Articles on investing

April 2009

Five questions to always ask about an investment

There are five questions you should ask about any investment before handing over your hard earned cash. The answers should all be in an investment statement, a plain language brochure provided with most new investment products.

Bonds have become popular recently, so I'll use them to illustrate how key questions can quickly highlight whether a particular investment is right for you.

What sort of investment is this?

This sounds like an obvious question. But it is essential that you understand exactly what you are getting into, and how one type of investment might differ from another.

For example, bonds are similar to term deposits in that you lend a company money and in return they pay you interest and pay back your money at some point in time. But the two investments are very different when it comes to how locked in your money is, the risks involved and the potential to make or lose money.

Never assume that you already know what the investment is and always read the description in the investment statement.

Who and what stands behind this investment?

When you make an investment, you expose yourself to the future and fortunes of the company offering the investment. So you need to know who these people are and what they intend to do with your money.

Before you invest in a company bond, you need to have an understanding of what the company does, the industry it operates in and how strong it is financially. This helps you gauge the company's ability to make scheduled interest payments and repay the principal at maturity date.

An independent credit rating from well-known agencies such as Fitch, Moody's and Standard & Poor's, can help you assess how likely it is that the investment will perform as promised.

The investment statement will also tell you about any guarantees being offered. Detailed information about any guarantee will be in the prospectus.

What are the risks and returns?

Whether an investment is right for you depends heavily on the expected returns and risks. The investment statement should plainly set these out.

It should explain how returns are made up and factors that might affect the level of the return. It should also explain any risks that your money won't be paid back in full or that you won't receive the return described in the investment statement.

Before you invest in bonds it's important to understand how their risks and returns can differ from other fixed interest investments like on call deposits. For example, with bonds you generally commit to receiving a fixed interest rate for a fixed period. If market interest rates go up or down, the interest rate on your bond generally won't change - as it might with a call deposit. This can be good or bad news depending on which way interest rates go.

If you buy bonds with a long life - say five or 10 years - there's also a possibility that inflation might affect the purchasing power of the principal and interest payments received.

Be aware that some bonds have interest rates that "reset" - meaning the interest rate you receive can change.

How easily can I get out of this investment?

The investment statement should explain whether you can sell your investment, any fees involved and if there's an established market to trade your investment.

This is important because if there is a market - for example where the investment is listed on the New Zealand stock exchange it is likely to be easier to sell.

With bonds, it's also important to understand that if you decide to sell, the resale price could be higher or lower than what you paid. Bond values are highly sensitive to market interest rates. If interest rates paid on bonds go up after you bought yours, then your bond will be less valuable and no one will want to buy it for its original face value. Conversely, if market interest rates fall, you may be able to sell your bond for more than you paid.

How much will I pay?

Usually bond investments don't attract fees, though some other kinds of investments do. Commission may also be payable if you are buying through a financial advisor.

If you don't understand the information provided in the investment statement seek independent advice.

For more information: www.looklearninvest.org.nz

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