Whether you're starting out or looking to learn more about investments, this guide will help you understand the investment essentials.
Time in market
‘Time in the market’ is investing your money in the market, being patient and staying invested over the long term. The longer the time you stay invested, the higher the expected return (with the help of compound interest) and the smoother the ride (the less volatility) because you ride out the market cycles.
This is in contrast to ‘timing the market’ which means getting your money in and out of the market over time by trying to predict in the short term the best times to be invested and the worst. This is impossible to do. The secret to creating long-term wealth and achieving your long-term financial goals is spending time in the market.
Volatility is the degree to which the value of an investment goes up and down (or its return varies) over shorter time periods. The wider the potential range of outcomes, in other words, the more erratic the returns, the higher the volatility. The more consistent the returns the lower the volatility.
Investments with higher long-term returns such as shares, have higher short-term volatility than investments with lower returns such as bonds and cash. In essence, investors are paid more for taking on this short-term unpredictability.
The longer an investment is held, the less volatile it becomes because the bumps along the way are smoothed out over time.
Diversification is, at its simplest, owning a range of different types of investments (such as groups of investments referred to as asset classes) to reduce risk. No one type of investment does well in all market conditions, therefore ‘not putting all your eggs in one basket’ gives you a better chance to grow your super and experience a much smoother ride.
Diversification can apply at various levels, that is, diversification between countries, asset classes (e.g. shares, bonds, property or infrastructure), sectors, investment styles and individual securities.
Inflation is a measure of the rate of increase in the price of the goods and services you buy. This is a risk for investing because if the value of your investments doesn’t rise more than inflation over the long term, then your investments aren’t keeping up and won’t be worth as much to you.
For example, say you started with $200 and bought an item for $100 and invested the other $100. After some time, you want to buy the same item again with the money you had invested. Let’s assume during that period of time your investment went up by 2% and inflation rose by 4%. Whilst your investment is now worth $102, the same item now costs $104. This is because your investment return was lower than inflation as your money won’t buy you as much.
Compound interest is the interest (or investment return) earned on both the initial amount of money and the interest/return built up during the period. Essentially, it is the result of reinvesting the interest/return, rather than paying it out, so that interest/return in the next period is then earned on the initial amount of money plus previously accumulated interest/return. Like a snowball, it gets bigger and bigger over time which is why the best way to build wealth is to take advantage of the power of compound interest/return.
When the interest/return is paid out as you go rather than reinvested, this is referred to as simple interest rather than compound interest.