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Risks and benefits of index-based investments

Investing in index-based investments can be a simple way to build wealth in one simple transaction. Like any investment, there is a risk and reward relationship to consider

Benefits of investing in index-based investments

Index-based investments can be sound long term investments, are easy to trade and require only a small amount of money to get started.

In one simple transaction, index-based investments provide exposure across the market represented by the chosen index. Many investors like the ‘off the shelf’ aspect of index-based investments because they remove the need to select individual securities. A diversified portoflio across a range of asset classes, such as Australian shares, international shares, listed property and bonds can be compiled in a relatively short period of time in a few easy transactions.

Liquidity is where investors and buyers can quickly exchange the index based investments. Not all are equally liquid. The potential to sell your holding, or sell them for the price that you want, depends on the availability of a willing buyer.

The process of buying and selling your holding can cost less than $20. You may need to pay more if you want advice and/or access to research. You can invest as little as A$500 (plus brokerage costs).

Depending on your circumstances, there may be tax benefits available to you if you invest in index based investments. For some investors, capital gains tax discounts of up to 50% may be available for index based investments held for more than 12 months. In addition, if the index based investment that you are investing in invests in Australian shares, you may benefit from franking credits paid on dividends. However, it’s important to ensure that your investments stand up on their merits regardless of any potential tax benefits.

Potential risks of investing in index-based investments

A risk and reward relationship exists with any type of investment. To receive a return on money invested you need to be prepared to place that money 'at risk'. Generally the greater the risk associated with an investment the greater the rate of return investors will expect.

Asset prices can rise and fall rapidly and investors must accept the fact that the value of their index based investment may fluctuate by as much as 50% or more in a year. General market risk can relate to a particular sector. For example, mining sector indices are usually more volatile than industrial sector indices.

Because of market cycles, some asset classes and sectors within asset classes have a higher degree of risk when the overall sharemarket has risen sharply and is set for a reaction. The opposite may apply when the sharemarket has gone into a strong decline and then starts to recover after showing some signs of stabilising. Not all sectors of the market follow the same price cycles. Understanding market cycles can help to manage the effects of timing risk.

Are the investment recommendations made to you supported by a thoroughly argued case, or are they merely hearsay? The more reliable information you have, the better your decisions will be. Recommendations involving high rates of investment return can fail to produce satisfactory results when taxation, ongoing fees and constant changes in investment cycles affect the performance. ASIC has some excellent information on getting financial advice on their website. 

Your investment strategies or even individual investments could be affected by changes to the current laws.