This article was originally published in August 2017
Well that was the plan at least, when I recently presented to Year 12 Accounting students for a personal finance and investment subject.
Everything starts with the question of “what are you saving for?” and the two most common answers would be to buy a house and to save for retirement (yes, I am generalising). I do realise that these goals would be at the bottom of the list for any 18 year old, but let’s assume they’ve made it through Schoolies, and have some form of employment and dealings in the grown-up world.
These goals need to be articulated with a time frame and amount. Unless you start with “I need to save $X in Y years”, it will be hard to achieve. Then there is only one more variable needed to work out the answer — the expected return on the money you’ve invested.
And that’s where the fun starts!
Risk assessment and risk profile
Before you should invest money, you need to have an idea of your tolerance for risk — this process is commonly called risk profiling. While it can be an extremely subjective process, it does prime an investor to consider how they may react to certain financial events or return outcomes.
The process usually consists of a series of questions with multiple choice answers, where the end result is a number which aligns with a certain risk profile. There is no definite number of risk profiles, but a common approach is shown in Figure 1.
Figure 1: Risk Profiles
Once you are comfortable that a risk profile fits your situation, it is now a matter of investing in assets that offer the returns and risk that can suit. The more risk you can take, the higher the allocation to growth (risky) assets.
Figure 2 shows that as you move up the risk curve, your allocation goes from 100% defensive assets (cash and fixed interest) to 100% growth assets (shares and property).
Figure 2: Asset Allocations to match Risk Profiles
The challenge with any asset allocation decision is you will only know the right one for you after the fact. For example, being in a conservative portfolio is only the right decision if returns end up being low or negative across more asset classes, whereas being in a growth portfolio was the wrong place to be during such times.
Asset classes and their expected returns
As shown in Figure 2, there are four main asset classes as follows, ranked lowest to highest risk and hence return potential:
- cash (depositing your money with a bank)
- fixed interest (lending your money to the government or companies)
- property (buying into a physical asset that is rented to a tenant)
- shares (buying an interest in a company/business)
While each asset class can offer a wide range of returns year by year, when combined in a diversified portfolio and given time (10 years +) to smooth out the ups and downs, a quality portfolio should offer the following returns:
Figure 3: Diversified Portfolio Projected Returns
What could go wrong?
The above explanation makes it seem so easy, and if we weren’t human it would be! But we are not mindless, unemotional robots that always do what is in our best interests.
While there are many things that can derail the best of financial plans, there are two main things that often get way in the of achieving our financial goals.
- Greed and fear — everyone wants to get a higher return, and this “greed” often leads investors to take on too much risk and think they can time when to take their profits and run. But that almost never happens. The flip-side is being too fearful of losing money (often as a direct consequence of once being greedy and losing money).
- Instant vs delayed gratification — Saving for a house deposit or retirement is so far away that the later, larger reward (delayed gratification) is very hard to see, so it is often difficult to resist the temptations of smaller but immediate rewards (like a nice car or holiday).
The secret to financial success can be as simple as spending less than you earn.
This article is the opinion of the writer and does not consider the circumstances of any individual. This document has been prepared by Peter Keogh (Authorised Representative No. 253538 of Paragem Pty Ltd AFSL 297276) and is intended to be a general overview of the subject matter. The document is not intended to be comprehensive and should not be relied upon as such. We have not taken into account the individual objectives or circumstances of any person. Legal, financial and other professional advice should be sought prior to applying the information contained in this document. No responsibility is accepted by Peter Keogh, Paragem or its officers.