Questions you need to ask before investing

Deciding where to put your money can feel complicated but there are some basic rules smart investors follow.

Investing is one of the most effective ways to build another source of income, but if you don’t know the rules of the game it can be overwhelming.

In this article, I cover the key things you need to know to be a smart investor and what you can do to get started.

Investment timeline

Any share investment is subject to the swings and roundabouts of the stock market, and property investments also have their highs and lows. The implication is that if you want to be a smart investor, you should be looking to choose investments that are suitable with how long you’re looking to invest your money for (your ‘investment timeline’).

If you’re investing for the shorter term, conventional wisdom (and historical market performance) suggests you should have more of a focus on stable investments like cash.

But, if you’re investing for the longer term you have the time to ride out the highs and lows of the market and invest into more growth focused investments like shares and property.

Educating yourself on the timeline of different investments and thinking through how this fits with your investment goals is the first big step in setting up your investments for success.

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Property investments have highs and lows so you need to know your investment timeline. Picture: iStock

Your asset mix or ‘risk profile’

You should be aware that different investments have different characteristics, and understanding the impact of these differences and then choosing a mix of investments consistent with what’s important to you will pay dividends over your investment journey.

The two broad categories of investments are ‘defensive’ or ‘income’ investments like cash, and then you have ‘growth’ investments like shares and property.

Income investments are generally more stable with lower chance of loss and – as the label suggests – aim to produce income. Investments that fall under the income or defensive category are cash savings, term deposits, corporate and government bonds, and other slightly more complex investments like hybrid shares.

These assets give investors more security and stability by being ‘secured’ against capital (another asset).

For example, when you put cash into a savings account, your investment return is the interest income on your money, and the value of your initial capital (money) that you put in remains the same and can be withdrawn even if your interest rate goes down.

Growth investments on the other hand have a focus on growing or increasing in value over time. Common growth investments include Australian shares, international shares and property investments.

Growth investments are referred to in this way because when you buy a share investment for $10 today, you would generally do this with the expectation that share investment would increase in value over time.

Your ideal or target investment allocation between growth and defensive investments is referred to as your ‘risk profile’, and will be one of the biggest drivers of your annual percentage investment return each year.

To establish the right risk profile for you, think through your investment goals and why you’re investing in the first place. Then look at which types of investments are able to deliver these results and confirm they fit in with your investment timeline.

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Good vs bad risk

You need to understand that not all investments are created equal. A common investment myth is that being an ‘aggressive’ investor or a ‘high growth’ investor means investing in more of those smaller high risk investments where your risk of losing all your hard earned savings is significant. This isn’t the case.

The example I like to use is investing in a start-up tech company vs investing with one of the big four banks. Because the tech company is small and just getting started, there’s likely to be more and bigger ups and downs in the value of your shares over time.

Over the long term the shares might do amazingly, but on they other hand they may go bust.

In contrast, if you were to invest with one of the big banks, because these companies have been around for decades and have significant business assets behind them it’s likely you will see less and smaller ups and downs over time.

If you want to get ahead as an investor without running the risk of blowing up your portfolio, think about keeping your focus on the more stable ‘good risk’ shares and you’ll not only get more stable returns, but you’ll be able to do it without the stress.

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Your ‘risk profile’ will have a major impact on your investment returns. Picture: iStock

Diversification

Diversification means spreading your investment risk across multiple investments, and is a highly effective risk reduction strategy that’s worth being across.

When you invest directly into only one company, the return on your investment will be simply the return on that particular company. But as soon as you have two investments, the highs of one investment are balanced by the lows of the other, meaning your return will be smoother over time.

The more different investments in your investment portfolio, the smoother your investment returns will be. You won’t get the big pay-off if you’re lucky enough to pick the next “big thing” but you also won’t get the lows of investments where companies crash and burn.

If you want to reduce risk when you invest, think about how you can leverage diversification to reduce your risk and set yourself up for a smoother investment journey.

Active vs passive investments

Active investing means, as the name suggests, your investments are managed “actively”. What this really means is that you’re choosing investments you think will do better than all the other options available to you.

This normally involves a “fund manager” trying to figure out which companies will do well and choosing more of them, while avoiding companies they think might experience average performance.

When you invest actively, you’re betting on the fact your fund manager knows what investments will perform best, and when you invest passively your main bet is really that the markets will continue to do what they’ve done for the past hundred or so years.

When you invest passively, you invest into the overall market to target the average market return. By following a passive investment approach, in addition to having a highly diversified investment portfolio you can have more confidence in your investments because you know they’re just tracking the market.

Both styles of investing have their advantages and disadvantages, but the statistics show that the majority of active investment managers (more than 70 per cent) fail to outperform the overall market over the medium to long term (i.e. more than five years), mainly driven by higher fees and the fact nobody can predict the future.

When you invest, educate yourself on these options and what you feel is most aligned with how you want to invest.

The wrap

To be a smart investor there are some things you need to work through to get good investment results. Take the time to firstly understand your investment timeline and get your risk profile right. Understand the power of diversification and how to reduce investment risk, then decide whether you want to be an active or passive investor.

This will help you create a rock solid investment strategy you can have complete confidence in, and one that will deliver the results you want over time. I promise your future self will thank you for it.

Ben Nash is a finance expert commentator, podcaster, financial adviser and founder of Pivot Wealth and author of the Amazon best-selling book Get Unstuck: Your guide to creating a life not limited by money.

Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.