Investing is the process of allocating money into an asset with the expectation (or hope) that it will grow in value over time, generate income or provide you with some future financial benefit. It is a critical skill that has a significant impact on your financial wellbeing.
If you're new to investing, it can be overwhelming. With so many choices and decisions to make, it's easy to feel like you're in over your head. While there is no one approach that will suit everybody, there are some considerations that can help you make better investment decisions. This includes proactively building up your investment knowledge and experience, managing concentration risk through diversification and having clear goals and objectives.
Knowledge and experience
You can be more confident in your investment decisions if you have knowledge and experience in the type of asset you're buying or selling. This includes knowing about the possible returns you can get, the risks you're exposed to, the costs in maintaining the asset and the required level of involvement from you.
Concentration risk and asset allocation
Concentration risk refers to having much exposure spread across over a very limited number of assets, whether it's a specific company, industry, or geographic region. Should something go wrong with the asset, you'll be vulnerable to significant losses. To manage concentration risk, diversification is key. By spreading your investments across different assets, sectors, and regions, you can reduce the impact of any single setback and increase the stability of your overall portfolio.
What is an asset class
An asset class is a group of assets that share similar characteristics. Treating them as a group makes it easier to manage and analyse than viewing each asset in isolation.
The group is determined based on several factors such as:
- Risk and return characteristics – assets with similar risk and return profiles are grouped together.
- Market behaviour – how assets respond to market conditions and economic events.
- Regulatory environment – assets subject to similar regulations are often grouped together.
Progress towards financial independence – before retirement
A key milestone in personal investing is to achieve financial independence. This is the point where you have enough assets to generate a sustainable income stream that can fund your living expenses. Reaching this point means that you can pursue a path more aligned to what you want to achieve in life, without having to rely on an income from your regular employment. It doesn't necessarily mean that you will stop work – only that you have the option.
The milestone is usually expressed as a lump sum of money – an amount that can generate an income that would last for as long as your lifetime. Such a calculation can be complex as there are many unknown factors. Nevertheless, using a rule of thumb we can arrive at a good estimate.
Firstly, add your current cost of living with any loan repayments, and gross this up to account for an average income tax rate of 25% (since tax is payable).
Then work out the lump sum amount required which can cover your total costs, assuming the investment earns an income rate of 5%, which is a sustainable rate of income without eating into your capital.
