There are many ways of making money, but only a few can be called true investments, says Martin Hawes.
There are only four true investments that should form the bedrock of any portfolio: shares, property, bonds, and cash. Most of the other things sometimes called ‘investments’ are usually, in fact, what I call speculation.
There’s a yawning gulf between investment and speculation, and it’s important you understand the difference.
Investments give a cash return that doesn’t come solely from a change in value. So, shares give you dividends; property gives you rent; bonds and cash give you interest. These returns (dividends, rent, and cash) are the primary focus of the investor – true investors buy for income first and let the capital gain follow along.
Speculation is something different: speculators buy something hoping that they’ll profit from an increase in its value when they sell it. They buy, say, gold or oil futures, bitcoin, art, or antiques, hoping it will rise in value. There’s no income return from any of these things and so the speculator is dependent on making the right call – and on the commodity going up in value.
We may call gold, art, or antiques ‘investments’, but in a true sense they’re not – they’re simply commodities people may speculate on, if they’re brave enough to try.
There’s no income from them and, if the asset price falls, the buyer will get nothing. This makes speculation risky and, therefore, I’d say that speculative assets have little or no place in a portfolio.
What an investor does
The basic difference between speculation and investment is that the investor buys something that generates an income.
Investors analyse the fundamentals of their assets: the income they’re likely to get, how sustainable that income is, whether the income will increase or fall, plus other factors.
If the investor gets the analysis right, and the income does rise, they get additional dividends or rent and, as well, the investment is worth more. So, they get both income growth and capital gains – a double whammy.
- The business model,
- The company’s plans,
- Its leadership, and
- An assessment of the team’s ability to execute those plans.
These assessments look at the likely future profit of the company.
Critically, investors consider how much income they will get (their share of the profit) compared to the price they have to pay. This is the price/earnings ratio (P/E), and it’s a basic measure of the worth of any company.
There are two categories that we call investments:
The first of these is managed funds: KiwiSaver accounts, property syndicates, unit trusts, superannuation funds, and the like. These are a means to access investments – in other words, ways a group of investors can use to get access to the investments of their choice.
Usually, managed funds are simply a way of investing in shares, property, bonds, or cash and, for that reason, they’re investments, because the things they’re based on are assets, which earn income.
Managed funds definitely have a place in most portfolios. Many investors like to invest direct (that is, buy individual shares, bonds, or properties), but there are some markets that are best accessed via managed funds.
For example, while you may be quite happy analysing and buying New Zealand shares directly, it’s certainly harder when it comes to buying international shares.
Other difficult markets may be commercial property, forestry, or tech shares, which either require a huge amount of money (beyond most investors’ means) or a lot of industry knowledge. So, investing in these kinds of opportunities is often better done through managed funds or syndicates, rather than using a do-it-yourself approach.
The second category covers ‘hedging’: things that don’t generate income, but that we might speculate on as a ‘hedge’, kind of like an insurance policy should your other investments decline.
Gold, commodities, cryptocurrencies, and similar assets do not generate income. This makes them risky, partly because they’re very hard to value and partly because, if they fall in value, there’s no income return.
If you speculate in any of these things, it should only be with money you can afford to lose, and even then, no more than 5 per cent of any portfolio should be in these assets.
Having said that, some assets that are normally speculative can have uses in an investment portfolio as hedges.
The best examples of these are probably gold and, perhaps, cryptocurrencies, such as bitcoin. These kinds of assets could hedge against some catastrophe within the global monetary system and could protect in the (fairly unlikely) case of a catastrophic breakdown of the financial system.
This line of thinking suggests that, in a financial crisis, the world might revert to gold or, perhaps, start to use bitcoin instead of other forms of money. For that reason, there may be a place for holding very small amounts of these kinds of alternative assets, which are usually reserved for speculation.
How to invest safely
The bulk of any portfolio should be made up of good, solid investments: shares in good businesses, property trusts, quality bonds, and some cash safely in a bank.
When it comes to investment, I believe you’re best to stick to the mainstream and be wary of the speculative promises that are often offered, but seldom delivered.
Speculation: Buying an asset in the hope of gain but with the risk of loss.
Bonds: A bond is a fixed-income investment in which an investor loans money to a body (typically councils or the government) for over a timeframe for an interest rate.
Portfolio: A group of financial assets held by an investor, sometimes managed by an adviser or broker.
Hedging: A hedge is an investment you make to protect you from the risk of prices dropping.
Cryptocurrencies: A cryptocurrency is a digital or virtual currency that uses computer cryptography for security.
First published Autumn 2018
By Martin Hawes
Martin Hawes is the Chair of the Summer KiwiSaver Investment Committee. Martin is an Authorised Financial Adviser, and a Disclosure Statements is available from him on request and free of charge at www.martinhawes.com. This article is general in nature and not personalised advice.
The editorial below reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.