulted in mixed blessings, and a look at past performance explains why.
While different asset classes perform better at different times, shares, despite their innate volatility, have historically outperformed other asset classes.
Admittedly, cash and bonds have outperformed shares for shorter periods.
But over the longer haul, history shows that shares have delivered better returns, especially once tax benefits (like dividend imputations) are factored in.
Shares add risk
Vanguard research shows average returns in the 10-years to 30 June 2024 saw listed Australian shares deliver 8.6% (U.S. shares 10.5% and global shares 8.4%), while cash and bonds delivered 3.4% and 4.3% respectively.
But remember, getting the (potentially) higher returns that shares typically offer means accepting higher risks than holding cash does.
So do your homework and never buy shares on tip-offs or unsubstantiated rumours.
And while it’s important to stay ‘in the market’, that doesn’t mean buying stocks and parking them in the bottom drawer indefinitely.
Similarly, while a gearing strategy – borrowing from a broker or bank to buy more shares – can accelerate your wealth creation, it means taking on even greater risk.
Don’t forget the value of the shares can go down as well as up, and if it falls below a set loan to value ratio, you may have to put up the additional cash.
So don’t borrow more than you can afford to service.
For the shares component of your financial portfolio, one approach is value investing – focusing on the very best companies and buying those shares at prices less than the business is worth.
