What are the key things I need to know before I start investing?

Starting to invest – perhaps on the recommendation of family or friends, or because you have been advised on an investment – is better than not starting at all.

However, you can increase your chances of being satisfied with your investments, however, if you understand your investment goals and how you can achieve them.

Whether you work through these questions yourself, or get help from a good financial adviser, the answers hold the key to how and where you need to invest.

What is investing?

While savers delay spending to accumulate something worthwhile for the future, investors look for returns to build wealth over long periods. Read more: What is the difference between saving and investing?

Long-term investors are also not traders seeking to make money over short periods such as days, weeks or months.

Traders buy and sell securities, such as shares, for quick gains, but successful traders are experienced and able to risk large losses.

There are fewer risks in long-term investing and you can be a successful long-term investor just by grasping a few basic concepts.

Long-term investors typically invest in the traditional asset classes such as shares, bonds, listed property and cash. They may also add some alternative asset classes such as commodities, private equity, hedge funds, infrastructure, physical property and currencies. Read more: How do asset classes classify the things in which you can invest?

Long-term investors use diversification and time in the market to mitigate the risks that come with investing in financial markets that are more volatile (can go up or down over short periods). Read more: What do I need to understand about investment risk and time? and Why should I diversify my investments?

Why am I investing?

Are you investing to grow as much money as possible by a certain date, or do you need to draw an income from your investment while it grows?

If you are investing for growth, you may have a target amount or investment goal you want to achieve – the amount you need by retirement, for example. You may be investing a lump sum, or smaller amounts more regularly, or a combination of both.

If you plan to live off your investments, as you may do when you retire, your aim will be to generate a reliable income stream. Read more: How much should I draw as a pension from a living annuity?

You may need to focus all or some of your investment on asset classes that can provide an income – for example, interest-earning bonds, money market instruments or shares that pay good dividends.

Fixed income investments can give you a reliable income, but if you need an income for a long period, you will also need to ensure your capital, and the income it generates, grows to keep up with inflation. To grow your income, you may sacrifice some of the certainty about the income you will earn.

Investing to generate an income requires more planning than investing to grow wealth, as the implications of drawing from your investment must be taken into account together with the investment risk. Read more: What are the risks when drawing retirement income from investments?

What is my investment goal?

If you are investing for growth, the first things to work out about your investment goal are:

• The targeted investment amount; and
• The date by which you want to realise your goal.

If you are investing for an income, your investment goal should include:

• The income you need;
• The annual increase in that income; and
• The period for which you need that income.

Read more: How do I set savings or investment goals?

What is my required return?

When you are investing, the amount you will accumulate depends on:

• How much you save;
• How long you save for; and
• The returns you earn.

If you are saving for a targeted amount by a particular date, achieving your goal depends only on two of these three factors:

• How much you save; and
• The returns you earn.

For example, if you want R50 000 in five years, and you can contribute R700 a month increasing by inflation each year of around 4.5%, you will need a return of around 7.5% a year to achieve your goal. 

However, if you can only contribute R650 a month, you will need a return closer to 10% a year to achieve your goal.

The 7.5% or the 10% return you need to meet your goal by the chosen date, is referred to as your required return or investment need.

Your required return must be higher than inflation. If your money earns less than inflation, it will be worth less each year, or if it just keeps up with inflation, it will not grow. Read more: Why must my investment beat inflation?

Returns are often linked to inflation. Investment and financial advisers therefore focus on the after inflation, or real return, you need. As long as the return target is a certain amount above inflation, it is less important what the actual inflation rate is. In the above examples, your real return would be 3% (7.5% minus 4.5%) or 5.5% (10% minus 4.5%).

The required return also needs to be realistic – a return you are likely to achieve by investing in financial markets. History is a guide, although you should always remember that past performance is no guarantee of future performance.

You can expect returns in line with the history of average annual returns for the asset classes - from one percentage point to seven percentage points above inflation - depending on where you are invested (see table).

However, remember that to achieve the average annual returns that have been measured over long periods for each asset class, you need to stay invested for at least the recommended term for each asset class.

What is the risk involved and can I stomach it?

Once you have determined your required return, you need to check what level of investment risk you need to take in order to achieve that return.

Investing in cash will not earn much above inflation, but is unlikely to result in a negative return making it an option if your investment term is short. Investing in equities, will earn you the highest return above inflation, but comes with the greatest investment risk. Time can mitigate this risk if you have a long investment term and can tolerate the ups and downs in your investment value over the term. Targeting a high return above inflation over a long term will give you the most impact from compounding returns.

Read more: What do I need to know about investment risk? 

What is my risk profile and why does it matter?

Why is compounding growth so important?

The next step is to work out the most appropriate way to invest. Read more: How can I get access to the markets?