Basics of investing

Click on the headings below to discover the basics of investing.

The major asset classes

The four major asset classes include:

Cash

Cash refers to investments such as bank deposits, cheque accounts and cash management trusts. Cash gives you income only (in the form of interest) and is the most secure form of investment.

However, the high level of security comes at a 'price', because over the longer term the return from cash is very low compared to other asset classes. A cash investment gives you interest only which means your capital does not grow in value over time, and you may face the prospect of your investment not keeping up with inflation.

Fixed interest

Fixed interest investments are generally income-producing assets although the capital value can rise (or fall) in certain circumstances. They are generally for terms of one year or more and include government bonds, debentures, mortgage trusts and fixed term deposits.

With most fixed interest securities you invest for a set term at a set interest rate, and receive your capital back at the end of the particular term. As with cash, however, fixed interest investments often don't keep pace with inflation.

Property

The various types of property investments available include residential, industrial, commercial, retail and agricultural. Property investments can provide tax-advantaged income from the rent received and can also grow in capital value. Retail, industrial and commercial investments are usually made via specialist property trusts.

Shares (equities)

When you buy a share you're buying a stake in a company. As a shareholder, you share in the profits and future growth of that company. The ownership of shares can provide a growing income stream from dividends, as well as the potential for capital growth.

Dividends are the portion of a company's profit that it distributes to its shareholders.

Dividends paid by Australian companies often include the benefit of 'dividend imputation', where investors receive 'imputation credits' for tax already paid by the company. If the shares are held by a super fund these credits can be used to reduce the amount of tax that your super fund pays on your behalf or, if held outside super, may be used to reduce your personal taxation liability.

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10 Golden rules to investing

1. Have a financial plan in place and review it regularly with your financial planner

Your financial planner is your guide to point out any hazards and help you along the way.

Without a financial plan you won't have a clear direction or defined path to get there. You should make sure that your plan is still relevant.

As your circumstances change, you should update your plan so that it is still taking you on the correct path.

Ultimately your financial plan is your guide to retirement and beyond. Your financial plan will ensure you can afford to do the things you want to as you progress through life.

2. Start now

It's never too late to start investing. Even small amounts can grow considerably over time, thanks to the magic of compounding interest. The earlier you start and the longer you invest, the more time your investments have to grow.

3. Become an investor not just a saver

An investor is a wealth accumulator. Investors make their money work hard for them by investing in assets that grow in value over the medium to long term; Shares are a typical example of growth assets.

A saver has a short-term focus and generally leaves their money idling away in a cash account which does not have the growth component associated with shares and can lose value in the medium to long term due to inflation.

4. Pay yourself first

Make sure you have a realistic budget in place and aim to put aside as much as you can afford.

As a general rule you should try to invest at least 10% to 15% of your after tax income each year.

If your budget is not realistic, you will eventually "break it" and will achieve nothing. Saving a little is better than not saving at all.

5. Invest regularly

Make investing a habit. Have money deducted directly from your bank account into a regular savings plan. This will make it easier to save and leave you time for the more important things. It will also help you to stick to your budget.

By investing regularly you will also be able to utilise the "Dollar Cost Averaging" method of investing, which is a very powerful tool. It is based on the principals that 'time in' the market is better than 'timing' the market and by investing regularly you do not need to monitor the price you buy assets as they will even out in the long run.

6. Reduce consumer debt

High interest rates on credit cards and personal loans erode your ability to create wealth. You should aim to minimise the size of these debts as soon as possible even if it means reducing your savings in the short term.

7. Reinvest your investments

If you don't need the income from your investments, leave it where it is. That way it will keep working for you and you will be able to earn interest on interest. You can always withdraw the money at a later date if you require it.

8. Don't put all your eggs in one basket

By investing in more than one asset class you are not depending on the performance of that asset class.. There are two ways to diversify your investments, you can:

  1. Design a diverse portfolio with your financial planner by allocating a portion of your investment to various asset classes.
  2. Invest in a diversified fund and let a professional investment manager do the diversification for you. Diversified funds are made up of a number of asset classes and are structured in such way as to achieve their predefined goals according to their allocation to various asset classes.

9. Harness the power of compounding

Compounding is when your investments earn money and those earnings are in turn invested so they can earn money.

By reinvesting your earnings, you are able to earn more. As your investments grow so too do your earnings, which creates a handy upward spiral in your wealth accumulation.

10. Invest in growth assets for medium to longer term goals

Over the longer term, growth assets (shares) will outperform income-producing assets like bank deposits. This is because they have both a growth and income component - as the company grows, so does the value of your shareholding. This also produces income in the form of dividends.

Therefore your investment will keep pace with inflation and maintain its value over the longer term, an income-producing asset will gradually deteriorate in value in the longer term.

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Reducing tax

Reducing your tax bill is an important investment strategy as it increases your disposable income to invest which increases the net return on your investments and ultimately your wealth creation.

Three strategies for reducing tax include:

1. Investing for growth

Investment returns are made up of both income and growth. Income is paid to you on a regular basis and included in your annual tax return whereas growth is tax when you sell the investment. This deferral of tax is an important wealth creation strategy and can make capital growth investments tax effective.

In addition, where an asset is held for more than 12 months before selling it you are entitled to a 50% discount. This means that if you are on the highest marginal tax rate of 48.5% your effective tax rate on the capital gain is only 24.25%. This compares favourably to the tax on income which is at your marginal tax rate of up to 48.5%

With this in mind, you can structure your investment portfolio to include investments with high capital growth rather than high income distributions. Of course, the tax advantages need to be balanced against other factors such as the overall return from investment and income needs.

2. Utilising Franking Credits

Franking credits can make investing in Australian Shares a tax effective strategy. Franking credits prevent shareholders being taxed twice on dividends as they provide a rebate equal to the tax the company has already paid on their profits.
For example, if you received $2,000 of fully franked dividends you would receive a franking credits of $857. You would then pay tax on both the dividend and the franking credit, then claim the amount of the franking credit as a rebate.

If you were on a marginal tax rate of 48.5% the tax payable on the dividend is as follows:

a) Calculate tax payable on dividend plus franking credit $2,857 x 48.5% = $1,385

b) Reduce tax payable by the amount of franking credit $1,385 - $857 = $528

In this example you would pay tax at only 26.4% instead of your marginal tax rate of 48.5%.

If you are on a lower marginal tax rate the franking credits are just as valuable as you are able to receive a refund from the tax office for any excess amount.

3. Income Splitting

Income splitting is a very effective strategy for couples. It takes advantage of two sets of marginal tax rates and is particularly effective where one partner is on a lower marginal tax rate than the other.

Income splitting is where you allocate ownership of investments to the lower income earners name to take advantage of the lower marginal tax rates.

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Disclaimer - The information contained on this website is given in good faith and has been prepared from information believed to be accurate and reliable. This information is of a general nature only. Mortgage One and its related entities, nor any of their employees, officers or directors gives any warranty of accuracy or reliability nor accepts any responsibility arising in any other way including by reason of negligence for errors or omissions herein. All assumptions and examples are based on the continuance of present laws and Mortgage One’s interpretation of them. Mortgage One does not undertake to notify recipients of changes in the law or its interpretation. This guide is not designed to be a substitute for specific financial or investment advice or recommendations and should not be relied upon as such. Please contact us for advice on your specific needs

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