The four elements
Many people typically have different investment goals. Imagine saving for an overseas holiday, and saving for retirement at the same time. So depending on what we need to achieve, we can have separate investor profiles to match each goal. Here are four key things to consider when investing: duration, returns, liquidity and risk.
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When considering...
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Ask...
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Duration
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How long do I want to invest for?
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Returns
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Do I want income and/or growth?
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Liquidity
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Do I need to get to my money easily?
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Risk
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What balance of risk and reward is right for me?
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Duration
Duration means how long we want to invest for.
- Short term – 1 to 3 years
- Medium term – 4 to 9 years
- Long term – over 10 years
Saving for an overseas trip in a year’s time is a short-term investment. So it’s important to be able to get it when we need it.
Saving for a deposit to buy a house in five years’ time is an example of a medium-term investment.
Saving for retirement is usually a long-term investment.
Over a longer period of time we’ll be more interested in capital growth. This is when the value of our investment (our capital) grows. If we invested $100,000 in shares last year that are worth $110,000 this year, our capital growth is $10,000, or 10%.
It's common to have different investments of different durations.
Returns — income or growth?
To work out the most suitable type of returns (the money we earn from investments), we need to decide if income or growth is a bigger priority. We could ask:
- Do I want to use the money my investment earns as income to live off during the duration of the investment?
- Do I want to reinvest it with the original amount, and grow my lump sum as much as possible?
If short-term income from investment is important, it's probably best to put the money where it will earn a guaranteed return. For example, a bank deposit paying a fixed amount of interest for a set period.
If we want to grow a nest egg as much as possible and don't need the income in the short term, we can consider investments that don't guarantee the return from year to year, such as shares.
Liquidity
Liquidity means how quickly we can convert our investment into cash before the end of the investment period.
A high-liquidity investment means we can get at our investment any time. A bank savings account is an example.
In a low-liquidity investment, it may take time to find a buyer and complete the sales process. Property is usually a low-liquidity investment.
Shares in public companies generally have reasonable liquidity.
Some investments may be ‘illiquid’ – we can’t get our money until a certain date or event (e.g. retirement).
Risk
Risk and reward is the classic investor’s balancing act.
The higher the risk we take, the higher returns we could receive, but the more chance we have of our investments losing value, fluctuating in value, or failing entirely.
With a low-risk investment, we generally know the return we will receive right up front. A bank savings account is a low-risk investment. We know the return (the interest rate), but compared to riskier investments, like shares, it isn't very high.
Higher returns are only available with higher risk. The risks come in two types:
- Volatility: The possibility that the value of the investment will go up and down.
- Performance: The possibility that the investment could fail and we lose all or part of our money – or the investment gives us a lower return than expected or needed.
If considering high-risk investments, be sure to balance the risks with other investments in lower risk areas (like short-term deposits, or cash and bonds).
Generally, it’s easy to recognise high-risk investments because the potential returns also stand out as really high. The promise of too-good-to-be-true returns is probably just that: not true.
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