Risk vs return

A general investment rule: the more risk you are willing to take – the more your investment can be expected to return.

Shares are the riskiest asset class. Share prices are volatile; meaning they can rise and fall significantly in the short term. However, over the long term they are often the best performing asset class.

Cash is the least risky asset class. The returns are generally predictable and there is practically no risk of capital loss. Returns are therefore the lowest.

The risk and return characteristics of each asset class are shown in the table below.

*Alternative assets, which include investments such as infrastructure (e.g. roads, railways, and airports), private equity, hedge funds, and commodities, sit in a kind of middle ground, containing characteristics of both growth and defensive assets. Returns will vary markedly.

Timing the market

Time is an important factor because of the way growth assets like shares and property perform. These asset classes are likely to give you the best long term returns. But the growth of these assets does not necessarily happen steadily and consistently.

Avoid the temptation to time the market. This means buying assets when prices are low and selling when they are high. It sounds like a good strategy in theory and it is. In practice though, it's very difficult to do successfully. Often it's better to formulate an investment plan and stick to it. That way you will always benefit from periods when share and property prices rise in value.

In the short term, share and property prices are not easy to predict. Prices may rise consistently for a period, stagnate, or even fall. However, over time investments in quality assets are expected to rise in value more than they fall. By investing for a suitable time period, you can ride out the periods of poor performance and take advantage of the good times.

Diversification

Diversification means spreading your investments over a range of different assets and asset classes. By diversifying your investments, the overall performance of your investments will not suffer if one asset or asset class experiences volatility in the market.

You can diversify your investments in many ways. Here are some examples:

• You can spread your portfolio over the five major asset classes. It would be unusual for cash, fixed interest, property, alternatives, and shares to all perform well or poorly in unison.
• You can spread your portfolio over assets of a different type in the same asset class, for instance, an office block and a shopping centre, or retail and mining company shares.
• You can spread your portfolio over geographical regions, such as industrial estates in Perth and Sydney, or shares in Asia, USA, and Australia.

Unless you have a lot of money and a lot of spare time, it's very difficult to build a diversified portfolio, so most people use an investment professional, like a super fund, to manage their investments for them.

Diversification smoothes the returns you get over time. However, when you invest in growth assets, like shares and property, diversification doesn't guarantee you will always receive a positive return, or a greater return than cash investments. If the whole market takes a dive, diversification may not prevent your portfolio getting a poor return in the short term.

Power of compounding

If you have money in super, then you're already taking advantage of compounding, because your money is invested. The income from these investments is reinvested so you earn returns on your returns. The earlier you start investing, the greater the benefits of compounding.

Compound interest works well in superannuation because it's a long term investment. You can't normally access your super until later in life, so your super benefits from many years of compound interest.

The graph below clearly demonstrates the magic of compounding. Look at what a difference $20 extra a week could make over 30 years. The pink sections of the graph show the compound effects and the blue sections show the principal investment.

 

Assumptions:
1. The calculation assumes savings of $20 per week for a time period of 30 years.
2. The calculation assumes the interest compounds weekly.
3. The interest rate assumed is 6% and is net of fees and taxes.
4. The information should not be used as a guide to future performance of any investment.
5. The total saved does not take inflation into account.
6. Check with your chosen savings product provider in regard to actual interest calculations.
The calculation provides an estimate of the future value of savings, which could vary significantly over time if any change is made to these assumptions.