Secrets of Wise Investing (Part 2)

Investment choices

There are many types of assets a person could invest in - far too many for me to cover in this short space. In the main, however, I have found the majority of people invest in cash, property, bonds and shares. In an attempt to help you decide what investment is appropriate for you, I have explained below a little about each class of asset.

• Cash – Probably the greatest benefit cash bestows is liquidity. This means it's on hand and available whenever you need it. That's especially handy in emergency situations. The second biggest plus in putting your cash safely in the bank is there's very little risk in losing your money. Sure a bank can go bust but that's a pretty rare occurrence.
• As we know, there is a relationship between risk and return. Hence whilst there's little risk to placing your gold in a bank, the returns you'll receive on that deposit investment tend to be minimal. In fact, money kept in a bank account usually provides one of the lowest returns of asset investment. This return can be so poor that over time, inflation can be greater than the return the cash actually produces. Eventually, the return can be eroded in its entirety.
• If you are putting funds into a bank, you might chose to put them on term deposit. This will mean that you'll have to wait for a definitive period of time, before you can gain access to your cash. Thus, term deposits aren't 100% liquid although in saying that, you can often forgo interest and take a penalty if you chose to cash up your term deposit before its maturity date.
• You'll always want to aim for your cash earning as much interest at possible. As such, you should keep an eye on the rates borrowers of funds have to pay. If borrower interest rates are on the rise it's likely deposit interest rates will also increase. If this is occurring in the market place, consider putting your cash on short term deposit or take a spread of terms. That way, if deposit rates rise, your money won't be stuck on a low interest rate for very long and you'll have the ability to take advantage of the increased deposit rates being paid by the bank.
  
  
  

• Bonds – Companies and governments frequently issue bonds to assist with running their operations or getting a specific project off the ground. A bond is akin to an IOU.
• The issuer will issue the bond to the bond holder (say Mr Smith) for a specific amount (called a par value), at a certain interest rate (called a coupon rate) and for a definite time period (called a maturity date).
• During the time the bond holder possesses the bond, the issuer will pay him interest, often bi annually. The bond holder will receive their initial investment back once the bond matures. It's a bit like a time term deposit
• The bond holder may sell their bond before it matures. They will do this on what is known as the 'secondary market'. When the bond holder goes to sell their bond on the secondary market, they will likely end up selling at either a 'premium' or 'discount' to the purchase price.
• To demonstrate, let us say Mr Smith purchased a bond for $1000. Its coupon rate is 7% and it matures on 1 April 2014.
• Prior to 1 April 2014, Mr Smith decides to sell his bond. At the time, interest rates are only 5%. This means a prospective purchaser would be willing to pay a premium to Mr Smith for the bond. Mr Smith is thus able to sell his bond to Mr Brown for $1,050,. In other words, Mr Brown has paid Mr Smith an extra $50 to acquire the bond. He has done this because the bond will pay interest at 7%, whereas if he invested his money in the bank he would only get 5%. Accordingly, Mr Brown is willing to pay a premium to Mr Smith to achieve a 7% interest rate of return on his money. Once Mr Brown buys the bond, the issuer will pay the coupon rate (interest) on the $1,000 bond to him at 7%. When the day of maturity of 1 April 2014 arrives, the issuer will repay Mr Brown the initial investment of $1,000.
• Conversely, let us assume that prior to 1 April 2014 interest rates have risen to say 9%. Mr Smith needs funds so he sells his bond. Because interest rates have risen over and above the coupon rate, the bond is not as attractive as before. Mr Smith sells his bond for say $950 to Mr Brown. This means Mr Smith has had to sell his bond at a discount. Mr Brown was willing to pay only $950 for the bond because he could have put his money elsewhere and achieved a 9% return on it whereas the return he is now going to receive on the bond is only 7%. At the date of maturity, the issuer will repay to Mr Brown the face value of the bond being $1000. Prior to maturity, Mr Brown will receive only 7% on his investment but he will pick up the extra $50 on maturity of the bond which equates to an overall return of 9%.
• Clearly because bonds pay out interest on a regular basis, they can be a good source of income.
• But you need to be aware that if interest rates move, the value of your bond can fall. They are also subject to inflation risk.
• The small print on bond applications needs to be carefully scrutinised. This is because not all bonds are created equal. For example, an issuer may have the ability to call for repayment of the bond before it matures. If this occurs, the bond holder may receive only the par value back. This could perhaps occur when interest rates fall and the issuer identifies they can buy back the bonds and then issue further bonds at a lower coupon rate thus saving themselves from paying out higher returns. Alternatively, it could occur if there was a right of early repayment when and if a change of control (e.g. a takeover) occurred.
• There might not always exist a prospective purchaser to buy your bond, hence they are not as liquid as cash.
• There are several different classes of bonds as well. For example 'junk bonds'. Never make the mistake that all bonds are therefore created equally.
• Overall if you are thinking of purchasing this type of investment, I recommend you do so through an Authorised Financial Adviser such as your stockbroker, as they will be familiar with the bond market.
  
  
  

• Property – Just like there are many different types of bonds, there are several sub categories to the property class of investment.
• For example, there is the residential market, the industrial market, the commercial market, the leasehold, etc. Additionally, within each sub category there are different categories. To illustrate, take the residential property market. Within this market there are apartments, townhouses, stand alone houses, joined together units, etc. To add more confusion to the mix, each of these will have their own particular market. A town house in Remuera or Park Lane for example will be a different price than one in Royal Oak or Islington.
• The first rule of thumb when investing in this asset is to truly know your objective and your market. You should understand why you are purchasing and what you are purchasing.
• You might wish to simply buy a home and live in it. Alternatively, you may wish to purchase a property for rental investment purposes.
• Irrespective of your reasons for purchase, you should be aware of some buying rules. For instance, try to buy below market price as this instantly gives you capital gain if you achieve this. Additionally, don't over capitalise your property when completing alterations and renovations as you won't get the extra funds you have put into the property back when you come to sell it. Buying rules are crucial if you wish to make money in property. For this reason, I recommend completing a property education course which teaches the rules of property investing.
• Regardless of your objective, I believe you should be aware of the demographics of the neighbourhood, the existing and proposed amenities in the neighbourhood, the prices other properties have sold for, the average rent charged in the area, etc.
• You should also understand supply and demand of a neighbourhood. For instance, if you purchase a property in a well known area where supply is limited and demand is high, you can expect to pay a premium for that property as many other buyers will be wanting to purchase the home. Conversely, when you want to sell the property, you would expect to have a ready market and not have too much trouble selling the property on.
• They say location is everything when purchasing a home. What they mean by this is you can make a greater capital gain by purchasing the worst house in the best street in the premium neighbourhood than you can by purchasing the best house in the best street in a less than desirable suburb. Always aim to buy your personal home in the best suburb you can afford.
• You should also think about what is driving the demand in any given area. Properties situated in suburbs that are close to the centre of any city and close to good schools have historically been more expensive than those homes in suburbs further away from a city's core. This occurs because people value their time and educational facilities. Accordingly, they will pay more to reside in a suburb where travelling distances are short to their work (city centre) and their children's schools.
• Likewise you need to consider what drives property prices in the area you are intending to purchase in. Mostly property prices rise over time but some house prices rise quicker than others. This is because there is not a natural cap on prices or the ceiling on the prices is fluid and able to move upwards. This tends to occur when the people in an area are able to afford those increased prices. For example, if a person has a job they will have an income. This helps them borrow funds from a bank which in turn, enables them to have enough money to purchase the property. From this you should gather that it is important to purchase property in cities rather than in rural communities if one of your objectives is to grow your financial wealth, because it is cities that have employment opportunities.
• Like most investments, timing is an important factor to take into account when purchasing or selling your asset. You want to aim to purchase at a time when the property market is depressed and prices are low. Conversely, if you are going to sell the property, you want to sell it when prices are high, as this is when you will make the most money.
• Of all the categories of investment you could make, property is one of the least liquid as it can take more time to sell the asset than, say, cashing in your term deposit.
• Unlike other forms of investment, many people leverage to purchase property. This means they use their own money and other people's money to complete the purchase. For example, a person may have in cash 20% of the purchase price but they may borrow from a bank the additional 80% of the funds required to buy the property. The return the property produces, however, is not simply on the individual's 20% deposit. Rather it is on the whole 100% of the money used to purchase the property.
• Being able to leverage can be a benefit this class of asset bestows over other assets. This is because it's often easier to leverage to purchase property than it is to purchase shares. This is because banks tend to be more reluctant to lend to an individual who wants to use the funds to purchase shares and more willing to lend to facilitate the purchase of bricks and mortar.
• Overall, people perceive the investment into property as less risky than the investment into shares. This occurs because individuals think that because they can see and touch their asset, the asset is a more solid investment than, say, shares. One must remember however, property markets can and have dropped.
• To ensure you make the right property purchase, I recommend getting a good real estate agent who truly understands the market you are thinking of buying in. You will also need a lawyer who is competent in conveyancing.
• If you are intending to purchase a property for rental or trade or development purposes, you will also need an accountant who understands structures and can advise you on the tax issues. This is absolutely imperative.
  
  
  

• Shares – A share is an ownership unit in a company. It represents part of the overall value of the company. Usually it entitles a shareholder to a proportionate slice of the company profits. When profits are paid out, they are referred to as a dividend.
• Most shares are extremely liquid, but shares in smaller companies may be less liquid.
• Your risk profile, your desired returns, the time you have available to meet your personal financial objectives and diversification are all important matters you need to consider when purchasing shares.
• Just like the property market, there are markets within markets when considering shares. For example, you can invest in domestic shares or international shares. You need to understand exactly what you are purchasing and you need knowledge of the company you are purchasing shares in.
• Share investing is probably one of the more risky types of investments a person can make in terms of day to day volatility. This is because shares are listed on stock exchanges and trade throughout the day, at whichever prices buyers and sellers are willing to transact at the time. This volatility can be caused by the actual activities the company undertakes, the positive or negative publicity a company's management can receive, or simply the industry the company operates in.
• In the short term, the returns from shares can vary widely but in the long run, the returns will tend to be higher than those received from other forms of investment. The ultimate return of course depends upon the success of the companies the shares are purchased in and how long the shares are held.
• Diversification to curtail risk is a very large factor sensible share investors practice. Accordingly, they will often hold mainly 'blue chip' shares, being shares issued by companies that are perceived to be relatively solid, rather than say "start-up" enterprises, which may be more speculative. By purchasing blue chip shares, the risk of volatility of returns and erosion of capital decreases. Companies that issue these types of shares often deal in necessary goods such as electricity.
• Some investors buy only in companies they really like. As Mae West said '"too much of a good thing can be wonderful". That, however, is not the way to going about building your wealth in the share market. Share investing can be complex in terms of the range of companies that are available to invest in. As such, it is vital to engage a qualified share broker/authorised financial adviser to advise you. You need to build a sensible share portfolio that is tailored to your needs and in order to do this, you need personal, informed, unbiased advice and assistance.
  
  

Summary

There's an old saying … "different stokes for different folks". That saying is a truism when it comes to choosing what you will invest in. For my part, however, I prefer to practice the lessons I've told you about in Part I of this series of Secrets of Wise Investing. In particular, I believe in diversification so that my bases are covered. As such, I have placed my money in cash, shares and property. I have chosen these types of investments because I believe everyone should have some cash at their disposal, I'm comfortable with the ups and downs of the share market and I enjoying being able to swing half a cat around my Parnell bricks and mortar pad.

In our next and final part of this series, we are going to explore what type of investment provides you with the highest returns. You may well be surprised at this outcome.