This week we are returning to the basics and redefining some common investment concepts.
Passive Income is income from Investment Assets. After the initial efforts used in making the investment, not much additional effort is required from the investor. The investment generates income on its own, hence the term ‘passive’. However, we must continue to monitor the investment to ensure it remains a worthwhile investment. Examples are dividend from company shares, interest from treasury bills and rent from rental properties. Salary on the other hand is an active income because if we don’t work as contracted, our employer would not pay.
Time Horizon is the time between when we make the investment and when we want to liquidate the investment by withdrawing both the principal amount invested and the returns accrued. This is determined by the purpose of investment and the age of the Investor. For example, our Retirement Savings Accounts (RSA); the purpose is to have money to spend when we’re no longer working and earning. PENCOM stipulates different Investment Guidelines to the Pension Fund Administrators for different age groups. The RSAs of people closer to retirement is made up of assets that can be easily converted to cash; unlike the RSA of a 25-year -old.
Personal Values are important in choosing investments. Some people would not invest in alcohol or tobacco companies, others want Sharia- compliant investments. In meeting our investment objectives, we must always obey our moral compasses.
Time Value of Money is the concept that states that N100 today is worth more than N100 next year. This is because, if the N100 is today invested in FGN Treasury bills at 4% p.a. the N100 would become N104 next year. The N100’s purchasing power is also affected by inflation. At 10% per annum, N100 this year can only buy N90 worth of goods next year. Hence, the need to ensure that we do not keep substantial funds lying idle in a current account.
Investment Risk is the possibility of losing the principal amount invested and Risk Appetite measures the tolerance of the investor towards that possibility. Factors to measure risk appetite include our – overriding desire for Capital (Principal) Preservation, tolerance for Price Fluctuation, need for regular cash dividends from the investment etc. Each asset class has its associated risks and some assets are riskier than others.
Portfolio Diversification, a risk management strategy, is the financial equivalent of the proverb ‘don’t put all your eggs in one basket”. There are many classes of investment assets like Money Market, Equities (publicly traded company shares), Mutual Funds (including Real Estate Investment Trusts REITs), Insurance Based Annuities, Private Equities (e.g. Crowd funding investments), Real Estate etc. The concept of Portfolio Allocation stipulates that we divide our investment portfolio amongst assets that suit our risk appetite, personal values, investment objectives and time horizon; whilE portfolio diversification teaches us to invest (1) across different asset classes and (2) across different assets within the same assets class, and so reduce the potential effects of associated risks. For instance, to diversify, we could invest in these 3 asset classes – money market, equities and REITs. Then within the equities class we further diversify by buying shares of companies in different economic sectors e.g. petrol marketers, banks and conglomerates.
Return on Investment(ROI)is measured in percentage terms or as an absolute figure. Those in percentage include Interest from Fixed Deposits and T-Bills, Coupon Rates from Bonds etc. These rates are always quoted and calculated on an annual basis. Rent from real estate is usually stated in absolute terms, but it could be calculated as a percentage in order to compare its ROI with those of other assets.
Risk-Return Tradeoff states that investments with high returns generally carry higher risks than investments with lower returns. For instance, there’s higher returns from investment in company shares than interest earned from savings accounts. However, the possibility of loss of principal is almost non-existent in savings unlike in the stock market where the value of the shares could fall below the principal invested.
Withholding Tax in Nigeria (WHT) is currently 10% flat on investment income. The new Finance Act has waived this on some investment assets because it is considered as double taxation, but most income still attract WHT.Interest earned from FGN treasury bills, FGN savings bonds and savings accounts with balances below N50,000 are tax free. Note, it is the interest/ income that is taxed, not the principal amount invested.
With our memories refreshed on these basic investment concepts, let us use them to build our wealth optimally. Happy investing.