Beginners guide to investing part 3:Types of investments

Welcome back. If you are just joining the investing series now, I do recommend that you start at part one. There is some useful terminology that we will be using in the articles.

Let’s dive straight into it and briefly explain the 5 main asset classes: Cash, fixed interest, shares, commodities and property.

 

1/. CASH

Overview: Cash from an investing perspective does not literally mean cash. Cash on its own is not considered an investment because we are not getting a return from holding cash. Investments, in the sense of the word, require some form of return.

Cash investments are considered relatively safe because we’re promised a fixed return. This is not always the best option, especially if we don’t need the money anytime soon and are a bit more tolerant towards risk. During years of high inflation, someone with an all cash investment portfolio can actually lose money in real terms.

Types: The most common cash investments are savings accounts and term deposits with banks. Another way of investing in cash is through a managed fund, where our money is pooled together with other individuals, managed by a fund manager and invested in various term deposits. Kiwisaver is a well-known example of a managed/mutual fund. There are many types of managed funds available, so if this is your favoured type of investment, make sure you choose the cash fund.

How: Putting money into a savings account should be common knowledge so I won’t delve into that here. As for a managed fund, you will need to first research which company you want to manage your investments. If we are time poor we can pay a financial adviser to do this part for us. What to look for from an investment firm? Low fees, transparency, reputation and investment strategy. I will briefly explain each of these now.

Even small differences in fees can really add up over time. Especially since the returns from cash investments are already low, any fees will make a significant impact on our returns.

Is important information such as fees and investment disclosure statements readily available? The less a company keeps hidden the more informed a decision we can make and the more we can trust them. How reputable is the investment firm? If they are large, have been in the business for a long time and have a lot of customers with positive client testimonials, then they are more likely to survive time. Finally, what is their investment strategy? If they only invest in one type of bank deposit account then that may be more risk than we need. Bank funds typically only invest in their own products. If we are seeking diversification, then we will be better suited to a managed fund that invests in a range of bank deposit accounts.

Once the investment firm has been decided on, the rest is pretty much in their hands. You will need to set up an automatic payment from your bank account of you are investing on a regular basis. Just let them know whether it is weekly, monthly, or some other frequency. Take note that some firms need minimum amounts invested per month (typically a minimum of $50), so check that before deciding on your investment.

Finally, for a managed fund you will need to give the fund manager your IRD information for tax purposes. Portfolio Investment Entity (PIE) funds are a type of managed fund. This fund offers investors a lower than standard tax rate. See rates here. Make sure your check the investment terms though, as there may be a penalty for accessing your money early. There may sometimes be a clause that prevents you accessing your money early altogether.

Advantages: Low risk of losing all your money, low fees, near guaranteed return, and we can withdraw our money whenever we want in most circumstances.

Risks: Inflation rising faster than the rate of return on cash investments. The risk of losing small amount of money if the cost of living grows at a faster rate than our returns. It is also very easy to access our money, thereby undoing our hard savings effort.

Ideally suited for: Individuals that have a very low appetite for risk, will not be tempted to touch the money before they need it, need easy access to the money or are investing for just a short period of time (1-3 years).

 

2/. FIXED INTEREST

Overview: More long term than cash, with maturities between 1 and 30 years. Fixed interest is where we lend our money to an institution for a pre-determined length of time. At expiry of this time, our money, plus some fixed interest, is returned to us. It is a way for government, councils and corporates to raise cash for their corporations.  We can access our money before expiry if we wish, but this does carry some risk.

Types: The most common that we will discuss here are bonds. Bonds can be either corporate (businesses), municipal (local council) or government. Government and municipal bonds tend to be lower risk than corporate bonds because government can raise cash much easier than businesses can if they get in to any repayment difficulty. Because of government bonds low risk, their interest rates (also known as coupon rates) tend to be in line with inflation. The returns from corporate bonds should be higher.

Callable and convertible bonds both carry special provisions that make it possible for these bonds to be terminated before the official expiration date. So, keep an eye out you are not buying these special types of bonds if you do not wish.

Callable bonds are terminated by the bond issuer. One advantage to these are that we will generally be paid higher coupon rates as compensation for the inconvenience of receiving our money sooner than planned. The downside being most bond issuers ‘call’ their bonds when there are sharp drops in interest rates. The bond issuer can then issue the bonds to a ‘new’ investor at lower interest rates. This opens us up to re-investment risk. We would now have our cash in a less favourable bond market with lower coupon rates if we were to re-invest in the bond market.

Convertible bonds are terminated by you, the investor. They are bonds that can be converted to shares of the issuing company’s stock. If the stock performs poorly we don’t need to convert the bonds. By leaving our investment as bonds, we will still receive the agreed coupon rate. However, if the stock price starts to outperform the coupon rate, then we may decide to convert our corporate bonds to corporate stock.  Convertible bonds have greater potential for appreciation, however, bear in mind that holders of convertible bonds will receive payment AFTER standard bond holders in events of corporate bankruptcy. Also note, that convertible bonds are also callable, in that the issuer can call the bonds away, thereby capping the investors gain. As a result, convertibles don’t have the same unlimited upside potential as common stock.

Rating agencies evaluate the bonds creditworthiness by giving the bonds ratings.  AAA to BBB bonds are considered credit worthy. Pretty safe for the investor. Lower than BBB are sub-investment or junk grade. This just means they have a higher likelihood of defaulting on your fixed interest payment. The lower the grade, the higher the interest rate SHOULD be.

How: You can invest in bonds through either:

  • A broker, such as Craigs Investment Partners, or a bank. Register your contact details and you will be given a shareholder number (CSN) and an identification number (FIN). Research the best company for you.
  • Investing into a fixed interest mutual fund.   

As with cash, each company has minimum amounts that you must contribute to remain active. Check these out before making your decision.

Advantages: Generally low risk, returns generally match or better inflation, and easy access to our money (not ‘locked in’)

Risks: Having to sell our bonds before expiry could result in either a loss or lower than inflation returns. This is due to changing interest rates. As the timeframe of the investment lengthens, borrower and lender are exposed to movements in interest rates, creating both interest rate and reinvestment risk. Potential buyers would be much better off buying new bonds at higher interest rates than our bonds at our locked in lower rate. Meaning we will get less for our bonds. Whereas, forced to buy when interest rates are low means our re-investments are not getting as high a return as if we didn’t have to sell.  Credit risk is also a possibility. This means if a company goes bankrupt, there is a risk we may not receive our money back. Bond holders do get paid before shareholders though.

Managing risk: Risks can be reduced by ‘laddering’ our investments. This basically means choosing bonds with different maturity dates. This means you will access your cash at different times in the market cycle. We could also diversify our bond investments, such as a mix of corporate and government bonds. Choosing different types of bonds across a wide range of companies and sectors will increase our chances that some bonds will perform well when others aren’t. Purchasing non-callable bonds can also greatly reduce interest rate risk.

Ideally suited for: Investors looking for some low risk security and fixed income in their investment portfolio.

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3/. SHARES

Overview: A share is part ownership of a company. Also referred to as stocks or equities. Shares are arguably the riskiest asset class, yet also the most rewarding. Shares are bought and sold on the open share market. The New Zealand market is called the NZX. The price determined by how much people are willing to pay. The share market is volatile, experiencing large up and downswings in value depending on the economy and investor sentiment (over confident, confident, or pessimistic).  For this reason, investing in shares is not recommended for the short term as human sentiment and future events are too difficult to predict.

Shareholders can get an increase in share value from one of two ways. Increase in share price and dividends. An increase in share value is not income unless we actually sell our holdings. Dividends are regular income paid out to the shareholder from the company earnings. If we are a long term investor, dividends are best re-invested into our investment, instead of cashing out. Not all companies pay dividends and the amounts vary greatly. Company dividend information can be found on the company website.

Because shares are arguably the best investment for wealth building, I will be dedicating the next three articles to go more in depth regarding the different methods of investing, risk management and the impact of human psychology in the sharemarket.

How: Similar to fixed interest, with one addition:

  • A broker, such as link market services, or a bank. Register your contact details and you will be given a shareholder number (CSN) and an identification number (FIN). You can then select individual stocks based on research.
  • Investing into a mutual fund.  An investment company with an active investor (portfolio manager) will select what they think are the best companies, and in what quantities.   
  • Investing into a low-cost index fund that mimics the entire market. No active management. Just low-cost passive investing.

With funds you will need to research the different companies to find one that you trust and offers what you are looking for. Low fees are important, but there are other factors worth considering such as how diversified the fund is and the reputation of the company. 

Each option carries varying degrees of time, cost and risk that needs to be considered.

Advantages: Potentially returns much higher than inflation, generally easy access to money (liquid), regular income through dividends.

Risks: Potential for negative returns, bad market timing (buying high, selling low), volatile returns (up and down), companies going bankrupt, change in economic policies such as capital gains tax, currency risk (if international trading), risks specific to industries such as weather, poor management of company or loss of key personnel, and liquidity risk (when demand for shares is weak will be difficult to sell).

Managing risk: I’m sure you have heard the saying “don’t put all your eggs in one basket” at least a hundred times before. It is worth repeating here - “don’t put all your eggs in one basket”. By spreading our money across different companies, different types of industries, different regions or countries and different asset classes, we greatly reduce our risk of losing money.

Investing our money in regular monthly payments, instead of a large lump sum will also greatly reduce the risk of bad market timing.

Ideally suited for: Long-term investing (10 years or longer). Investors willing to take on more risk in order to receive the potential higher returns.

 

4/. COMMODITIES

Overview: Are raw materials or physical assets that can be bought and sold on an exchange or in the cash market.  Trading goods, not stocks. They fall into 5 main categories:

  • Energy – crude oil, natural gas, gasoline and heating oil.
  • Agriculture – Wheat, corn, soy beans, cotton, sugar, coffee and cocoa.
  • Industrial metals – Aluminium, copper, lead, nickel and zinc.
  • Livestock – live cattle, feeder cattle, and lean hogs.
  • Precious metals – gold and silver.

Commodities, in the market sense, are generally raw materials that are used to produce other goods.

How: In order of most to least risky:

  • You can buy some commodities, such as gold, direct from the dealer. Some examples are here or here. On purchasing these bars and coins, we become the owner of the physical unit. We store the gold. Storage and insurance are important considerations. It really is as simple as buying online with our contact details and credit card. Commodity dealers are not regulated, so research and prudence are paramount.
  • You can purchase commodities via a manged fund. Many banks offer this service, as well as investment firms. Commodities carry high risk, even more so when the managed fund trades in the futures market. The futures market basically means the fund managers are anticipating the market to go one way over another. Making exchanges now based on guesses to the future price. Buying and selling now at guesses of future prices. Make sure to read terms and conditions of the fund and ask them what investing strategies they use. Unlike buying direct from the dealer, we don’t store the physical commodity, we just benefit from the increase or decrease in price.
  • The final way of investing in commodities is by investing in shares of commodity producing companies.

Advantages: Diversification benefits from owning an asset that often has low co-relation with other types of investments. In other words, when all other asset classes are falling, commodities may be increasing. Maybe not also. Commodities are often used as a hedge against rising inflation/cost of living. Potentially high returns.

Risks: Physical commodities require storage and insurance solutions and money is only made if we’re able to sell it for more than what we paid, which relies on strong demand. There is no interest, cashflow or dividends to be received from physical commodities. Direct sales of physical commodities are not regulated by any NZ market. Generally higher trading fees. High volatility – prices can change in a very short time (up and down) due to economic, geographic, environmental and market conditions.

Managing risk: Diversification plays an important role here too. If we are willing to invest in commodities it should only make up a small part of our overall portfolio. By doing so, we will limit any downturns, whilst still getting some benefit from upturns. This also includes having a wide range of different commodities, different regions, or different investment companies. Research into dealers, funds, stocks and mangers are recommended.

Ideally suited forExperienced investors willing to take on more risk in order to receive the potential higher returns. An investor looking for further diversification.

 

5/. PROPERTY

Overview: Investing in property is a very popular pastime in New Zealand. Owning our own house is not investing in property though, unless we plan to rent out rooms or space, or sell within a very short timeframe. Our own house should not be classed as an investment.

Part of this popularity comes from gearing. This means that we can purchase 100% of a property using as little as 10% of our own money. Different governments regulate the amount of gearing allowed in different ways. This allows many people the ability to invest in property, that may not have been able to otherwise.

How: There are two main ways to invest in property:

  • Purchasing a rental or commercial property. Our purchase is then rented out to tenants to use.
  • Purchasing a real estate investment trust (REIT). A REIT is a managed fund that invests pooled money in various listed property companies that own income producing properties., such as office buildings that rent out offices. Similar to shares in that we are a partial owner in the company and we receive dividends when the company deems applicable. This allows us to get into the property market without the major start-up costs and maintenance costs needed when purchasing our own property.

Advantages: Property is not highly co-related with other asset classes. It’s inclusion in an investment portfolio reduces overall portfolio risk. Gearing, explained earlier, is another advantage. Finally, tangibility is an advantage. People tend to like having an investment that they can see, touch and feel. Returns from property investment tend to be higher than bonds and cash.

Risks: Property values are tied to interest rates. Interest rates are outside of our control, making the risk of owning a home high if we want to sell when there are high interest rates. Demand will be lower, and we will not receive the price we wanted.

Property is not very liquid. This means that it takes time to turn property into cash, so if we need cash in a hurry, property is not the best investment.

Property incurs high opening, closing and maintenance costs.

High gearing can also be a negative. Because we can borrow 20% the value of a property, if that property were to decrease we would lose out not only the money we invested, but the value of the whole house. For example, if we borrowed 20% ($100,000) against a $500,000 house and it went down 2% in price, we would not lose 2% of our $100,000 ($2,000), we would instead lose 2% of $500,000 ($10,000). Our loss would be 10% which is 5 times greater than a standard investment such as bonds or stocks returning 2%

Property requires a lot of maintenance and time.

Geographic risk – property is tied to one area. If any event such as earthquake or a gang headquarters moving in nearby, were to happen in the area, our home may lose a significant amount of value.

Managing risk: Kiwis often have a high proportion of their investments in property. This risk can be reduced by investing in other types of investments, such as bonds or shares. Investing in REIT’s can also reduce risk by removing the buying, selling and maintenance costs involved, as well as allowing us to diversify as each fund invests in a wide range of commercial properties.

Ideally suited for: Long-term investors due to high start-up costs. Investors willing to take on more risk in order to receive the potential higher returns.

 

FINAL THOUGHTS

Owning or creating a business is another wealth builder/investment that we haven't gone over as it applies to a minority. It can be a great option, but not one we will discuss in this series. 

This has only been a brief overview of the main investment asset classes. Each one with its own distinct benefits and risks. Commodities tend to carry the highest risk, followed by shares, property, bonds and cash with the least risk. Only you can decide if you are willing to take the risk required to achieve your desired reward. Remember, highest risk does not always mean highest reward. We can also employ strategies designed to minimise the risk as much as possible.

Investing should not be a gamble. It should be well researched and calculated. If we have neither the time, the knowledge or desire to invest then it is best to have someone else manage our portfolio or not invest at all. Otherwise the outcome can be costly. It is still important though to understand what decisions our investment adviser is making and why. After all, it is our money.

It is always a smart idea to research the company with which we will be investing through too. A quantitative analysis will consider the numbers of the decision, whereas a qualitative analysis will consider non-measurable factors such as reputation, expertise and so on. Both qualitative and quantitative are important when making our decision.

Remember, investing isn’t about making money. It is about using money as a vehicle to achieve our life goals. Anything more is greed and extra risk than we need to take on. Anything less is not achieving our desired lifestyle.

The investing world is not that scary once we can understand the basics and that is what the first 3 articles in this investing series aimed to achieve. The next 3 articles in the series will explore what has historically been the best performing asset class. Stocks. I look forward to seeing you back in a few days.

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here

 

Comment below. What is holding you back from investing? Have you made major mistakes when investing? Any tips for new investors?