Good financial planning should be viewed as personal healthcare and maintenance checks or reviews, just like medicals, should be performed on a regular basis. It can get to a point where current investments may not be providing you with the goals that you set out to achieve. The following article will provide some information on common investment options of shares, bonds, real estate and derivative contracts. Hopefully, these comparisons will help in any financial decision making, going forward.
Shares and Funds
Shares may prove to be the most popular investment choice for several reasons. Shares are the most liquid asset on the market, meaning they can be bought or sold quickly. While a lot of research is needed to make returns on an actively managed fund and ‘beat,’ the index, shares have a much higher potential return than most other securities. The flexibility of shares is also attractive, in that they may be bought in several different industries to diversify a portfolio and used for income (dividend pay-outs) or growth objectives.
The reliable long term upward trend of shares is nothing to ignore – all major share indices have seen positive historical returns, even after considering bear markets. For instance, the average annual return for the S&P500 over the past 90 years has been 9.8%; 7% if factoring in inflation.
Around 40% of these returns came from dividends, so reinvesting these income streams can offer even higher returns. The FTSE100 in the UK has seen a similar story, experiencing a rate of 5.4% in the last 20 years. Clearly, even just investing in ‘index trackers,’ is a popular option by many passive investors.
Of course, another option is to invest in funds. Setting up a portfolio from scratch takes a lot of market research and knowledge of the investing environment. Investing in funds is economically attractive for new investors. Investing in individual shares can incur charges of up to £15 per transaction, which is why beginner traders may see a great deal of their returns eaten up.
However, shares are one of the riskiest asset classes. Volatile, high-risk and subject to frequent short-term fluctuations, shares can be a poor option for investors looking for a safe place for their money. While the S&P500 has seen high historical returns, it matters greatly where you invest – the market performed very well for investors between 1950 and 1965, but anyone who invested in 1965 would have experienced 15 years of disappointment. Shares are also subject to high taxation n the form of transactional income and capital-gains tax, though these could be mitigated by using a tax-friendly vehicle such as a stocks-and-shares ISA in the UK for example, which is tax exempt.
Bonds, or gilts in the UK, provide low-risk returns and a safe haven for capital. Of course, this is referring to traditionally ‘safe’ bonds such as Treasury bills or UK gilts, rather than riskier emerging market sovereign debt. The risk of loss of principle on these securities is generally considered negligible. As with shares, bonds are some of the most liquid assets on the planet, aside from cash.
However, over the long term, shares have outperformed bonds. Using the USA as an example again, the S&P500’s 10% historical returns since 1928 compare to around 5 to 6% in government debt. This poses a problem when considering that most bond payments are fixed, therefore returns may not keep pace with inflation. Aside from inflation risk, interest rate risk can be an issue to those looking to sell bonds before maturity. Bond prices move in the opposite direction to interest rates, so this is another risk to consider.
Real estate investments are a tried and trusted method to making high returns on your capital. Indeed – low risk, low volatility and strong returns are key characteristics of these investments. The tax benefits on real estate are another reason to invest – mortgage interest tax deductions from income, deferral of capital gains, write offs for depreciation and more can all be expected. For those willing to invest in real estate but don’t want the stress that comes with home ownership, REITs (Real Estate Investment Trusts) may prove to be an attractive investment
However, compared to shares and bonds, real estate takes a lot more hands-on work that can result in higher stress all-around. Real estate can also be riskier than shares in some respects – firstly if there are no tenants in your property, the investment could end up costing money every month in the form of maintenance bills, tax, utilities, insurance, and more. Furthermore, while a portfolio can be diversified with shares and related commodities, real estate is not a very diversified product so may be at significant risk in the case of a bear market in housing (as seen in 2006/2007). Given that real estate is the most illiquid asset out there, it can be hard to reduce your losses when house prices drop.
Derivatives are not as widely understood as other securities and may intimidate beginner investors. They are financial products or agreements, which derive their value from other assets – sometimes compared to ‘bets’ on the price of other assets. One of the most popular derivatives is a CFD, or a ‘Contract for Difference’. In simple terms, a CFD is an agreement between a broker and yourself to pay each other the difference between the price of an asset at the current time period, and its price when the contract is terminated. Derivatives are designed to improve returns while reducing risk and may be used to ‘hedge’ a diversified share portfolio, so for this reason they may be more suited to experienced investors. Derivative contracts such as CFDs, futures or options are widely regarded as forms of ‘insurance’; utilised as a form of risk management strategy.
As a whole, whatever option you decide on should be based on your financial goals and long-term strategy. Financial planning is necessary for investing – whether the investments are to be used for fast returns or pension plans dictates which option is better suited to you specifically. Speaking to a financial advisor may prove to be worthwhile in adding value to all of your investments and ensuring that the best income method is decided upon based on your risk appetite and goals.