I’m still in Dubai and spent the week checking out cultural monuments and learning a little about the history of Dubai on a tour.
A few weeks ago I wrote about things to consider when creating an investment portfolio, but in today’s blog post, we’re going to explore the factors or things that impact the growth of your portfolio, so you can decide what instruments to add in your portfolio.
There are 3 key factors that impact the growth of your portfolio:
1. Interest (compound interest)
In a nutshell compound interest is interest upon interest.
The higher the interest rate on the investment, the higher your rate of return.
All investments have a return on investment (negative or positive), which is the interest you get from buying the share or the mutual fund or unit trust.
So if you invest ($100) and compound interest is 12% per annum it means that your investment will get 12%, after one year you end with $112 and then the next year the investment 12% is added on $112 etc.
This is because all investments are risky (apart from government bonds); every time you invest in something you're taking a risk because you don't know what the future holds.
Any financial services person that tells any investment has a definite return, better be a great psychic or they’re not being truthful.
So how can you gauge the rate of return of any investment?
Good question that we will explore in depth later, because there are 2 schools of thought around this and they have been fighting forever.
For now I’m going to suggest another method: ask your financial advisor or investment banker to draw up a risk scenario analysis for you.
My financial advisor does this for me every quarter – it’s basically a spread sheet where they look at how a change in the rate of return will affect your portfolio, so you have a worst case and best case scenario based on the investment instrument's past performance.
This way you know what you're buying into and you can start to see if your portfolio is underperforming, based on historical performance.
Note: the higher the rate of return, the higher the risk so you have to find a way to balance the two.
I keep saying investment is a time game, and for someone as impatient as me, that's not a good thing.
The longer you hold a share or unit trust or mutual fund, the more time it has to accumulate compound interest.
Remember compound interest is interest on top of interest - so you actually make more interest over 20 years than you would over 5 years on the share or unit trust.
This is why investors like Warren Buffet say you should think long term and advise us to buy shares and hold them for 10 - 20 years. They argue against trading shares and trying to make a quick buck.
Active traders actually lose a lot of money in the long run because they're constantly chasing returns and also end up paying a lot in transaction fees.
Note: time balances risk - often the longer you invest for, the lower your risk because so many good and bad things happen in that time period, that there's a balancing effect.
3. Capital (Money invested)
Capital is the initial amount of money that you use to buy the investments.
You can put a lump sum in and just let it sit and accumulate interest in different investments or one investment.
Or you can invest a set amount every month or every year (this is called dollar-cost averaging).
The rule of thumb is - the more money you invest, the more money you get out, which makes sense because 12% of $1000 is a lot more than 12% of $100.
But that being said, avoid the mistake most people make which is to assume you need a large sum to start investing.
In South Africa you only need R200 to start investing in SATRIX (stock market) or in unit trusts.
In the USA, you can start investing in mutual funds with as little as $100.
But remember it isn't just about the amount of money that you invest. It's also about the rate of return on your investments and the amount of time you invest that money for.
All these factors play a role and work in tandem to influence your rate of return on investment.
So in a nutshell: you want to invest in investments with high rates of return (but they tend to be high risk), you want to go into any type of investment (even the stock market) with a long term view and you want to invest a good amount every month.
Let me know your thoughts in the comments section below.