Heeding the warnings to diversify
When you diversify, you spread your investments across a range of asset classes to limit your risk. The four main asset classes (or types of investments) are shares, property, cash and fixed-interest investments.
These are either classified as growth or defensive, depending on what returns they are expected to give, and how volatile the asset class is.
Shares
Growth assets, like shares, have the potential to earn a higher rate of return. However, they are likely to fluctuate in value in the short to medium term so need a longer investment timeframe.
Australian shares can offer local investors capital growth, income, and tax benefits in the form of credits for any tax the company has already paid on the income distributed to the investor.
Share prices can, however, rise and fall suddenly. This could happen in response to company profits, market sentiment, industry issues or economic trends.
To reduce your exposure to volatility, it is therefore important to view shares as a long-term investment. It is also a good idea to invest across a range of shares in different sectors in the economy.
You can also access different markets by investing in international shares. However, the income return from international shares generally does not provide investors a tax benefit, and the capital value and income return will be influenced by currency exchange rates.
Property
Property is also a growth asset. But you don’t have to invest in it directly by buying a property, you can invest in listed property securities which have the advantage of being easy to buy and sell.
Listed property securities provide more diversification than direct property purchases because they provide access to a range of properties including residential, commercial, retail and industrial.
This means you can invest in the sector without tying up the significant amount of money involved in a property purchase.
The value of listed property trusts will however increase or decrease in value in accordance with movements in the sector and the sharemarket generally, so property is also a volatile, long-term investment.
Australian and international fixed interest
Fixed-interest investments like bonds are defensive assets and less volatile. Bonds pay their investors a fixed-dollar income in the form of a coupon payment for an agreed period of time.
If you sell fixed-interest investments prior to maturity and interest rates fall during the time you hold the investment, then you enjoy a gain on the original investment.
But if you sell a fixed-interest investment prior to maturity and interest rates rise during the time you hold the investment, then you receive a lower value than you would have received on maturity, therefore incurring a loss.
There are many forms of bonds, including investment-grade corporate bonds, emerging-market bonds, nominal-government bonds, and inflation-linked bonds.
You can also access fixed-interest investments in foreign currencies. However exchange rate movements will impact on the capital value and the income return of the investment.
As bonds can fluctuate, they offer a higher potential rate of return than cash and short-term securities, but a lower potential rate of return over the long term than growth assets.
Cash
Cash and short-term securities are generally the least volatile asset class, offering the lowest potential return over the long-term.
These investments include deposits, bank bills and other assets whose price is linked to short-term investment rates. With this asset class a risk to be aware of is inflation eroding your interest rate gains.
Understanding what you are investing in, having a diversified mix of investments, and taking the advice of a financial planner will limit your exposure and help you withstand the ups and downs of the market.