Three Questions to Answer Before You Invest

In our last issue of WD Life, we discussed how & why building an investment portfolio is a powerful tool in wealth creation. However, what do you need to ask yourself and know before you embark on your investment journey? This month we explore 3 questions you must answer before you make the decision to invest.

A question most commonly asked by all investors is “How can I build the best investment portfolio possible?” However, every individual, and family, has its own unique set of goals, strategies, risks, abilities, and personalities. What works for your peers may not work for you, thus there is no “best” portfolio, only a portfolio that works for you. Likewise what was suitable earlier in life may no longer fit your needs later in life.

Below are three questions that you should ask before you construct your investment portfolio

1. In Which Asset Classes Will You Concentrate Your Funds & Why?

Each asset class has it’s own particular risk and economic behaviours, thus  your asset allocation strategy is key to succeeding as an investor. Asset allocation is the practise of dividing capital amongst different categories such as equities, fixed-income, and cash equivalents. Balancing risk and reward by appointing assets according to your goals, risk tolerance, and investment horizon, as well as keeping in mind the need for a stable cash flow, will inform your decision on how to handle your money between the different asset classes.

  • Shares statistically and historically have provided the highest long-term returns as they represent real ownership stakes in businesses that sell real products and services. Some of these profits are also made in the form of dividends. However, shares can fluctuate often and significantly in the short term and the long term. It is not unusual to see the market value of your holdings declines by 30% or more at least once every 36 months. For stable, good companies, with real profits, this is not of much relevance.
  • Real Estate is considered the second best long-term holding. Real estate often does not grow much beyond the inflation rate unless you are fortunate enough to hold property where supply is limited, population growth is prevalent, or in densely populated areas. However, property does often keep pace with the inflation rate and provide stable income streams. Real estate investors that have the capacity and prudent can use leverage in the form of secured mortgages, to hold greater exposure to property. Being mindful of cashflow, insolvency and being adequately insured are also important factors to consider when using leverage to invest in real estate.
  • Bonds & Fixed Income Securities are debt instruments that generate fixed returns in the form of interest payments to investors. Firms raise capital from issuing fixed income products to lenders who are compensated in the form of interest payments Bonds have an inherent safety mechanism in them, no matter how far the price declines, as long as the underlying company has the money to meet its contractual obligations, the bond will be redeemed at par on the maturity date. However, when the inflation rate accelerates, the value for each future dollar you are promised decreases in purchasing power. This can be devastation to long-term fixed-rate bonds that are locked in for 20 or 30 years.
  • Cash & Cash Equivalents, including bank deposits and short-term Treasury bills, are considered risk-free assets for an investment portfolio. Cash plays an important role within a portfolio to allow you to pounce on opportunities to buy cheap shares, bonds, and real estate in challenging cycles of the market. As performance in most economic conditions is subdued, holding excess cash could reduce your purchasing power due to inflation.

2. Will You Prioritise Cash Flow Over Long-Term Growth?

Within asset classes, investments can re-invest their earnings back into future expansion while others may distribute most of the income in the form of rent, distributions or cash dividends.

Companies that provide dividends can be a vehicle for long-term growth if you opt to re-invest dividends back into more shares as this provides the ability to compound the earnings with future growth.

3. What Liquidity Do You Need?

Liquidity is an important aspect with regards to creating your investment strategy. Sometimes more important than performance. Questions to ask to understand what level of liquidity is right for you can include:

  • What are your liquidity needs?
  • What is the likelihood you will need to access the wealth you’ve put aside?

If you require short term liquidity and cannot support a five-year time horizon, the liquidity risk associated with shares and real estate may outweigh your immediate needs.

To help safeguard your liquidity needs, you can put in place minimum cash balance requirements or if possible, limit the exposure to assets with less liquidity. The right answer depends on your personal circumstance. Are you in the accumulation or the draw down phase of your life and what is the overall investment objectives of your portfolio.

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