Evaluating investment options

There are a number of different types of investments that have different levels of risk and different returns. This chapter will outline things to think about to help you decide where to outlay your resources.

Risk and Return

In any investment there is a possible risk that corresponds with possible return. The possibility of a high return entices investors into taking a risk, outlaying money for an investment that may not be secure. Risky investments may reward investors with a higher return but there is also a higher possibility of failure.

Liquidity

Liquidity is the ability to turn an asset into cash. The term 'liquidity' refers to cash being the most easily exchanged resource in the financial market (think about the difference in exchangeability between ice and water). Generally, the more liquid an asset, the lower the return. If you were looking to outlay money where you can easily access the return from an investment, then you would look for liquid investments such as a cash account that earns interest, rather than investing in property. Property takes longer to convert into cash and it is hard to gauge its value until someone makes an offer. Property, therefore, is subject to market demand.

How much?

The more money you have, the more opportunity you will have to invest. Some investments have a minimum investment amount, for example, a company might state that you must buy 100 shares before you can trade. You would also need a lot of money to consider investing in assets such as property.

The amount you invest will also affect your return. Any return relates to the amount you put in; if you invest $1000 in a cash account paying 5%p.a., then you will receive $50 in a year but if you invested $10 000, your return would be $500.

Diversity

Diversifying your investments is the practice of outlaying your money in different areas for the purposes of financial security. This would ensure that if one investment failed, you would be able to rely on your other investments for returns, and allows for greater accessibility because you can combine long and short-term investments.

A diverse investment portfolio (collection of investments) allows a mix of high risk and low risk ventures and ventures with high and low liquidity. This ensures that you can safeguard your money and enables you to tie up your money in one area but have another, accessible fund elsewhere. Your ability to diversify your investments may depend on the amount you can invest.

Taxes, Fees and Inflation

Taxes, fees and inflation will affect the rate of return. The government considers investments a form of income, so you will need to factor in that you will pay tax on the return, which would affect the amount you actually receive.

Real, in a financial sense, refers to the actual value of money or an asset. Inflation is the decline in the value of money. You must measure any money you make against the level of inflation. If you invested $1000 in an account that earned 3%, but the level of inflation was 4%, then you would actually lose money in real terms. Nominally, it would look like your investment earned $30 in a year, but the $1030 you possess would not have the same purchasing power as the $1000 you started with the year before; to have the equivalent purchasing power, you would need $1040 to equal the level of inflation. It would be wise to factor in the level of inflation when you consider an investment so you can see if you are making a real return.

Research

In order to evaluate an investment option, you need to conduct research or have someone with expertise research it for you. This may include looking at the investment history (such as returns from previous years) or at the company's annual report if your investment involves a business. This allows you to make sure you understand the terms and conditions of the investment. You must also consider where your outlay will go and how it will be used in order to understand how it will earn money.

The level of research required will also influence any decision to invest. Investors who are interested in and willing to examine the finer details of the economy are more likely to outlay money for complex investments than those who are unwilling to make the effort. It may therefore follow that the convenience and simplicity of an investment strategy will affect an investor's decision to outlay money.

You, the investor

The type of investment you make may depend on personal factors such as your age, earning capacity and your personal preferences. Younger investors are more likely to consider long-term investments because they have time to wait for the investment to mature. Investors who are close to retirement who may look to getting a quicker return. Younger investors can also afford to take more risks as they have a longer working life and therefore more income opportunities ahead of them.

Earning capacity may also affect how much you can invest and the degree of risk you may be willing to take. Low-income earners, for example, would be better off starting with secure investments so that there is less risk that they lose the little they do own. High-income earners may be willing to take more of a risk because they have the earning capacity to cover their losses.

Personal politics and preferences will also influence investment decisions. With regard to the principles of ethical investment, politics could affect where an investor prefers to invest. Personality will influence the degree of risk they are likely to take. Many people often set personal rules taking into account these considerations, so their tenacity and discipline in following their rules will also affect where they are likely to outlay money.