Introduction
In today's fast-paced and ever-changing economic landscape, investing has become an essential skill for young Australians seeking financial security. With the rising cost of living and growing economic uncertainties, making informed decisions about where to allocate money has never been more important. This guide, "Investing 101," provides a comprehensive overview of key investment concepts tailored for young and emerging investors. By demystifying topics like the time value of money, risk management, and various asset classes, it empowers young Australians to take control of their financial futures. Whether starting with first savings or exploring more complex investment strategies, this guide offers foundational knowledge to help money grow and work effectively in the long term.
Investment Principles
1 - Time Value of Money
The stock market is a volatile place, and it can be difficult to navigate. However, there are some things that investors can do to help their chances of success. One of these is understanding the time value of money principle.
The time value of money is a core principle of valuation that states that money as of the present date carries more value than the same amount received in the future. The concept of time value of money is influenced by economic factors such as inflation and interest rates. Inflation represents the overall rise in prices, which erodes the purchasing power of money over time. As a result, a dollar in the future will have less buying capacity compared to its present value.
Interest rates are closely tied to changes in the price level. Financial institutions factor in the time value of money when determining the interest rates for loans, such as mortgages or car loans, to individuals and businesses. Furthermore, interest rates represent the potential earnings individuals can gain by investing their money rather than keeping it as idle cash. This reinforces the principle that a dollar today holds more value than a dollar in the future, as it can be invested to generate additional returns.
2 - The Role of Interest Rates
Interest rates play a crucial role in determining the value of money over time. When investors invest or deposit their money, they earn interest, which is essentially the cost of borrowing money or the return on investment. The higher the interest rate, the faster their money grows. It's essential to understand how interest rates affect the time value of money to make informed financial decisions.
3 - Return and Risk
The return on an investment measures its performance over time, consisting of two components: income (e.g., dividends, interest, or rental income) and capital gains (or losses). For example, if an investor buys a stock at $60, holds it for five years, earns $10 in dividends, and sells it for $80, they realise a $20 capital gain. The total gain is $30 ($20 capital gain + $10 dividends). The rate of return is calculated by dividing this gain by the initial investment, resulting in a 50% return over five years.
Risk refers to the chance that an investment's actual return will be less than expected. Investors generally dislike risk but prefer high expected returns, so they demand higher returns for taking on more risk. U.S. Treasury bonds are considered among the safest investments and offer lower returns because the U.S. government is less likely to default. In contrast, corporate bonds carry a higher risk of default, so they offer higher returns to compensate investors for this added risk.
Investment risks are broadly categorised into systematic and unsystematic risks. Systematic risks, or market risks, affect the entire market and are difficult to mitigate through diversification. These include political, economic, and interest rate risks. Unsystematic risks, also called specific or idiosyncratic risks, are unique to particular industries or companies. Examples include management changes, product recalls, or new competitors. Investors typically manage unsystematic risks through portfolio diversification.
The principle is that the more substantial the risk one takes, the greater the return one will demand to justify the possibility of incurring a loss. This dynamic is fundamental to investment strategy and affects how portfolios are constructed, as investors seek to align their risk tolerance with their financial goals.
The Increasing Risk Ladder
1 - Cash
Cash investments are regarded as the lowest-risk asset class on the investment risk ladder, with three main types: bank deposits, Money Market Accounts (MMAs), and Certificates of Deposit (CDs). While depositing money in a bank may seem straightforward, it is an investment with low risk due to the bank's guarantee of access to funds. Savings accounts are the most common type of bank deposit, offering interest. Although they are considered a safe option for growing money, the interest rates are typically very low.
2 - Bonds
A bond is a debt instrument representing a loan from an investor to a borrower, typically a government agency or large corporation. The borrower pays a fixed interest rate to the lender in exchange for funds to finance projects or operations. Bond prices and interest rates are inversely related. While most bonds are publicly traded, some are privately held between lender and borrower. The bond's value is primarily determined by its interest rate.
3 - Stocks
Stocks are securities that represent ownership in a corporation, allowing investors to claim a portion of the company's assets and profits based on their shareholding. Primarily traded on stock exchanges, stocks can also be privately bought and sold. They have historically outperformed many other investments over the long term, making them a popular choice for building wealth. Stockholders enjoy benefits such as voting rights in shareholder meetings and potential dividend payments. There are two main types of stocks: common stocks, which provide voting rights and dividends, and preferred stocks, which typically offer higher claims on assets and dividends but no voting rights.
4 - Risk Premium
An investment with zero risk is called a risk-free asset. An investment which has a risk element is called a risky asset, the higher the risk the higher the expected return. Risk premiums represent the additional returns that riskier investments provide over safer alternatives, such as government bonds. This premium serves as a form of compensation for investors who tolerate the increased uncertainty inherent in riskier assets compared to more secure ones.
Consider the rationale behind an investor’s decision to engage in the stock market rather than depositing funds into a bank account. The choice often stems from the expectation that, although the stock market involves more risk, it also typically offers a higher return as a reward for bearing that risk. On average, historical data shows that stocks have yielded a risk premium of approximately 4-6% over Treasury bonds. This premium incentivises investors to allocate capital to the stock market, accepting the additional risk in anticipation of greater financial rewards.
Current Macroeconomic Landscape
Inflation and Interest Rates
A rise in inflation can also place upward pressure on interest rates, as lending facilities usually seek additional compensation to provide money that can buy fewer goods and services when it is paid back in the future. This is reflected through the higher interest rates charged to customers which then places downward pressure on the value of some investments, even those seen as long-term investments such as property.
The CPI data for the June Quarter 2024 shows a 1.0% increase in prices for the quarter and a 3.8% rise over the past year, highlighting ongoing inflationary pressures. Inflation complicates investing by eroding purchasing power and requiring higher returns to maintain real wealth. It often leads to increased interest rates, which can negatively impact bond values and stock prices, especially for growth companies. Investors may need to shift towards inflation-resistant assets like real estate or commodities while navigating increased market volatility and sector-specific impacts. Additionally, inflation complicates long-term financial planning and necessitates more frequent portfolio rebalancing, creating a challenging environment for investors to manage effectively.
Continued inflation can also have a far-reaching impact on the economy as central banks introduce stricter credit and lending conditions which slows economic growth overall. However, a low and stable level of inflation is regarded as a good thing for economies, with the RBA Governor and Treasurer agreeing that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3%, on average, over time. This suggests that inflation is all about balance, positive inflation can be considered necessary for the growth of economies, however, exponential growth can be damaging.
How Does Inflation Impact Investors?
As aforementioned, rapid increases in inflation can make obtaining debt a more difficult process and therefore may reduce the ability of individuals to obtain the finance required to fund their investments.
Inflation also impacts investors and the actual rate of return they receive on their investments. For example, if you invest in a term deposit that pays 4% p.a., and the inflation rate is 2% p.a., your actual rate of return is 2% p.a. Therefore, a higher rate of inflation means investors need a higher rate of return to break even and have a profitable investment.
However, it must be noted that modestly rising inflation is seen as a positive force in the share market as it is consistent with sustainable economic growth. Despite this, inflation above 2-3% or unexpected increases can have negative implications for investors which typically result in:
Increased borrowing costs
Decreased value of fixed-income assets
Increased risk of speculative behaviour
All of these factors place downward pressure on stock prices, hence hindering the potential returns of investors.
It should also be noted that not all stocks are impacted in the same way and inflation generally affects growth stocks more than defensive assets, but in saying this, fixed-interest investors are not immune to inflation changes.
Defensive stocks from sectors such as consumer staples, healthcare, and communication services are non-cyclical, meaning they’re not sensitive to the different phases of the economy between boom and bust and because of their low volatility and tendency to deliver steady returns (earnings and dividends) through most economic environments, defensive stocks are considered safe-haven investments. These companies are characterised by robust cash flows and resilient operations that can withstand economic downturns. A key feature of these industries is their consistent dividend payments, which can help stabilise their share prices during market declines. Their ability to maintain performance in challenging economic conditions makes them attractive to investors seeking stability in their portfolios.
Investing Trends
Young Australian investors aged 18 to 24 are becoming increasingly risk averse than their older counterparts. They are the least likely to tolerate moderate or high variability in their investment returns due to the lack of familiarity with the market, fear of the unknown and potential losses can lead young investors to favour conservative investments, such as bonds and money market funds, reflecting their risk-averse behaviours. These are among the key findings from the just-released ASX Australian Investor Study 2023, which also found that the main investment goal for 36% of “next generation” investors over the next 12 months is to build a sustainable income stream.
Online investing in global equities has surged to 1.28 million active investors in the first half of 2024, reflecting a growth from 1.22 million in the previous six months. This surge is predominantly driven by younger investors starting their online investing journey, particularly those aged 18-24. This demographic now constitutes close to one-third of new online investors, significantly impacting market dynamics. These new participants were often prompted to start investing online by the ability to invest small amounts of money and access investment-related education.
The report highlights that investor sentiment towards equities has seen a marked improvement over the past six months. This positive shift extends to cryptocurrencies, where the outlook has quickly turned favourable. All investor segments – new, dormant, and reactivated – have shown a more optimistic view of the market, particularly for international shares compared to domestic equities. The results show that online investors expect, on average, a 5.3% return from domestic equities, and a 6.1% return from international equities over the next year.
Conclusion
In conclusion, investing is a powerful tool for young Australians to secure their financial future, especially in today's uncertain economic climate. By understanding key principles like the time value of money, risk and return, and the impact of macroeconomic factors, investors can make informed decisions that align with their financial goals. With the right knowledge and a solid strategy, young investors can confidently navigate the market and build long-term wealth.
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