Updated: Mar 29, 2021
I will continue elaborating on how to start the investment journey. You can check Introduction to Investment 101 - blueprint and foundation to catch up with the house analogy we are using for the investment Journey.
I will explain the fundamental principles you will need to learn to become clued up on the different investment products. 🤓
01 Understanding the difference between Savings and Investment
Savings is the safest form of investment since the returns are almost guaranteed. The reason for this is because the government has strict laws and regulations to protect citizens. Banks and micro financiers offer the most saving options, and the returns are very low (below the long bond rate).
💡Long Bond Rate
Is the interest you would get by investing in a government bond. Government bonds are deemed to be low risk. Investors use this as a benchmark. Investments should at least give you a return equal to or greater than the long bond rate due to the risk you are taking. Saving always gives you a return lower than the long bond rate. At the time of writing, the long bond rate (10 years) in Kenya is 13%.
Savings will not give you very high returns, but they are quite stable and reliable if you are looking to keep your money away for less than a year. Other options are fixed income like corporate bonds and government bonds, as explained in the Fixed Income Asset Class.
On the other hand, Investment involves assets with higher risk, higher volatility, and little or no minimum returns guarantee. As a result, investors might expect higher returns from these assets or higher losses. All the investment asset classes will be tackled on their specific asset class on the site, and you can use these links to access them.
02 Understanding Risk and Return
As most of you already know, investment returns are always quoted in % per annum. I.e., how much your money will grow each year. For example, suppose an investment returns 10% per annum, and your initial investment was Kes 10,000. In that case, your interest will be Kes 1,000 the first year.
To avoid unrealistic returns and expectations, remember professional investors average 15% - 20% per year. So don’t fall for 100% in a month scam.
Always remember that people quote returns as positive and leave out the other side of the equation. For every positive (+) return, the risk is equal to the negative (-) amount of the number. For example, a 10% per annum return should be quoted as +- 10% per annum because it could go either way!
The only assets with a guarantee of positive returns are fixed deposits from banks. All the other assets attract both negative and positive returns. Instead of only thinking about how much you might make with an investment promising 100% return in a month, always think of how much you might lose, which is 100% in a month. 😉
03 Understanding Probability
I am very sure most of you vaguely remember what a probability is- the likeliness of an event to occur.
Probability applies to investment, and I will give an analogy using an investment that returns 10% per annum. As we learned above, you stand to gain or lose 10% in a year on your investment. However, you should make sure the probability of gaining 10% is higher than losing 10%. You’ll do this through research(in cases where information is public, e.g., a publicly-traded company). You will need to identify if there is a growth possibility in the future.
Since investment is a long-term game, your returns will be + in some years and - in other years; however, in 5 years, you should average around 10%-15% per annum. Like the returns below:
Year 1 (-5%)
Year 2 (+20%)
Year 3 (-5%)
Year 4 (+10%)
Year 5 (+15%)
Compounded return = 6.5%
The takeaway here is that the higher the return, the higher the risk.
Albert Einstein coined the saying, “compound interest is the eighth wonder of the world.” He said this because even the smallest amounts compounded together will surely become a sizable amount over many years.
For example, a modest kes 10,000 as the starting investment and topping Kes 1,000 each month over 15 years will compound to a whopping Kes 423,000. Assuming the investment returns 10% p.a. You can use simple financial calculators online to calculate. You can easily achieve kes 1,000,000 in 15 years by increasing the monthly repayments. ⌛➡️💸
The takeaway here is patience and consistency- which are very hard to sustain. That’s why an investment group is recommended or an investment partner to always keep each other in check.
As we have learned about the fluctuating nature of investments over the years, it’s good to stay safe by investing in different assets. As the saying goes, don’t put all of your eggs in one basket.
The key to diversification is the weak correlation between assets. Assets that don’t move in one direction for example when one asset return decreases the other asset return increase. To learn more about diversification, check out this link.
In the long run, this helps magnify the returns and reduce the risk of investment since the weighted return will be higher than the worst investment and a bit lower than the best investment. The benefit of diversification is illustrated below:
Investment A = 10% return
Investment B = 5% return
If you are lucky and invest in Investment A, you will get an outright 10%, but what if you choose B as the most attractive investment? You will only achieve a 5% return.
The best-case scenario is investing 50% of your money in A and 50% of your money in B since you are not sure of the future investment performance. As a result, you will get a weighted average return as follows:
50%*10% + 50%*5% = 7.5%.
Diversification makes a bigger difference if you have a sizable amount spread across various investments.
Make money work for you! When you earn a salary, you are working for the money, but when you put away a certain amount of money every month, the money starts working for you.
At this point, you will have built the walls of your investment journey, that’s if you’ve read the blueprint and foundation. Now what’s remaining is the roof. Subscribe to get an alert when the next article in this series gets published Introduction to Investment 103 - The roof.
Since you are now savvy, you can start reading more on specific asset classes to know where you will start.
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Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor. Full Disclaimer