Stay Cool - 4th February 2004
Annette Sampson - Sydney Morning Herald
There's no big secret to making money - just a few basic principles, hard work, and an eye on the future, writes Annette Sampson.
There's an old saying that you don't have to be wealthy to be an investor, though you do need to invest to be wealthy. Trite, but true. The simple fact is that you don't need buckets of money to get started on a wealth creation program. Australia has many untold success stories of people earning modest incomes who have worked to achieve a good level of financial comfort. (We also have countless horror stories of big earners who have got into financial trouble and ended up with nothing.)
Nor do you need a PhD in quantum economics to get started. The experts like to create an aura of mystery around the subject, but most investment strategies focus on a few basic principles. Understand these, and you're well on the way to success.
"To be successful, you have to be motivated," says Paul Brady, a certified financial planner with Brady & Associates Financial Services. "All the rest is meaningless unless you have something that means enough to you to get up and make a start and then stay the course. If you don't have clear and achievable goals, it doesn't matter how much investment smarts you bring to the table. It isn't going to work."
Brady says your goals need to be specific, but there are no hard rules on what are "good" goals and "bad". If your goal is to save for a big holiday, that's fine. At the other end of the scale, your goal might be to generate enough wealth so that you have an income to live on.
But for them to work, your goals must be realistic. You can't, for example, expect to save $10,000 for a trip next year if you're only prepared to put aside $100 a month. Draw up a savings plan that will allow you to achieve your goals and make a commitment to getting there.
"To have positive experiences about money, you need to think about what you need to do to get what you want and realise it's not all about instant gratification," says Brady. "You need to be realistic about your time frames. Some things will take longer, but you can enjoy watching your progress along the way."
THE BIG PICTURE
The first question every would-be investor asks is "What do I invest in?" But Brady says it is much more important to make sure you're financially organised first. Draw up a budget listing your income and expenses, and work out how much you can afford to save. "Successful investing is often more about how much you save than the rate of return," he says. "If you save $1000 and earn 5 per cent, you'll be better off than if you saved only $500 with a return of 10 per cent."
For that reason, says Brady, your best "investment" may be to spend money upgrading your skills to increase your value to your employer or business. "If you can earn an extra $10,000 a year, that can make a big difference to your wealth creation."
Brady says it's also important to get rid of costly, non tax-deductible debts before you even think about setting up an investment program. "It doesn't make sense to invest $10,000 and run a $6000 car loan or credit card bill," he says.
RULE OF 72
Nicole Small, the head of education with BT Financial Services, says it was Einstein who originally described compound interest as the eighth wonder of the world. In very simple terms, compound interest is the snowballing effect of earning interest on your interest each year that you remain invested.
Let's say you invest $1000 at 6 per cent. By the end of the year you will have $1060, assuming you reinvest your interest rather than spending it. Next year you'll earn 6 per cent on $1060 - about $64 in interest, ending the year with $1124.
The best bit is, the longer you let your money compound, the greater the effects will be. In this example you'll have doubled your original $1000 by the 12th year but tripled it in year 19.
There's a rule of thumb - called the Rule of 72 - that can help you work out how long compound interest will take to double your investment. Simply divide 72 by the rate of return on your investment. If you're earning 10 per cent, it will take 7.2 years to double your money; 12 years if you're earning 6 per cent.
Peter Thornhill, the principle of Motivated Money, says investors often overlook the fact that compounding also works with share investments. He uses the example of Company X, which, each year, earns a 10 per cent return on dollars invested. Like most companies listed on the Australian Stock Exchange, Company X doesn't pay all its profits out each year to investors as dividends. It pays half as dividends, but keeps the other half to reinvest in its business.
So if company X started the year with $100 in capital (OK, so it's a small company), it would earn $10 over the year, pay $5 out to investors and reinvest the other $5. Next year it would have $105 to invest. It would earn $10.50 in profits, pay $5.25 in dividends, and start the next year with $110.25.
You can really kick compounding along by reinvesting your dividends so that you are earning future profits on all your earnings. Many popular shares and managed funds have reinvestment facilities where they automatically do it for you.
Brady says compounding can also be kicked along by committing to regular savings. He says it's a good idea to sign up for a savings plan where a set amount - even if it's only $100 a month - is taken automatically from your pay and added to your investment. "It's out of sight, out of mind," he says. "It's much easier than having the money in your hand and choosing to do something about it."
If you get a pay rise, he suggests, direct all or part of it to your investment program rather than increasing your spending. If it's money you're not used to having, you'll be less likely to miss it.
Thornhill says the other big test of commitment is whether you have the intestinal fortitude to stick to your plan. He says one of the biggest dangers in investing is reacting emotionally to day-to-day movements in investment markets, rather than thinking things through rationally. A good example of this was the recent downturn in world sharemarkets, which had many novice investors bolting for the doors. That meant they missed out on the recent rebound.
"It's very easy to fall into the trap of chasing high returns," says Small. "It can be really tempting to move into investments that have recently done well, but it can actually increase your losses. It was Warren Buffett who once said that stockmarkets are all about transferring wealth from the impatient to the patient."
Unfortunately, fear and greed are the driving forces of many investors. On the one hand, they want their investments to multiply overnight; but on the other, they are terrified of ending up in a One.Tel or HIH and losing the lot. The upshot: total paralysis.
Small says the best way to deal with this is to take the time to understand how each of the four main types of investment (the pros call them asset classes) is likely to behave.
Cash is generally the most secure investment. It offers safety and a regular income, but it won't grow and the returns are generally only a bit better than inflation over the longer term. It's what is known as an income-based investment.
Fixed interest investments are also generally secure and pay an interest-based income. However, unlike cash investments, the interest rate is fixed for the term of the investment and you run the risk that you'll lose out if interest rates rise and your money is tied up. By the same token, this can be a good thing if interest rates fall. Because you're committing your money for a set period and taking this risk, fixed interest investments generally provide a higher return than the cash rate over the long term.
Shares and property are both known as growth investments because their value can fluctuate. Over the long term both have traditionally provided higher returns than cash and fixed interest, but they can incur sizeable losses as well - particularly over the short term.
Small says it's important to plan your investments in terms of your needs for income and growth, rather than just looking for high returns. If your goals are short-term, it's a big risk to put your money in an investment that can fall in value. But if you're investing for a longer-term goal, growth-based investments may be better.
"Risk means different things to different people," says Brady. "For some people being too defensive can be higher risk because they may underperform over the long term, even though, over the short term, they get a steadier result.
"Long-term investments need to be thought of as a long-term pool of capital, and then there are short-term needs, which need to be catered for with short-term investments. But the important thing is to look at the big picture and accept that you'll always have some investments that are not doing as well as others because, at different times, different investments will do better."
No matter how smart you are, there's no such thing as a sure thing. This is why most investment professionals say it's critical not to put all your eggs in one basket.
Small says you need to diversify across the main asset classes (bearing in mind your need for growth versus income), and also within each asset class - having a mix of shares, for example, rather than just one or two companies.
"The easiest way to start is with a managed fund," she says. "You can get exposure to a mix of investments for as little as $1000 and can choose a fund that offers a more conservative or growth-oriented approach, depending on your needs."
Brady says one of the hardest things about investing is learning to do things that may not initially feel comfortable. "Everyone makes mistakes and, because there will be losses, you should never put too much money into any one area, no matter how good it may be," he says.
"Most Australians have gained their wealth through home ownership, using other people's money," says Brady. "They start off about 80 per cent geared and have confidence that over the long term they're doing the right thing. But when it comes to investing, they forget
Borrowing big to speculate can be a high risk venture, but using other people's money as part of a long-term investment plan can really leverage your results.
Let's say you have $1000 to invest. If you invest it for five years, and earn 10 per cent each year, you'll end up with $1610 before tax - assuming you reinvest all your income. But if you borrow an additional $4000 so that you have $5000 to invest, and pay interest each year on the loan at 6 per cent, you'll end up with $6587 - a profit of $2500 versus $600. If you borrow to invest in an income-producing asset, the interest on your loan should be tax-deductible as well.
"These days, people aren't afraid of debt," says Thornhill. "They'll borrow to buy a car or for personal spending, but it's what you do with the borrowings that's important."
Thornhill argues it's better to have "good debt" - debt used to buy investments that will increase in value - than "bad debt", or debt to buy consumer items that lose value as soon as you take them out the door.
Thornhill says it's important to only borrow what you feel you can comfortably afford, and to ensure the money is invested in a mix of quality investments. "You don't want to shoot the lights out and borrow too much."
Brady warns that if your investments go bad, leverage can also increase your losses, so it should not be undertaken without care and attention.
"You need to have your investments well spread, provide for a long-term time frame, ensure you have a solid income and surplus cash, and then stay the course," he says.
THINK BIG AND START SMALL
Demian Thornhill had a head start in the investing game - a father in the finance industry (see main story). But the work that has gone into building a sizeable investment portfolio has been all his own.
Encouraged by his father to invest in managed funds during his childhood, Thornhill took his first serious investment steps when he was still at university and working a part-time job.
"I took out a small personal loan - about $5000 - and invested it in a managed fund," he says. "Because it was only a small loan the repayments were quite easy to manage, and any dividends I received went back into the loan as well. Over that period the dividends were almost equal to the interest payments, so in a sense I was ahead of the game, as most of my extra repayments went to reducing
"At the start of each month I would pay the minimum loan amount and I'd try to put a bit extra aside as well, though some months, if I was going out a bit more, I wouldn't manage that."
Thornhill used his initial loan as a start in learning more about markets as investing. As he grew more confident, he diversified into buying direct shares. When he left university and got a full-time job, he took out a larger margin loan facility to fund further investments.
"Because my shares have increased in value, I don't have to worry about things like margin calls. Proportionately, I can afford to take a bit more risk now," he says.
Thornhill says he found the most important things about getting started were starting small - "You need to invest amounts you're comfortable with and not go hell-for-leather and lose everything" - and investing in quality shares, rather than chasing the latest hot story. "One thing my dad said that stuck with me is that people will always eat, buy clothes, drive cars and so on. So I've invested in those sorts of companies."
Thornhill says the hardest thing was borrowing the original $5000. As he had no existing loans, he had no credit rating and lenders viewed a loan to buy shares as a somewhat risky proposition. However, Thornhill says he was quite comfortable with the debt. "I had faith I could make money out of the sharemarket over the longer term, and because the loan was relatively small, I knew it wouldn't be disastrous."
Nevertheless, he admits to the fear of losing money he has worked for and does everything he can to ensure his investments are solid.
For other would-be investors, his advice is simple: "Start now and start off with small amounts. You don't need lots of money to play with, but the sooner you get started the better."