Prophet’s Guide to Investing is a ten-part series that will help build the foundations of everything investing. We cover topics such as what is investing, What are shares, ETFs, Which shares to buy, investing vs trading, How to press buy, and advanced trading techniques.
This is the best free Australian Investing Guide.
We seek to answer the questions you have about getting started in the difficult world of investing. This is the straightforward guide we wish we had when we started investing. We welcome you to the Prophet Community. In this first lesson we investigate Why Invest?
Why Invest: What can be Possible
One of the most common questions we always get is How do I invest? We get the appeal behind investing and how exciting it can be to jump in and start trading stocks. But jumping straight in skips over the first, and most important step.
First, you have to ask yourself, Why do I want to invest? By first identifying our reasons we can then tailor our investments to suit our needs.
Simply throwing $1,000 into the stock market is pointless if you don’t have a plan.
Common Reasons People Invest include:
- Save for a goal
- Build Wealth
- Beat Inflation
- Become (try to) Wealthy
- Add diversification to a portfolio
Why Invest? Inflation: The Erosion of Money
Inflation is the price increase of goods and services over time. Inflation decreases the purchasing power of your money. Inflation is a key metric for investors, as in order to grow the value of our wealth we must consistently beat inflation over time.
Inflation is measured using the Consumer Price Index (CPI). CPI measures the percentage change in the price of a basket of goods and services consumed by households. Source, RBA
CPI: Consumer Price Index is an instrument to measure inflation
CPI is calculated by the Australian Bureau of Statistics (ABS) each quarter (31 March, 30 June, 30 September, 31 December). It is calculated by tracking the price increase of a representative ‘basket’ of goods and services.
We can see the representative basket is based upon the Australian average, but will actually vary from person to person, dependant on their consumerism.
This graph shows the fluctuations of inflation over time. We can see inflation has been relatively low in recent years.
CPI has Averaged 2.8%
On average we must achieve at least 2.8% to beat inflation and maintain or grow the value of our money. So, ask yourself how much your savings account earns you.
This means that whilst CPI is at 2.8% and banks are only paying a top of 0.99% on term deposits, you are actually going backward with your money held in savings or cash compared to CPI. By holding your money ‘safe’ in one of these term deposits you’re actually devaluing it at a rate of 1.81% per year.
By Holding Your Money “Safe” In Cash You’re Actually Going Backwards
To put this into perspective $10k invested over 10 years at 0.99% would payout $10,499 but would only buy $7,928 worth of assets.
Everyone talks about investing being risky. But we can see that remaining complacent when it comes to investing can introduce the risk of losing returns. This brings us to the next point. High risk equals high reward.
Risk and Reward
All investments have risks. As we just mentioned even leaving your money in a term deposit can be risky, as we may forego larger returns.
When we think about risks in finance we know that risk is often tied to reward.
- Low Risk=Low Reward
- High Risk=High Reward
What this means is that investments with the potential to return the most are also usually the riskiest, and make us vulnerable to lose the most. Meanwhile, safe investments usually earn very low returns.
Where this fits into not only equities but all investments is that the higher the range of outcomes around an average, or the standard deviation, the higher the possible returns.
If we map out some of the average returns on assets over the past 20 years we can see that money markets such as term deposits have ranged from 1.7% to 7.6%. We can see there is a very small deviation, low risk, and low reward.
Bonds have performed very similarly to cash over the period.
When we examine equities over the same period we have seen them range from -40% to 39.6%. While they have been much more volatile they also clearly have the potential for higher returns.
The risk-return tradeoff is evident in our real-world examples across these asset types.
Risk Reward and Your Portfolio
Every investor has a different appetite for risk. Risky investments aren’t for everyone and from time to time your personal goals may change and your portfolio and risk level can change to accommodate this.
A persons risk appetite is often dependent on three things:
- Time horizon
- Attitude towards volatility
- Stage in life
The Time Horizon of Risk: 7 Years
Investing in stocks generally isn’t recommended for the short term. If you’re needing your cash within a year or so, the stock market probably isn’t the place. Instead, we’d lean towards cash.
The recommended investment timeframe for shares should be at least three years and preferably even seven years or more. Shares tend to be highly volatile over the shorter term, meaning you are likely to produce negative returns and lose capital. Although over the longer term shares have the potential to produce high returns, with reduced risks.
Here’s the Proof:
We see taking the market over random 7-Year time frames, the ASX All Ordinaries have not lost capital. This appears to be true across any 7-year period, except surrounding the 2008 GFC crash.
As our investment timeframe reduces to 3 Years we start to experience a loss in 14.3% of periods. With a short-term time frame of 1.5 Years, we realize a loss in 35.7% of periods.
Putting the Risk and Reward Into Perspective
Over a seven-year time frame, we have seen the risk of losing money in broad market equities is extremely low. Given a return of around 8% we could expect:
A $10,000 would be worth $22,196
Over the shorter time frame of 1.5 years. We know our statistical probability of losing money increases to 35.7%. Hence we could expect:
A $10,000 may be worth $10,860 Or Less than $10,000 (35.7% of the time)
Given a cash rate of 1% over the same time period we would expect our investment to be worth a guaranteed $10,150. Hence, we have to ask ourselves over the short term: is it worth risking our capital for around $710?
Over the short term, the risk-reward ratio often isn’t worth it. Hence why equities are a long-term investment.
Why is it important to understand the Risks? Our COVID story
When you take an investment in any asset you are taking on the risks and potential rewards that come along with it.
When you keep your money in a term deposit earning 0.9% you can almost certainly count on that interest to be paid each year. But with your rates locked in, there is no chance for returns to skyrocket.
Likewise, when you invest money into equities you must expect volatility. This volatility brings on higher risk of losing our money, but could also lead to greater returns.
By knowing and accepting these risks we can begin to accept market volatility as a trade off for higher rewards. When we wrote our book on investing we studied the market volatility during the GFC and understood the potential risks.
Understanding the risks allows you to deal with volatility.
When the COVID crash came we were then well acquitted to the market volatility which allowed us to not only hold onto our shares and accept the risk, but to dramatically increase our holdings. During this period we contributed $5,000 a day until the market recovered. Needless to say, we made an excellent profit.
What Does the Risk/Reward Ratio Tell You?
The risk/reward ratio helps investors manage their risk of losing money on trades. Even if a trader has some profitable trades, they will lose money over time if their win rate is below 50%. The risk/reward ratio measures the difference between a trade entry point to a stop-loss and a sell or take-profit order. Comparing these two provides the ratio of profit to loss, or reward to risk.
Investors often use stop-loss orders when trading individual stocks to help minimize losses and directly manage their investments with a risk/reward focus. A stop-loss order is a trading trigger placed on a stock that automates the selling of the stock from a portfolio if the stock reaches a specified low. Investors can automatically set stop-loss orders through brokerage accounts and this typically does not require exorbitant additional trading costs.
How Much Do I Need To Invest?
You can start investing for as little as one dollar with micro-investing apps such as RAIZ. Shares and equity products are purchased through a broker with a typical minimum entrance of $500.
So, investing doesn’t necessarily require large amounts of cash to get started. However, investing can be a risky practice so as a rule, you should be in a position that losing all your invested cash doesn’t have a large impact on your financial situation. Or you are well diversified to mitigate risk.
When to Invest, Are you Ready?
You should have enough cash to cover any expenses and unforeseen events that will come up during that year. Investing is for the long term and to achieve a compounding effect typically the longer the investing horizon the better the compounding effect.
Micro-Investing platforms such RAIZ have very low fees. This makes any amount of cash a feasible place to start. Brokers charge a fee usually in the range of $10-20 for trades up to $5000.
When to invest? Diving into your Finances
There are Four steps we must conquer before we begin investing to ensure we are investing safely. By skipping steps and jumping ahead we may end up over-investing, leading us to pull money out during dips, go into debt, and have serious financial hardship.
This can be frustrating, but doing this right can lead us to financial independence, the ability to bet big at the right times, and ultimately a path to financial success.
Step 1: Create A Budget
The first step is an extremely important starting point. In order to win with personal finance, you need to spend less than you make. To do this you need to create a detailed written budget with all your income giving every single dollar a purpose. This is the foundation for your wealth.
Budgeting gives you clarity for both your income and your expenses, which can then help you address your surplus. Just writing it down will help relieve stress and give you hope. Moneysmart has a free easy to use budget tool. Record all your income and record all your expenses and identify areas where you can reduce spending and allocate money to each area. Be sure not to go over the budget once it is established.
When looking at areas to reduce your expenses I want to draw focus to the four most important things: Shelter (paying your rent or mortgage), Food (not eating out, the bare essentials to survive), Utilities, and Transportation. These are the four critical things, address these first and pay the minimum on all your debt, anything after this is a luxury.
Step 2: Build An Emergency Fund Of $2000
The emergency fund is exactly that: An Emergency Fund. It is strictly for absolute emergencies and should be kept in a savings/checking account separate from your finances. This fund is simply there to act as insurance against emergencies. Instead of borrowing when your car breaks down your fund can be used to keep the wolf from the door and keep you on track.
Step 3: Attack Your Debt
Now you need to line up your consumer debt from smallest to largest (everything except your mortgage and student loans). List them all out and pay minimum payments on everything except the smallest. The smallest we will pay down as quickly as possible.
I know this may sound counterintuitive as mathematically we should pay off the highest interest first. However behavioral finance has shown that knocking out your debts smallest to largest creates momentum and a higher chance of getting it done.
While we have debt (other than HECs) there is no point in investing. We could make a solid ‘return’ by simply paying off high-interest debts. And this is practically risk-free.
Step 4: Grow Your Emergency Fund
After knocking down your debts it’s now time to increase your emergency fund to 3-6 months of expenses. This is going to allow a bigger security blanket for the unknown and help relieve financial stress with peace of mind. The 3-6 months is up to your judgment. If you’re in an uncertain place with your job or moving around a lot aim for the 6 months.
Step 5,6,7: Invest
This is the final step and varies from person to person. First, you need to identify your goals and work towards them. Maybe you want to max out retirement further, to live a comfortable retirement. Any money you put into superannuation will be preserved until retirement. If you think you will want access to the funds before retirement you should skip this step. Maybe you like the idea of retiring early and having financial independence. This is a whole separate topic but maybe maxing out super and creating a bridging brokerage account to see you through to retirement age is the way to go.
Now that things are under control we can start to build wealth. These steps should be done simultaneously so we’re not leaving either step too late. You should max out your retirement to around 15% and pay off your mortgage as quickly as possible. A paid-for house is an excellent foundation for financial stability and wealth. By owning such a massive asset and never having to worry about rent or a mortgage again you can begin a path to wealth and financial independence.
15% is an excellent amount towards retirement while still leaving enough in the budget for general life. Check out our article on tips to maximize super.
Generally we at Prophet like two types of assets: Property and Shares. When saving for things less than three years away we keep our money in cash, after this we keep our money in ETFs. For help getting started in investing check out our beginners guide here for all things investing in Australia.
What is Investing?
Investing is simply the practice of forgoing short-term benefits namely liquidity or cash flow in the hope of achieving better financial gains in the future.
This is usually by taking on risk or losing liquidity or both. Investing is really delaying the gratification of the present to have additional in the future. Investing could be buying a quality share or investment property and holding for a long period.
Welcome To Prophet Invest
Over this 10-part series, we will show you everything we have learned about ASX investing for beginners.
We are two brothers from Brisbane Australia, who started investing as soon as we were legally able to open a brokerage account. We have had some very good years and a few lessons.
Prophet Invest has the mission to share our thoughts with millions of people on all things shares, crypto, wealth, and property.
A lot of the information from this series was inspired by our best-selling eBook, available on special now.