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Introduction to Investments
What's the difference between saving and investing?
Saving is a stage on the way to investing. You cannot be an investor without being a saver but you can be a saver without being an investor. When we talk about savings and saving money we could be talking about a piggy bank on the mantelpiece or a high interest deposit account. Savings are effectively cash or cash instruments, such as deposit account, term bonds etc. Investing is what you do with the savings you have created if you are looking to generate a return on your money that is greater than what is already available to you through your savings instruments.
As a saver, you will be taking very few and very small risks with your money. As an investor you are taking a much greater risk. Not only is the return on offer to you likely not to be fixed or guaranteed, the capital sum you invest may be at risk as well.
Why on earth would you want to take such risks? The short answer, of course, is because the potential rewards may be greater and you want to make more of your money than is possible just by leaving it on deposit in the bank or building society.
Is my money safe?
There is really no such thing as a cast-iron, rock-solid, 100% safe saving scheme or investment scheme. If anybody tells you different, don't believe them! Not even government-backed bonds are 100% safe. You think governments don't go bust and repudiate their debts? Ask any family with old Czarist or Chinese railway bonds from the Nineteenth century. For that matter, ask anybody who had money invested in various Latin America debt instruments in the 1970s and 1980s. Even governments can go out of business!
However, the likelihood of the UK government repudiating its bonds Gilts and National Savings & Investments accounts is vanishingly small and, realistically, these are among the safest homes for your money. Some savings and some investments are a lot safer than others. But not even your basic bank or building society savings account is completely free of risk.
There is a safety net for your money, provided by the Financial Services Compensation Scheme FSCS. It does depend on the FSCS itself staying in business but if the government has repudiated its bonds and the FSCS had defaulted, it is likely that we will have larger problems at hand than worrying about our investments!
The FSCS provides protection for consumers of deposit-taking companies for example banks and building societies. The maximum level of compensation you can receive from the scheme for a deposit claim is £31,700 100% of the first £2,000 and 90% of the next £33,000. The compensation limit applies to each depositor and covers the total of all their deposits held with that firm. In the case of joint accounts each individual is eligible to receive compensation up to the maximum limit in respect of their share of the deposits FSCS will assume the split is 50/50 unless evidence shows otherwise.
The maximum level of compensation you may receive from the scheme for a claim against an investment firm is £48,000 100% of the first £30,000 and 90% of the next £20,000. The FSCS covers two kinds of investment loss:
- When an authorised investment company goes out of business and cannot return your investments or money
- Loss arising from bad investment advice or poor investment management
Is investing all about my attitude to risk?
In large part, yes; the more attractive the potential rate of return on offer, the bigger the risk to the capital that you invest. That applies across the whole spectrum of savings and investing vehicles, from deposit accounts to shares. How much you should invest and what you invest it in will depend on three key factors: your attitude to risk; the level of return you want to achieve; and how long you are prepared to invest your money.
If you are, for example, close to retirement you won't want to take too many risks with your money. On the other hand, if you have few commitments and are several years away from retiring, you may be prepared to take a punt and invest in something with a high risk in the hope of getting a high return. If you want to aim for a higher level of return but still with a relatively low risk element, then you should be prepared to tie your funds up for some time. Most forms of investment offer greater potential returns for those prepared to invest for the long-term, although this isn't guaranteed.
Broadly speaking, we may place most forms of savings and investments into a risk spectrum with derivatives at the speculative end and Gilts and National Savings & Investments at the very low risk end.
Highest Risk Derivatives Penny Shares High Risk Emerging Market Funds Blue Chip Shares Medium- High Risk Collective Equity Funds investment trusts, unit trusts and open-ended investment companies oeics High-Income Bonds Medium Risk With-profits Bonds Corporate Bond Funds Low Risk Guaranteed Income Bonds Permanent Interest Bearing Shares
Should I be investing in the stock market?
As inflation has fallen over the last couple of decades so have the returns available from basic savings accounts. In fact, many instant access accounts no longer keep pace with inflation at all. Leaving your money in any savings account or investment earning less than the rate of inflation actually means it may be falling in value!
The traditional approach to investment offers a surprisingly dull answer - that one should hold a combination of cash in an interest-bearing account, of course and invest in a fund that follows the movements in one of the main stock market indices - an index tracker fund. This is because, unless you really know something the rest of the market doesn't, you won't, in the long run, be able to beat it. According to this theory, increasing or decreasing the level of risk in your investment strategy is merely a matter of lowering or raising the balance of your cash holdings vis-a-vis your fund investment.
Unfortunately, anybody who has been following this theory over the past few years will be feeling a little bit like the Grand Old Duke of York, watching the value of their investment march up and down and up and down, and so on. According to some experts, the key to successful wealth creation is diversification. Others will tell you it is all a matter of timing.
If you are looking for shares to invest in, there are some simple guidelines to stockmarket investment. The most important is to invest in companies whose business model you understand. That is to say, look for companies in which you can recognize the sources of profit and revenue.
Be prepared to be disciplined and ruthless with yourself. Do not be a victim of what the psychologists classify as "cognitive dissonance". This is a fancy phrase, which describes the reluctance we feel about selling shares that we know we should sell but dont want to because they have become part of our identity and we are too embarrassed about the losses we face. Too often private shareholders hold on to shares that are losing them money while selling shares that are making them money - this is entirely the wrong way round!
You may prefer to join an investment club, rather than go it alone. Investment clubs are clubs set up by individuals who have a common interest investing in the stock market. ProShare Investment Clubs estimates that it has guided the setting up of over 12,000 investment clubs in the UK.
What about investing in a fund?
You may feel uncomfortable with the idea of picking your own shares to invest in even though you may believe the stock market still offers the best prospect for future returns. So what about collective investing? A collective investment is a fund that takes money from a number of private investors and pools it together. A professional fund manager will then use his or her skill to increase the value of the funds under management by investing in a portfolio or wide range of companies
There are three types of collective investment you could choose from:
OEICs are like unit trusts, which they were designed to replace, in that they are open-ended. However, they are structured as companies and are generally cheaper to invest in. For most people, OEICs are likely to be easier to understand than either unit or investment trusts because they have a single price unlike unit trusts which often have different buying and selling prices for their units and are not prone to discounts or premiums as is the case with investment trusts.
What sort of investment fund should I be looking for?
Most of us probably won't pay too much attention to the structure of the fund we invest in. We are, rightly, more concerned about whether it will make money for us. In the 1990s, index tracker funds became more and more popular. However, if the general market is rising, tracker funds rise as well. They outperform average human fund managers because their costs are lower. In a falling market index trackers fall with the market while real live fund managers may at least attempt to do better.
What an active fund manager does is try to pick stocks that are going to do better than their competitors. This is called not surprisingly stock picking. Although the idea was out of favour for most of the 1990s as relentlessly rising stock market indices trounced its followers, stock picking came back into fashion in the more volatile markets of recent years.
Other classifications of funds that you may wish to consider are income funds and specialist sector funds, investing in specific business areas. Income funds, as the name suggests, focus on providing an income and look to invest in shares that pay good dividends. Obviously, companies that continue to make profits and pay dividends when times are tough will weather a downturn better than so-called "growth stocks" whose valuations rely on future prospects rather than current earnings. Among specialist sectors you may choose to focus on are stocks specific to one geographical area, say the UK, Europe, etc., or on funds that focus on investing in one industry sector such as property, mining or finance and so on.
If you are looking at investing in shares, the key question is whether you feel qualified to pick winners on your own or whether you want a fund manager to attempt it for you.
How can I beat the market?
Beating the market at its own game is actually a lot simpler than you might think! However, it is not a question of sitting glued to a computer screen watching share prices like a hawk. All you have to do is invest on a regular basis. Choose how much you want to invest on a monthly basis and stick with it.
When the price of your chosen investment fund or share or bond falls, your fixed sum investment will buy more units or shares or bonds. Of course, when the price rises, your monthly investment will buy fewer units or shares or bonds but the value of the larger number you bought at the lower price will also have risen.
Thus, over time, the average price you will actually have paid to build up your investment will actually be lower than the average market price of the unit or share or bond you are buying over the time you invested in it. This mathematical wrinkle is known as 'pound cost averaging'.
Should I be investing in bonds?
In general, a
You may hear people talk about a bonds 'coupon' when they talk about the interest it pays. This dates back to when bondholders quite literally had to tear off coupons from their bond certificates and present them in return for payment of interest due.
If you are looking around for an alternative to shares and share-based investments, a variety of bonds are available. Uncertainty and volatility may be stock market watchwords for some time. If, for whatever reason, you are unwilling to put your money into shares, then take a look at bonds or bond funds. You may prefer the certainty of return or the relative safety of investment that is offered by bonds that is not available through shares.
However, do make sure you understand what kind of bond you are investing in. Be aware of the difference between bonds that pay a fixed interest and those that do not. Some bonds or bond funds may have a substantial shares element, thereby also relying on the performance of the stock market to meet their specified rate of return. Bonds exposed to shares include high-income bonds, with-profits bonds and guaranteed income bonds.
You must be able to distinguish which kinds of bonds may put your capital investment at risk. Among bonds in which your capital may not be returned in full are: high-income bonds dependent on stock market index growth; with-profits bonds; corporate bonds and gilts.
Alternatively, you could put your money into Premium Bonds and hope for a million from Ernie. As of August 2005, the Premium Bond prize fund rate was set at 3.00%. NS&I 'gives away' over one million tax-free prizes each month, including two £1 million prizes. The odds of winning a prize are 24,000 to 1, meaning that someone with the maximum investment in Premium Bonds of £30,000 could, with average luck, expect to win 15 tax-free prizes a year.
Should I be investing in property?
You may wish to look to property as an investment either by investing in a fund, which invests in property - either commercial or domestic - or you may wish to go into the landlord business for yourself. If you do decide to purchase directly a property for investment purposes, you must realise it will be for the long-term. As the experts put it, bricks and mortar are "highly illiquid". That means if you are likely to want your money out fast, you need to be investing in something else.
Most people on the verge of retirement hand over their pension savings to a life insurance firm in return for a regular annual income, an annuity. However, with annuity rates dragged down by low interest rates, volatile investment returns and rising property values in recent years, the buy-to-let market has become more and more a part of investment planning for retirement. Mortgage interest on a buy-to-let property may be set against the tax due on the rental income.
However, you should not underestimate the cost or complexities of being a landlord, which may include agents' fees, gas inspection charges, insurance, council tax, service charges and repair and maintenance as well as the cost of 'void' periods when the property is empty. If you have bad tenants, you may even face legal bills for the cost of evicting them, making good any damage they have caused and claiming unpaid rent. You should also remember that if you sell a second property that is not your principal residence, you may have to pay capital gains tax on the proceeds.
What should I be doing next?
Review your financial position. Are you making the best of the money you save and invest? Re-evaluate your savings and investments. Are your short-term savings trapped in a low interest account? Free them to earn you more! Are you taking advantage of all the tax breaks available? Do you want to broaden your investment horizons but aren't sure how to go about it? Are you making proper provision for the future through your pension plans?
Take a long careful look at how your existing savings and investments are performing. Are you happy that you are getting the best possible return from them? Do they fit in with your current "risk profile" - should you, if you are getting closer to retirement, be thinking about reducing the level of risk in your portfolio of investments or should you actually be thinking about taking a few more risks if you have plenty of time in which to build up an investment.
Shop around for the best rate for your savings. Remember, you get no reward for loyalty to a financial institution paying a lower rate of interest! Unless, that is, you want to admire the marble porticos in the City of London and elsewhere. Look for savings accounts with rates better than the rate of inflation otherwise the value of your money won't even stand still. Remember, if you are a taxpayer, to check the net rate of interest that you will receive. It will obviously be less impressive than the gross rate but it is what you will get but don't forget that higher-rate taxpayers will also have to pay an extra 20% on the published net rate.
You may have been canny enough to build up investments in
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