A 2020 study by Bank Leumi revealed that 72% of consumers in the UK don’t have investment accounts. 18% said they don’t have any knowledge of investing.
An investment is defined as “an asset or item acquired with the goal of generating income or appreciation”. Asset appreciation means the increase in a value that happens to an item over a period of time.
A foundational principle of personal finance is knowledge of investing.
Why don’t people Invest?
Despite there being little difference in the way they spend disposable income, men are more likely to invest than women. Women do recognise the importance of investing. But barriers such as lower pay and a lower aversion to risk prevents them from doing so.
People are disadvantaged when they don’t invest. It reduces their likelihood of being financially independent. Moreover, women are more likely to struggle financially in older age because they tend to live longer, whilst having a lower pension compared to men.
Why should you invest?
You should invest because money held in investments outperforms money held in cash savings. A perfect example of this is:
If my family had invested $2000 in the S&P 500, (a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States) in the year 2000, these are the returns that could be expected today :
- $2,000 invested in stocks would give you around $4,190 today.
- The same amount invested in bonds would give you around $3,550 today.
- $2,000 put into savings would give you around $2,560 today.
To get the best results from investing, you should be aiming to hold your investments for the long term. The minimum should be 5-10 years. For the best results, you should aim for around 20-30 years.
Investing does come with risks, as you may get back less money than you put in. However, the risk of investing can be mitigated through diversification.
The Principles of Investing
1. Risk Versus Reward
Investing involves risk. Risk is defined as the probability that actual return will be different from the expected return. Risk can be high or low. The higher the risk of a particular investment, the higher the likelihood of a higher return and the lower the risk of an investment, the lower the potential return. Simply, there is no reward without risk in investing.
Another important aspect is risk appetite. Risk Appetite is a person’s ability and willingness to take risks. If you have no debts and a fully funded emergency fund, then you have the ability to make investments that are higher in risk compared to someone who doesn’t.
Conversely, a person may be cautious by nature, even if they have the ability to take on more risks or they may be willing to take on more risk even if they don’t have the ability to.
Before you can decide what to invest in, you need to understand your personal risk appetite. The stock market always experiences volatility and you need to be able to hold your nerve through those peaks and troths and allow your money the time it needs to grow.
2. Assets and Risk in Investing
Low Risk and Low return investments include Cash because it’s a liquid asset that can be easily accessible when required. Cash offers low returns because of low interest rates of cash saving accounts.
Another type of low risk and return investment is Bonds, which can be issued by Governments or Companies. A bond is a fixed income instrument that represents a loan made by an investor to a borrower.
Bonds offer a fixed interest rate and you will be paid an income that correlates to that interest rate based on your investment. Furthermore, when a bond reaches its maturity date, the issuer (company or government) will pay you the value of the bond.
Corporate Bonds work in a similar way to Government bonds but they are riskier because once issued, may be traded on the stock market and the bond price can change over time. But they offer higher rates of interest compared to Government bonds because a company is riskier and more likely to default than a stable government.
On the higher end of the risk spectrum, are Equities, which are also known as Stocks. Equities are shares in a company and having an equity means you have ownership of a portion of the company. There are differing levels of risk within equities as well and the return of investment varies.
Smaller companies are riskier to invest in as they are new, they don’t have bigger balance sheets and they are exposed to more risk in comparison to bigger companies. The rate of return in equities is not fixed or guaranteed, which makes them riskier but there is potential for higher return compared to bonds or cash.
3. Asset Allocation and Diversification
When investing, it’s important that your assets are invested across a variety of categories. It’s a way of mitigating your risks, so that if the value of one asset falls, then you can have another one performing well, to balance the risk. You should not put all your eggs in one basket or take on more risks than you can afford.
You must spread your investments across various asset classes, different countries and different sectors. My personal investment portfolio is spread across growth stocks, emerging markets, cash, value stocks, long term bonds, medium term bonds and various global industries.
You should also ensure your investments are uncorrelated, which means that they perform differently at the same time. That means If one investment is underperforming, it can be offset by another performing well.
4. Compound Interest and Investing
Compound interest is Interest you earn on interest. Albert Einstein once said “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
To illustrate the point: if you have £100 and it earns 5% interest each year, you’ll have £105 at the end of the first year. At the end of the second year, you’ll have £110.25. Not only did you earn £5 on the initial £100 deposit, you also earned 25p on the £5 in interest.
While it may not sound like much at first, it adds up over time. Compound interest can work to increase the value of your investments or to increase the amount of debt you owe.
You may think that putting your money away for long periods of time is ridiculous but the time will pass anyway, so you may as well invest. Thinking about where you want to be in 10, 20 or 30 years down the line can motivate you.
You must have a willingness to wait and ride out storms of the stock market. Not panicking allows you to maximise the returns you may generate. Furthermore, the earlier you begin, the longer your money will have to make those gains.
How to Start Investing
There are several ways in which you can start your investment journey. You can invest in individual stocks and shares, funds, ethical funds, bonds, cash and other asset classes. Some of the companies you can invest with in the UK are: Vanguard, Hargreaves Lansdown, AJ Bell, Nutmeg, Moneybox, Wealthify and many others.
An important thing to note is the investing fees that each company charges. You need to keep your investment fees as low as possible so they don’t eat into your profits.
“Robo Advisors” such as Wealthify and Nutmeg have lower fees compared to other companies, as your money is automatically invested by computer algorithms with minimal human interaction.
Although investing through Robo Advisors offers immediate diversification through collection of funds across territories and class allocations, you don’t have much choice over where your money is invested.
Investing with companies such as Vanguard, AJ Bell and Hargreaves Lansdown etc. allows you to pick funds that combine your areas of interest with your risk tolerance but fees may be higher.
History shows that investing over a long period of time yields a higher return for your money. A lot of people don’t invest because they don’t know how or where to begin.
Before investing, you should ensure that you understand your risk appetite. You should also aim to diversity your investments and understand the power of compound interest.
Do you currently invest? If so, what do you invest in? If not, what has stopped you from investing?
**Please note that the information written in this blog is for educational purposes only and is not financial advice.