Morningstar Investor users sign in here.

Personal Finance

Foundations of financial independence Module 1: How to invest successfully

Mark LaMonica, CFA runs through how to set up the frameworks for investing successfully, and how to think about risk. 

Co-Author | Mark LaMonica, CFA


Additional resources: 

Article: Are investors thinking about the wrong types of risk? This article explores why it is important to focus on the right type of risk to invest successfully. 

Tool: Vanguard Asset class tool. This tool shows annual returns for selected asset classes, ranked in order of performance in each year. The purpose of this tool is to show that if you were to chase returns, you would always be switching in and out of investments. Each asset class has a different risk and return profile. Although it may be uncomfortable to experience volatility with your investments, we believe at Morningstar that the real risk is not achieving your goals. See the article on ‘risk tolerance vs. risk capacity’ above to understand the difference between risk tolerance (how much risk you’re comfortable with) and risk capacity (how much risk you need to achieve your goals).

Proceed to Module 2: How to set yourself up for investing success: Ensuring you have set the right foundations prior to investing 

If you were building a house, you would need to ensure it was built on good foundations to ensure its longevity. The same goes for investing. Shani Jayamanne outlines the foundations that you need to invest successfully for the long-term. This includes understanding your position with debt like mortgages and personal loans, tax, time horizon and safety buffers.

Back to course outline.

Module transcript

Mark LaMonica: In our first module, we're going to cover some of the foundational concepts of investing. But first we want to talk about what makes a successful investor. Because after all, this whole course is designed around helping you become a successful investor and we need to define that first. And there are lots of different ways to define success. But ultimately what it is, is achieving your goal. And we all have very unique goals and we're going to spend a lot of time talking about goals. But what we want you to do is imagine the future that you want to create by saving and investing. And then enable yourself to achieve that success.

So let's start with the basics as we said. The foundation of investing, something that you'll hear a lot about. And that is risk and reward. And we want to frame this in the right way for investors. But we must remember that there's a linkage between risk and reward. And ultimately taking on risk is what we're doing as investors. And the reward we get for that is the performance from the investments that are in our portfolio and from our overall portfolio. And that performance is what's going to allow you to get from where you are today to where you want to be in the future.

So why don't we start with risk? Risk is a little more complicated than it seems. There is certainly an industry definition of risk, a financial services industry definition of risk. And that's volatility. So volatility simply refers to how much your investments are going to bounce around in value. And we do need to be clear that that will happen. As a long-term investor, you're going to experience times when the market and your portfolio is going down. And we also want to be clear that certainly there is the chance that a certain investment in your portfolio could become worthless. And we'll spend a lot of time talking about ways to make sure that that's not going to impact you and impact your ability to achieve your goals. But it is important to come out there and say that right at the beginning.

So as I said, the financial services industry defines risk as volatility. But we don't necessarily think that that's the risk for most investors. And reframing that risk is really important. So throughout this whole module, we're going to talk about risk a little bit differently. And if you go back to our definition of success, you can see that really the risk that you're facing as an investor is not achieving your goals.

There's a trade-off between risk in return and risk as the financial services industry defines it. So really what you're faced with, is you're faced with a situation where your portfolio may fluctuate in value over the short term. But over the long term, you're going to get those returns that will help you achieve your goals. What we're exchanging as investors is we're exchanging volatility, so short term fluctuations in the value of your portfolio for the long term returns that you need to achieve your goals. And when we put it within that context, then all of a sudden we can start realizing why the real risk for most people is not investing.

So let's use a very simplistic example. And we'll use retirement as a goal because that's a goal that most people have. So instead of investing, let's say you decide to save money for retirement and just put it under your mattress. So you're earning no return on it. And if you're taking 10.5%, which is the mandated amount that goes into super, and with every paycheck you're getting 10.5% of that and you're sticking it under your mattress, we can think about how risk really is just not investing and not achieving your goal. So let's say you work for 40 years. You save 10.5% of your salary for 40 years. What do you have at the end of that time? Well, you have about 4.2 times your salary. Now, that is obviously inadequate for most people in retirement. Many of us today with lifespans increasing are going to be retired for just as long as we're working.

Now, that's a very simplistic example. And obviously, because you're taking an investing course, we assume that you don't just want to take your money and don't need to be convinced that you shouldn't take your money and put it under your mattress. Ultimately, as an investor, there's some context we need to put around returns. And the first one is inflation. So inflation has obviously been in the news a lot, but inflation is simply the fact that your money loses purchasing power over time. So when we think about returns, what we need to earn is returns in excess of inflation. Because after all, saving and investing is just delayed gratification. You're not spending money now because you want to spend it on your goal in the future.

So we never hear inflation, or we very rarely hear inflation included in any type of returns that you actually receive. So think about returns in excess of inflation. That's called real returns. So very simply, if inflation is 4% and you earn a 10% return, what you're really getting is 6%. The other thing that comes out of returns is of course any costs associated with investing. So that can be transaction costs, so that's what it costs to buy and sell the different investments that are in your portfolio. It can be any fees you're paying for somebody to manage your money. And it can also of course be taxes. Now all three of those costs all are within your control as an investor. And we're going to spend some time throughout this course talking about how you can minimize all those costs. But really that's in your hands. It means not trading as much. It means taking a long term view. It means trying to minimize taxes and fees.

So we've talked a little bit about risk. We've talked about returns. Now we need to think about how those two intersect. And as I said before, it's a trade-off. And the different asset classes that you have an opportunity to invest in, so whether that's shares, whether that's bonds, whether that's cash at a very high level, they all have different risk and return profiles. So volatility and returns. And they're very much linked. So let's start with cash. We use this simple example where you stuffed money under your mattress, but most people keep cash in the bank. You do earn a return on that, of course. But if we go back historically and go back to 1900 and look at the excess return that you get from cash on top of inflation, it's very small. So it's only 0.7% a year. If we start looking at bonds, we're getting a 2% to 3% return over that same time period in excess of inflation. So maybe that's enough of a return for you, maybe not.

Then when we start talking about shares, and if we look at Aussie shares and U.S. shares as an example, you're earning a return of around 6.5% to 7% a year in excess of inflation. So when we tie that back to success and achieving your goals, we need to get the right mix between those different asset classes in order to set ourselves up to receive the return we want. Now, as we go from cash to bonds all the way up to shares, there are going to be changes in volatility. And of course, cash has no volatility. It sits in the bank. You know it's going to be in the bank. You'll get a certain amount of interest. Bonds have some volatility. They will bounce around in price a little bit. And then shares have the most volatility. But they also have the highest return. And that's where we get to that intersection between risk and return and those trade-offs you're making.

So when we frame this once again around the real risk that you face as an investor not achieving your goals, it's most likely going to happen because you are not going to earn the return needed to get from where you are now to where you want to be in the future. And this is how we have to frame this risk that we always hear about in the financial services industry, this volatility. You are making that trade-off and that trade-off is actually going to allow you to achieve your goals.

So hopefully this was helpful. This will frame the different discussions we're going to have in the different module. But just remember, keep concentrated on your goals. We'll spend a lot of time defining them. And think about the different investments you're going to make and the risk you're taking on as an investor in terms of meeting your goals and not just short-term changes in price.

 



© 2024 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This report has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or New Zealand wholesale clients of Morningstar Research Ltd, subsidiaries of Morningstar, Inc. Any general advice has been provided without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782.

More from Morningstar
Understanding the power of compounding
Personal Finance
Understanding the power of compounding
Gaining a greater understanding of compounding can put you on a pathway to financial freedom.
Why high growth may lead to poor outcomes
Personal Finance
Why high growth may lead to poor outcomes
Historical patterns repeat themselves. And lessons from history show us the genesis of financial disasters lay in visions of limitless growth.  
Save on tax with Education Bonds
Personal Finance
Save on tax with Education Bonds
The tax efficient way for parents to save on education expenses. 
Tax implications when investing in overseas shares and ETFs
Personal Finance
Tax implications when investing in overseas shares and ETFs
A significant factor that determines an investor’s total return outcome is tax. We outline some general rules for how tax may work with foreign...
When should you sell shares?
Personal Finance
When should you sell shares?
Plenty of people will tell you what to buy but few weigh in on when to sell. 
The key to personal financial planning: Being lazy
Personal Finance
The key to personal financial planning: Being lazy
There are benefits to following a simplified approach.