Albert Einstein called compound interest “the greatest mathematical discovery of all time”. We think this is true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.

The wonder of compounding (sometimes called “compound interest”) transforms your invested money into a state-of-the-art, highly powerful income-generating tool. Compounding is the process of generating more income on an investments reinvested earnings. To work, it requires two things: the re-investment of earnings and time.

To demonstrate, let’s look at an example:

If you invest $10,000 today at 6%, you will have $10,600 in one year. Now let’s say that rather than withdraw the $600 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236 ($10,600 x 1.06) by the end of the second year.

Because you reinvested that $600, it works together with the original investment, earning you $636, which is $36 more than the previous year.

The link between risk and return is a fundamental rule of investing. To achieve higher returns, you may need be prepared to accept higher risks. All investing involves risk and there are different types of risk, such as losing part or all of your money, not receiving the return you were expecting, or not being able to access your money when you need it.

Another risk for many people is actually being unwilling to accept the risks and invest in the type of assets required to achieve their investment goals.

Spreading your money across a number of different investments and/or asset classes is known as diversification. This is the simplest way to reduce risk. For example, investing in ten different companies carries a lower overall risk than investing in one, particularly if they are in different industries or countries. Different types of investments perform differently under various market conditions – so whatever your investment goals, appropriate diversification is very important.

The value of an investment may fluctuate to varying degrees. For example, the value of a stock tends to fluctuate greatly, while low-risk fixed income investments have historically been more stable. The greater the potential return, usually the greater the volatility, and therefore potential loss if you need to access your investment when its value may be down. One simple strategy to mitigate the effects of volatility is to invest regularly and benefit from Dollar Cost Averaging.

This is the strategy of buying a fixed dollar amount of a particular investment (i.e. shares) on a regular basis, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time (i.e. when the price is high).

For example, you decide to purchase $100 worth of ANZ shares each month for three months. In January, ANZ is worth $33, so you buy three shares. In February, ANZ is worth $25, so you buy four additional shares. Finally, in March, ANZ is worth $20, so you buy five shares. In total, you purchased 12 shares for an average price of approximately $25 each.

All investments need to be considered in the context of time. Some investments such as term deposits can only be accessed at the end of the specified period. Time is also important with more volatile investments such as shares, both in terms of entering and exiting the investment. The more volatile the investment, the greater the time required to ‘ride out’ any possible downturns in the investment’s value and maximize long-term returns.

Gearing is investing using borrowed money. This has the potential to increase returns as well as losses. Borrowing money costs money. So to be worthwhile the total return (income and capital gain) needs to exceed the cost of borrowing the money and outweigh the risks of ‘losing’ the borrowed money that you will still have to pay back.

Each asset class has different characteristics, in terms of their structure, potential returns and risks. It’s important to understand these characteristics so you can choose the investments that best suit your purpose.

A share is a part ownership of a company. You are literally buying a share in the company. You may receive dividends paid from the company’s profits and if the company’s profits and prospects grow, so will the value of your shares. Companies have limited liability which means you have no personal liability for the company’s debts and obligations. Equally, you have no guarantee of the return of your capital or income from your investment in the company.

‘Australian shares’ refers to the shares of companies listed on the Australian Securities Exchange and ‘international’ or ‘global’ shares refer to companies listed on overseas exchanges such as the New York or London Stock Exchanges. Some global companies, such as BHP Billiton, are listed on both Australian and international exchanges. Shares are generally considered growth assets which can fluctuate in value based on their own performance and broader market sentiment, but they are as diverse as the businesses, industries or regions in which they operate.

This is an investment that promises a particular return and the return of your capital, usually over a specified period. The level of return is compensation for the risk you take. The risk is the issuing organization’s ability to pay back the promised return. Government and corporate bonds are examples of fixed income investments.

Like shares, many fixed income investments can be traded on markets and their value can fluctuate depending on the perceived risk of the issuing organization, as well as prevailing interest rates and outlook.

Investing in buildings used for offices, industry, retail and residential can provide regular income as well as capital gains. Investing in property companies and trusts listed on stock exchanges effectively means investing in existing buildings, developing buildings, and managing the properties and related services for the businesses that lease them.

Similar to property, investing in infrastructure such as roads, rail, seaports, airports and pipelines can provide regular income as well as capital gains. Similar to many property companies, infrastructure trusts and companies are often listed on public stock exchanges. Infrastructure usually requires large amounts of initial development capital with income returns generated over the long term.