Understanding the Basics of Investing Your Money taken from our ‘On Target Newsletter’ issue no 265
All investments fall into particular categories. If you’re going to design a moneycraft to maximize your wealth it’s important to understand the differences…
► Fixed income and fixed capital. When you make a fixed deposit with a bank, for example at 3 per cent, you know that you will get 3 per cent – not a cent more, nor a cent less – and that if you invest $1,000 you will get back exactly $1,000 at the end of the period for which the deposit is fixed (plus $30 interest for the final year).
► Fixed income but varying capital. When you buy a loan stock or debenture, you can count on receiving the same amount of interest each year. But if you decide to sell the security, the price you realize is unlikely to be the same as you paid for it. If interest rates in the economy generally have moved up, you should get less; if interest rates have fallen, you should get more.
The value of an asset moves in a direction opposite to that of the rate of return.
► Fixed capital but varying income. With certain bank investments you can be certain of getting back exactly the same amount when you redeem them, but the rate of income you receive from them is likely to fluctuate during the period you hold them.
► Varying income and varying capital. Neither dividend rates nor the capital values of investments such as ordinary shares and mutual fund/investment trust units are fixed, though their capital values tend to increase over the long term.
► No income and varying capital. Collectables and precious metals yield no income (although they can be used as collateral to earn income). Their capital values do tend to increase over the long term.
► Income but no capital. Annuities are the only investment in this category. Capital invested in them can never be clawed back, but buys an income, usually for the life of the annuitant/s, or sometimes a fixed period of years, whichever is longer.
To forecast the real rate of return you can expect to receive on any investment you must work out the rate of income (interest, dividend or rent) you can expect, add or deduct any capital gain or loss that is likely, and deduct the expected rate of inflation over the period you are considering. An investment adviser will find from the futures market the inflation rate the market is expecting for the period.
In forecasting capital gain, remember that the past is not necessarily a valid guide to future performance. Each asset should be studied separately. However, it is generally a better rule for the long term to invest in those where prices are depressed and the outlook seems gloomy than in those where prices are buoyant and the outlook seems bright.
If the inflation rate does accelerate, growth assets such as shares, mutual fund/unit trust units, real estate, precious metals and collectables can, over the long term, be expected to adjust to it. To a lesser extent insurance products partially linked to growth assets will also adjust to it.
As a higher inflation rate means higher nominal interest rates in the long run, all fixed-income investments would be left behind. Those with varying capital values would be most hurt.
Finally, remember when looking at the prospective rate of return on an investment that it cannot be considered in isolation. It must be related to other factors such as risk and liquidity.
OT 265 27 March 2021
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