What Is Investment Management?Investment management is a discipline that could cover many, many subjects. To most, it describes looking after a pension fund or some kind of shared investment (unit trust or mutual fund). However, to others it may mean completely different things. To the average man on the street, investment management is the art (or science) of achieving set goals over the medium to long term via invested capital. Those goals might be to preserve capital, to produce the maximum growth or generate an income on which to live. In a nutshell, it is the efficient and effective use of capital. Whatever investment management may mean to you, there are several factors that you must ponder before jumping in. Some of these issues are: Risk vs Reward. How many times do we hear about this? Buying a share on the stock market is low risk whilst the shares increase … but should they fall, you will suddenly understand the risk you have taken! As a general rule, any Low Risk investment (cash held on deposit, government loan stock, etc) will offer low potential returns. However, the risk of losing your money is minimal. Although the risk to your capital in the short term is minimal, over longer periods the effects of taxation and inflation may reduce purchasing power significantly. Yes, that's right! You didn't realise that bank accounts were risky? An investment that is Medium Risk will often be stock market linked (perhaps it is a mutual fund) and so the value of your capital may fall or rise in value. Due to the greater potential for risk, it is often advised that an investment of this sort is held for the 'medium term' which is usually used to suggest five or more years. High Risk investments are almost always linked to the stock market. Often they will be invested directly in shares or in the shares of a sector (eg technology) of a market. Perhaps the investment is in a different market (eg Far East or Eastern Europe). These types of investment are often highly volatile (the value will rise and fall quite dramatically) or illiquid (the market is very 'thin' and there may not be a buyer available when you plan to sell). The question then becomes, how might I be affected if I were to lose the money I invest? This is the ultimate test. Getting a great return each year is one thing, but if you need the money to pay for your childrens education, should you really be using it to back a horse? Expected Return. How profitable might the investment be? If you know that you are guaranteed to make 100% in a month and there is no risk, then you should invest all that you can find. It is possibly the best investment on earth at the time. But, if you might make a 100% profit and it will take 15 years to do so, you will invest far more cautiously. If you are able to make an educated guess at your expected return and the time frame needed to achieve that result, you can make a comparison with other investments. Which investment takes the most or least risk for a given return? Which investment is more likely to produce the return you hope for? The ability to make decisions like these consistently will make you very wealthy. Just ask Warren Buffett. Time. If you can take on board what I just described, then the next factor is time. Let us say that you have found an investment that should provide you a return of 10% each year after inflation. You next need to assess how long this result might last. The longer the better! In the same way that compound interest makes it difficult to ever repay a loan if you fall behind, compound growth makes investments very profitable if it can be achieved reliably over the long term. This is actually one of the key tenets of pension planning. If investments grow year on year, the longer they can be left to grow and compound, the greater the total return. This means that the earlier you start saving towards your retirement, the easier it will be. More of your total will be created by compounding growth and so the actual £, $ or whatever amount that needs to be saved will be lower. The motto here is START YOUNG. Inflation. Your purchasing power is linked very closely to inflation. By purchasing power, I mean the continued ability of your money to buy the goods and services you want and / or need over time. Even inflation running at very low levels (such as 3 or 4%) will over time have a serious impact on the current value of your money. This idea works in exactly the same way to wages. If inflation is 5% pa and you receive a pay rise of only 3%, then you are able to buy less goods and services over time. If in year 1 you were paid 10,000, your pay rise would mean that in year 2 you were earning 10,300. However, goods worth 10,000 in year 1 are now worth 10,500 in year 2. This makes you 200 worse off. I hope this makes sense to you. Understanding the effects of inflation are critical to investment planning. Taxation. Your investment planning should also take into account the likely tax implications. Will you face an annual tax bill? Pay taxes on the income? Or pay tax on any gain in value of the capital? What effect will this have on your likely return? As your knowledge of finance grows you will automatically become more tax aware. Just remember that avoiding taxes is legal, evasion is illegal. In most western nations, you will probably find that all the above apply. You will pay tax on any income generated and you will pay tax when you sell or dispose of the asset (known as a chargeable event). For this reason, asset structure can be vital. It may be more tax efficient to hold assets within a pension scheme or some other government approved tax shelter. Dependent on tax rates in your home country, it can be more important to worry about the taxation than the actual potential of the investment. I remember some time ago, a close friend described to me tax rates on dividends paid by shares in the UK in the 1970s (under the then Labour government). I wasn't born at the time - but income on dividends was taxed at 98%! Obviously it was vital to invest in assets that did not pay a dividend. Hopefully, that is an extreme never to be repeated, but it does highlight the importance of assessing your likely tax bill before you buy an investment. Luckily for me, investment management is a varied and indepth subject, so what I write here can only scratch the surface.
About Stuart Langridge
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