Investment terms simply explained

Investing can feel like learning a new language, with terms and concepts that seem daunting. But fear not! We're here to demystify common investment terms like diversification, asset allocation, ROI and p.a. making them easy to understand and apply. Whether you're just starting your investment journey or looking to brush up on the basics, this guide is tailored to you. Let's dive in and make investing less intimidating and more accessible. 

Diversification: Don’t Put All Your Eggs in One Basket 

What is Diversification? 

Diversification is a strategy that involves spreading your investments across various assets to reduce risk. Imagine you have a basket of eggs. If you drop the basket and all your eggs are in it, they might all break. But if you spread the eggs across multiple baskets, dropping one won't mean losing all your eggs. 

Why is Diversification Important? 

By diversifying, you protect yourself from the poor performance of a single investment. For instance, if you invest all your money in one company and that company fails, you lose everything. However, if you spread your investments across different companies, sectors, or asset classes (like stocks, bonds, and alternative assets), the poor performance of one investment is offset by the better performance of others. 

Practical Example: 

Jane is a new investor with €10,000 to invest. She decides to diversify by putting €4,000 into a stock index fund, €3,000 into a bond fund, €3,000 into alternative assets like whisky, art, sneakers and more. If the stock market dips, her bond and alternative asset investments may remain stable or even grow, reducing her overall risk.  

If we look at the visualization above, we can see that Janes portfolio is well diversified into three main categories or baskets. 

Asset Allocation: The Art of Balancing 

What is Asset Allocation? 

Asset allocation is the process of deciding how to distribute your investment portfolio among different asset classes, such as stocks, bonds, and alternative assets. The goal is to balance risk and reward according to your specific financial goals, time horizon, and risk tolerance. 

Why is Asset Allocation Important? 

Different asset classes have varying levels of risk and return. Stocks, for example, tend to offer higher returns but come with higher risk. Bonds are generally safer but offer lower returns. Cash is the safest but offers negative returns due to inflation. Proper asset allocation helps you optimize your returns while managing risk. The key here is to allocate capital in a way that suits your personal risk tolerance and growth expectations.  

Practical Examples: 

There are a wide range of approaches when it comes to asset allocation. I will highlight two popular and sensible strategies for asset allocation.

Modern Portfolio Theory (MPT) focuses on building a diversified portfolio that balances risk and return. Imagine a mix of stable and volatile investments to create a smooth overall ride. 

The Core-Satellite strategy uses a core of broad investments like index funds for stability, then adds smaller "satellite" holdings for targeted goals or higher potential returns. Think of it like a central, balanced portfolio with additional investments orbiting around it. 

Let us take a look at asset allocation at different levels of wealth. Alternative investments are a bigger part of portfolios for wealthy investors. The average investor has only 5% in alternatives, but millionaires put 26% and ultra-high-net-worth individuals (those with a net worth of at least $30 million) invest 50% of their portfolio in alternative assets. This suggests that alternative investments become more attractive as your wealth grows. Source: The Motley Fool 

ROI: Measuring Your Investment Success 

What is ROI? 

ROI, or Return on Investment, measures the profitability of an investment. It's calculated by dividing the net profit from an investment by the initial cost and is expressed as a percentage. 

Why is ROI Important? 

ROI helps you evaluate the efficiency of an investment and compare it with others. It answers the crucial question: “Is this investment worth it?” 

How to Calculate ROI: 

ROI = (Net Profit / Cost of Investment) x 100 

Practical Example: 

Emily invested €5,000 in the artwork “Sleep of Love” by Marc Chagall with the Splint Invest app. 1.5 months later, the asset was sold. Her Splints are now worth €5,770. Her net profit is €770. 

ROI = (€770 / €5,000) x 100 = 15.4% 

This means Emily's investment grew by 15.4% over 1.5 months holding period. 

Per Annum (p.a.): Understanding Annual Rates

What is p.a.? 

p.a., which stands for "per annum," is a Latin term used to express a rate or amount calculated on a yearly basis. It's commonly encountered in finance, particularly when discussing interest rates, investment returns, or fees charged annually. 

Why is p.a. Important? 

p.a. clarifies the timeframe for a rate or amount. Knowing an interest rate is 5% p.a. tells you exactly how much interest you'll earn per year on your investment, not per month or quarter. This allows for easier comparison of different financial products and helps with financial planning. 

Example: 

A savings account offers a 2% interest rate p.a. If you deposit €1,000 in this account, you'll earn €20 in interest after one year. 

In the example of the Marc Chagall painting mentioned above the annualised return would be 136% p.a. This is because the 15.4% return was realised in 1.5 months, when you want to get a p.a. or annualised return you have to multiply this return to account for 12 months of a year. This is how you end up with a 136% p.a. return.  

Bringing It All Together: Building Your Investment Strategy