The document provides an introduction to investments and covers key concepts such as risk and return, asset classes, diversification, and inflation. It explains that higher risk investments like shares and property have historically delivered higher returns than lower risk investments like cash and fixed interest. It emphasizes the importance of diversification across different asset classes and managers to reduce risk.
2. Introduction to investments
Risk and return
Asset classes
Defensive and growth assets
Asset class performance
Managing risk through diversification
Index and active investment
The impact of inflation
This module explains many of the fundamental investment concepts like risk and return,
asset classes, diversification, and inflation.
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3. The basic investment tradeoff – risk versus return
Emerging
markets
Higher risk,
higher return
SHARES
Medium risk,
medium return
Return
PROPERTY
Lower risk,
lower return
FIXED INTEREST
(or bonds)
CASH
Money
in bank
Risk
The fundamental investment principle is that you can only earn a higher return if you take
more risk. To put this another way, if you want to reduce your risk, you must be prepared
to accept a lower return. For example, if you put all your money in the bank, your return
will probably be very low but you have the comfort of knowing that the amount you
deposited will always be there.
On the other hand, if you put all your money into emerging markets, your return could be
very high for one or two years, then very low and quite possibly negative the next. In other
words, your returns, particularly over the short term, are likely to be very volatile.
Neither of these investments is necessarily right or wrong. Whether you invest your
money in cash, fixed interest, property or shares depends on what type of investor you
are – more conservative or more aggressive. This depends on things like your age,
income, savings and personal preferences.
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4. Asset classes
AGGRESSIVE
Shares
ASSERTIVE
• Part ownership
• Capital gain + dividends
BALANCED • Potentially very risky
Property • Highest average
Return
long-term returns
CAUTIOUS • Access to range of property
• Listed property trusts
• Capital gain + rent
CONSERVATIVE • Potentially risky investment
Fixed interest
• A ‘loan’ agreement
Cash • Interest plus principal
• Instant access, security • Price reflects interest rates
• Low return BUT low risk • Lower risk / lower returns
• Short-term timeframe
• Interest but no capital gain
• No inflation protection
Risk
The main asset classes are cash, fixed interest, property and shares. The Aon Master Trust also
invests in alternative assets (for example in its sector options).
Cash offers instant access to your money, a high level of security and, historically, the lowest
return of all asset classes. It is usually the best option when you have a very short investment
timeframe and you want a stable return. Although cash is considered to be a very low-risk
investment, it offers little protection against inflation.
Fixed interest or bonds are a loan agreement between a borrower and a lender. Fixed interest
investors receive regular interest payments plus their original investment at maturity date. Bond
prices fluctuate according to movements in interest rates. If interest rates rise, then bond prices fall
and vice versa. Although bond prices fluctuate, they are generally less volatile than property or
share prices and for this reason they usually offer a lower return.
Property trusts allow smaller investors to pool their money and invest in large-scale,
professionally-managed property assets. Property trusts offer capital appreciation from rising
property values and income from rent. Property can be a risky investment because property prices
fluctuate. Property trusts that are listed on the share market are not only subject to movements in
property prices but also to movements in the share market itself.
Shares provide investors with the potential for capital gain from rising share prices and income
from dividends. Share prices can also fall so share investors must be prepared for the chance of
short-term losses. Over the long term, however, shares have delivered the highest average returns.
Alternative assets typically include hedge funds, private equity and infrastructure. Hedge funds
use specialist investment strategies to trade shares and fixed interest assets. Private equity
investments are made in companies not listed on a stock exchange. Infrastructure investments
include utilities and other physical assets. These funds aim to achieve positive returns in both rising
and falling markets and are typically included in diversified portfolios to reduce exposure to risk
over longer time frames.
Superannuation funds tend to invest in the main asset classes in different proportions so that
generally speaking, all types of investors – from the more conservative to the more aggressive –
will find a suitable investment option.
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5. Defensive and growth asset classes
Asset class performance
10 yrs to 31 Dec 08 (% pa)
7.5%
7.0%
6.2%
5.8%
2.5%
Defensive assets Growth assets
0.0%
-2.0%
Cash Aust fixed Int’l fixed Listed Aust Int’l
interest interest property shares shares
The asset classes are broadly divided into defensive or income assets and growth
assets.
Defensive assets include cash and fixed interest investments. They’re called defensive
because their returns are generally more stable than growth investments. All the return
from cash is in the form of interest. There are no capital gains, and therefore no capital
losses, on cash. You can make a capital gain from some longer-term fixed interest
investment such as government bonds, but the regular interest payments are still the
main attraction of fixed interest investments for most investors.
Growth assets include shares and property and they are called growth assets because
historically, the bulk of their return has come from increases in their price. They also
provide some income in the form of dividends from shares and rent from property, but this
is typically a smaller proportion of the total return over the long term.
Over the long term, growth assets tend to offer a higher return than defensive assets,
which reflects the increased risk of investing in shares and property. This higher return
can make a big difference to long-term investments like superannuation. The weak
performance of growth assets over the 10 years to 31 December 2008 reflects the great
uncertainty stemming from the global financial crisis of 2008.
Please note that past performance should not be considered a guide to future
performance.
This graph uses the following market indices:
Australian shares: S&P/ASX 200
International shares: MSCI World ex-Australia index in A$
Listed property: S&P/ASX 300 Listed Property Trust Accumulation Index
Australian fixed interest: UBS Composite Bond Index
Global fixed interest: Citigroup World Govt bond Index hedged in A$
Cash: UBS Bank Bill Index
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6. Asset class performance (value of $1,000)
Markets are affected by political and economic events and ups and downs are a fact of
life for investment returns.
This graph shows the performance of the different asset classes over the 20-year period
31 December 1988 to 31 December 2008.
The share and property markets have had a bumpy ride while the cash and fixed interest
markets have been comparatively stable.
The strong bull market in Australian shares and property in the early years of this century
reversed dramatically as the global financial crisis emerged in 2007 and 2008.
Please note that past performance should not be considered a guide to future
performance.
This graph uses the following market indices:
Australian shares: S&P/ASX 200
International shares: MSCI World ex-Australia index in A$
Listed property: S&P/ASX 300 Listed Property Trust Accumulation Index
Australian fixed interest: UBS Composite Bond Index
Global fixed interest: Citigroup World Govt bond Index hedged in A$
Cash: UBS Bank Bill Index
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7. You just can’t pick it
This year’s winner
could be
next year’s loser
Investors are constantly reminded that past returns are no guarantee of future returns.
This graph shows how a market can go from best to worst performer, or from worst to
best, in just 12 months. It can be a real roller-coaster ride - look at Australian shares
between 1990 and 1994.
The lessons here are:
this year’s winner could be next year’s loser
trying to pick the winners is a risky practice
spreading or diversifying your money across different investments reduces that risk and
helps smooth investment returns.
Please note that past performance should not be considered a guide to future
performance.
This graph uses the following market indices:
Australian shares: S&P/ASX 200
International shares: MSCI World ex-Australia index in A$
Listed property: S&P/ASX 300 Listed Property Trust Accumulation Index
Australian fixed interest: UBS Composite Bond Index
Global fixed interest: Citigroup World Govt bond Index hedged in A$
Cash: UBS Bank Bill Index
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8. Growth assets can mean volatility
41.6%
Minimum and maximum returns 45.4%
1988 - 2008 34.0%
24.7%
20.1%
18.4%
4.8%
-2.6%
-4.7%
-27.4%
-38.4%
-55.3%
Cash Aust fixed Int fixed Listed Australian International
interest interest property shares shares
People tend to concentrate solely on return when they are evaluating their investment
options. But the RISK of the investment, which refers to the extent to which returns
fluctuate from year to year, is equally important.
The chart shows the highest and lowest returns recorded by the major asset classes over
the 20-year period December 1988 to December 2008. The volatility, as indicated by the
difference between the highest and lowest returns, is clearly evident. Cash is the least
volatile but tends to offer the lowest return while shares offers the highest potential
returns but are the most volatile. In the third quarter of 2008, highly-geared listed
Australian property securities continued to feel the fallout of the credit crisis - this is
reflected in the worst single-year return over this 20-year period.
The lesson for investors in all this is to think about what’s more important to you – the
opportunity to earn higher returns and the likelihood of a bumpy ride, OR more stable but
lower returns and a good night’s sleep.
Please note that past performance should not be considered a guide to future
performance.
This graph uses the following market indices:
Australian shares: S&P/ASX 200
International shares: MSCI World ex-Australia index in A$
Listed property: S&P/ASX 300 Listed Property Trust Accumulation Index
Australian fixed interest: UBS Composite Bond Index
Global fixed interest: Citigroup World Govt bond Index hedged in A$
Cash: UBS Bank Bill Index
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9. Types of investment risk (volatility)
Mismatch Legislative Diversification
The investment you Your investment could All your capital could be
choose may not be be affected by changes affected if you invest in
suitable for your needs in current laws and a single asset class
and circumstances regulations
Inflation
Credit
INVESTMENT The purchasing power
Your interest payments
of your money may not
or your capital may not
RISK match inflation
be repaid
Liquidity Interest rate Market
You may not be able to Your expected income Investment markets
access your money might not be available if might move suddenly
quickly or without cost interest rates move and unfavourably
when you need to unfavourably
There is no single type of investment risk. Rather, there are many different types of risk
that together make up investment risk.
For example, you may choose investments that aren’t suitable for your particular
circumstances, sometimes called mismatch risk. Then there’s the risk you may not get
your money back, or you may not be able to get it quickly, or legislation might change,
interest rates could go up or down, you may not have spread or diversified your
investments sufficiently, inflation could erode your purchasing power, or investment
markets might move unfavourably.
As an investor, you’ll never be able to avoid these risks entirely but with the right advice,
they can be managed.
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10. Managing risk through diversification
Diversified
investment
Investment A
Return
Investment B
Diversification
1. Across asset classes
2. Within asset classes
3. Across managers and manager styles
Years
Years
Even professional investment managers cannot accurately predict the future direction of
investment markets. So rather than take a bet on which asset class will perform best, a
better strategy is to spread your money across all the different investment types. In this
way, you will reduce the impact that a poor performance in one particular sector will have
on your overall return. The theory says that by diversifying your investments, you will
benefit from some investment ‘ups’ while avoiding the worst of the ‘downs’.
There are a number of ways to diversify your investments. You can spread your money
across asset classes – for example, by putting some money in both shares and cash.
There are different sectors within the share market such as banks, mining, retail, food
and household goods and so on. There are also different share market managers who
have different investment styles so you can spread your investment across managers as
well.
The whole idea of all this spreading or diversification is to make sure that if one asset
class, or individual investment or individual investment manager doesn’t work out, then all
isn’t lost because you had all your eggs in the one basket.
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11. Pre-mixed investment options
HIGH GROWTH
Growth 100%
GROWTH
Defensive 15%
Growth 85%
BALANCED
Return
Defensive 30%
Growth 70%
CAPITAL STABLE
Defensive 70%
Growth 30%
Growth assets Defensive assets
SECURE Australian shares Aust. fixed interest
Defensive 100% International shares Int’l fixed interest
Property Cash
Alternative Alternative
Risk
One way to make sure your investment is diversified is to invest in a pre-mixed
investment option. Pre-mixed investments typically hold a mix of defensive and growth
assets.
The pie charts show the strategic asset allocations for the Aon Master Trust’s
Pre-mixed investment options:
• Secure and Capital Stable hold a greater proportion of defensive assets.
• Balanced, Growth and High Growth hold a greater proportion of growth assets.
Please note that actual allocations may vary from strategic allocations.
Most investors, regardless of whether they are more conservative or more aggressive,
will usually find a pre-mixed option suitable for their particular investment profile.
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12. Index and active investment
Index
– seeks to track performance of relevant index
– sometimes known as ‘passive’
– typically a lower-cost approach.
Active
– uses research, active portfolio management and trading
strategies to outperform benchmark
– typically a higher-cost approach than index.
Major considerations when investing include how a fund manager can add value to
exceed an underlying market index or benchmark, the risk undertaken by the manager,
and the management fees.
Index fund managers seek to track the performance of a stock index. For example, the
Australian Shares – Index option is designed to closely match the performance of the
S&P/ASX 200 Accumulation Index for Australian shares. Index managers typically charge
less than active managers. See also Understanding performance – an outline of how
performance has been affected by the 2008 credit crisis in ways you may not expect.
Active fund managers aim to outperform their benchmark by using research, active
portfolio management and trading strategies. There is a risk, especially over short time
horizons, that an active manager may underperform the relevant market index. Active
fund managers typically charge more for taking this approach, but believe potential
improved investment performance will justify the cost.
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13. Inflation – a powerful enemy
IMPORTANT
From an investment
point of view, the
$100
quot;realquot;, after-inflation
$90
return is the most
Purchasing power
$80 important because
this figure determines
$70
what your money will $67.30
$60 buy
Rate of
$50
$45.60
inflation
$40
2%
$31.18
$30
4%
$21.45
$20 6%
$10 8%
$0
1 5 10 15 20
Years
Inflation is the rise in the price of goods and services and if it is not managed properly, it
has the potential to undo much of the good groundwork laid down by compound interest
and regular saving.
If the price of goods and services rises faster than your income, both your purchasing
power and your standard of living will fall.
Inflation in Australia has been relatively low in recent years, compared to the high inflation
rates of the 1970s and 1980s. Over the 10-year period to September 2008 inflation has
averaged just over 3% per annum. But no one can predict where inflation will go in the
future.
One way to offset the impact of inflation is to have at least some of your money in growth
assets such as shares. This is because the price of growth assets, like the price of any
asset, tends to move in line with the general rise in prices, so the rate of inflation will also
boost the performance of growth assets. From an investment point of view, the ‘real’,
after-inflation return is the most important because this figure determines what your
money will buy. In Australia we use the Consumer Price Index (CPI) to measure inflation.
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