Financial Literacy - Personal Investments Notes

Learning Objectives

• Explain fundamental concepts related to investment risk and return, as well as methods of measuring investment performance.
• Describe factors influencing an investor’s risk tolerance and implications for asset allocation.
• Identify and describe different asset classes.
• Evaluate advantages and disadvantages of indirect vs. direct investment.

Importance of Personal Investments

• Personal investments are crucial for financial planning and significantly determine wealth.
• Most individuals have investment exposure, typically through superannuation funds in Australia.

Investment Decision Factors

• How to Invest: Decision to invest directly (e.g., purchasing stocks) or indirectly (e.g., through managed funds).
• Which Asset Classes: Broad categories like property and shares.
• Which Assets: Selecting specific assets (e.g., within Australian shares, choosing between Telstra and BHP).

Investment Risk

• Definition: Uncertainty regarding expected returns. Variability in prices indicates risk.
• Types of Risk:
  1. Systematic Risk: Affects all firms market-wide (e.g., economic events).
  2. Idiosyncratic Risk: Firm-specific events (e.g., management changes affecting one company).

Diversification

• Concept: Reducing overall portfolio risk by combining various risky investments.
• Example: Holding both BHP and Telstra:
  • Systematic Risk Scenario: Economic downturn impacts both stocks negatively.
  • Idiosyncratic Risk Scenario: A negative event for BHP affects it alone, while good news about Telstra may yield a positive return.

Investment Returns

• Returns correlate positively with risk; riskier asset classes (e.g., international shares) typically yield higher returns.
• Only systematic risk is rewarded; idiosyncratic risk can be diversified away and thus does not merit additional return.

Measuring Investment Performance

• Performance Measures: Returns evaluated against risk levels, important for risk-averse investors:
  • Sharpe Ratio: Excess return as a ratio of total risk.
  • Treynor Ratio: Excess return as a ratio of systematic risk.

Risk Profile

• Risk profiling assesses an individual's risk tolerance:
  • High tolerance: Aggressive asset allocation (growth assets).
  • Low tolerance: Conservative asset allocation (defensive assets).

Factors Influencing Risk Profile

• Age: Indicates liquidity needs and investment horizon.
• Investment Horizon: Longer horizons allow for riskier investments.
• Experiences and Beliefs: Personal experiences may influence risk attitudes.
• Financial Situation: Impacts liquidity needs and overall ability to take risks.

Asset Allocation and Diversification Guidelines

• Determine allocation based on:
  • Age
  • Investment objectives
  • Annual savings capacity
  • Current investments value
  • Economic outlook

Asset Classes Overview

• Cash: Lowest risk, stable returns.
• Fixed Income: Risk varies from government bonds to corporate bonds.
• Property: Invested directly (residential) or indirectly (managed funds).
• Alternatives: Investments uncorrelated with traditional assets (e.g., hedge funds, cryptocurrency).
• Domestic Shares: Shares listed in the investor’s country; higher risk but potentially higher returns.
• International Shares: Riskier due to less transparency, currency risk.

Funds Management

• Managed Funds: Allow indirect investment in diverse portfolios with small minimum investments.
• Fund Types: Traditional managed funds vs. ETFs. Passive vs. active investment strategies.

Key Takeaways

• Positive correlation between systematic investment risk and expected return, measured by Sharpe and Treynor Ratios.
• Risk tolerance is influenced by age, investment horizon, personal experiences, beliefs, and financial conditions.
• Aggressive asset allocation suits higher risk tolerance, while conservative suits lower.
• Consider cash, fixed interest, property, alternatives, domestic, and international shares for asset allocation decisions.