Spreading your money among different types of investments is generally accepted as the best way to reduce risk and build a strong portfolio. But what should you do when you are starting out with a small amount?
MyWealth examines whether you should try and diversify from the get-go, and what your options are.
Know why you are doing what you are doing
Setting your investment goals at the outset is the most important thing in terms of defining the level of risk that is acceptable for you.
For instance, are you planning to use your money in the short term, or are you investing for the long haul in order to set yourself up for a comfortable retirement?
Ultimately most of the decisions an investor makes will be driven by risk. That is, either the desire to dial it back at times when it is more important to protect the money you have, or ramp it up a notch at times when you are wanting to focus on longer term capital growth.
At the end of the day though, while there are always going to be risks involved in investing, you don’t want to throw your money away by putting it all on black, so to speak. This is why the concept of diversification is so important.
The golden rules
Senior executive leader for financial literacy at the Australian Securities and Investments Commission (ASIC), Miles Larbey, says whatever your reasons for starting to invest and the amount you have to begin, there are some “golden rules” to follow.
“The first of those is to work out your needs and objectives, or what you are trying to achieve from your current situation and the timeframe you are investing over.”
Larbey says while a general rule of thumb is that higher potential returns involve a higher risk, some investments might be riskier than you appreciate without seeming to offer returns much higher than other offers around. This is why it is important to not just look at risks but also be sure you understand what it is you are investing in.
“This means considering such things as whether you will be able to access your money quickly if you need to and monitoring the progress of whichever product you choose over time and checking in to see if it is performing in the way you want it to.”
So, can you diversify with a small amount, say less than $10,000, and should you even try?
Your first investment doesn’t have to be property
Financial planner at Epona Financial Guidance, Lisa Duggan, says regardless of how much you are starting out with the level of risk you are exposed to should never be too far from mind.
“My perspective is to diversify right from the start – even if you have $10k or less, otherwise you are taking on too much risk,” Duggan says.
Both Duggan and Larbey talk about the importance of considering whether you can access your money quickly if you need to—in other words, having a “rainy day” fund—and also regularly checking in to assess whether your capacity to take on risk has changed or whether a particular decision could leave you over-exposed.
“I have this conversation with a lot of younger clients, who want to go into direct property straight away where we know that property is a big, lumpy asset,” Duggan said.
“My preference is to start off building wealth in a diversified manner and once that wealth has started to accumulate, looking at direct property, but not as the first asset.”
Larbey says that if $10,000 represents the entire sum of money you have saved then you might think about things like whether you need to protect your capital which will in turn influence your investment choices.
“But it is important to know that small amounts of money can, over time, grow to large amounts and particularly if you are looking at long term horizons, $10,000 can grow to a very sizeable amount.”
What are your options?
There are a number of different vehicles you can use to invest and try to either grow your money or protect it.
The kind of investments that will be suitable will depend, as above, on considerations such as your time frame and goals.
While investing directly in the shares of a large listed company is a common way in Australia for investors to try and generate a return, it is by no means the only option. Particularly if you are starting out with a smaller amount of capital, it can be a good idea to know what other options are available.
“Diversification is all about spreading risk and can be harder with small amounts if you are buying individual assets,” Larbey says.
“This might mean looking at ways to diversify using a fund such as a managed fund or an ETF [exchange traded fund] which can be a way of achieving a broad spread with a small amount, or you can start to build a portfolio of different shares if that’s what you are interested in.”
Duggan agrees when you are looking at starting with less than $10,000, “ETFs and managed funds, provided they are competitively priced, can be one easy way to start investing”.
Funds such as ETFs and managed funds operate by pooling together the money of multiple investors to give you a stake in a portfolio of assets.
In other words your exposure will typically be much broader and in the case of ETFs will mimic the performance of a market index.
As with any investment though, it’s important you fully understand the benefits and risks before making any decisions. You can use our 60 second guide to ETFs as a starting point to get your head around what might be involved in this type of fund.
Ultimately, it is about your level of comfort. Regardless of how much you have available to invest, you want to make sure you adopt a strategy that is compatible with achieving your goals.
“The most important thing when it comes to investing is making sure you can sleep at night. You need to be comfortable with how much risk you are taking on. If you overextend then regardless of what you are trying to achieve, you might not end up reaching those goals anyway and you won’t be sleeping at night,” Larbey says