Understanding Investing

See also: Investment Tips

Investing is putting money into a financial scheme or commercial venture in the hope of making a profit. It comes with a potential risk of losing money—but also a potential reward of getting back more than you put in.

There are many different types of investment, and each one has a different level of risk and reward. Within each type, of course, different investments will also have different levels of risk and reward.

This page explains the broad classes of assets in which individuals can invest. It also explains the idea of risk and reward, and the balance between the two, and suggests when it might be appropriate to invest, and when to save instead.

When to Invest

If you have some spare money left over each month, you have a choice about what to do with it. You can pay off long-term loans such as a mortgage, you can save it somewhere, or you can invest it.

How do you decide what is the best option?

First, if you have large amounts of short-term debt, you should pay this off first before investing. You should not be considering savings or investments if you have large amounts of expensive short-term debt such as credit cards or short-term loans. Any spare money should go on paying off those debts.

However, long-term debt is different. If you have a lump sum, you might choose to pay off some of your long-term debt, such as your mortgage. However, you might also invest your money. What you choose will depend on whether you think your investments will make more money over the long-term than you will spend in interest on the loan.

Sometimes people choose to invest on a regular basis to pay off a mortgage in the future. This is the principle behind interest-only mortgages (and there is more about this in our page on Understanding Mortgages).

Beyond that, the choice between savings and investments is usually made based on your time horizon.

Generally speaking, you should save (in cash) if you are going to need the money in the next five years. If your investment horizon is longer than that, you may be better off considering one or more of the other classes of investment.

However, before you embark on any investments, it is a good idea to ask yourself a few questions:

  • Do you have access to some emergency cash savings in case you need them quickly? You don’t want to be liquidating investments just to fix a broken boiler, especially if the stock market has suddenly dropped.

    A Cash ‘Cushion’

    Experts suggest that you need a cash ‘cushion’ that is enough to cover your living expenses for between three and six months. This will be enough to pay for any emergencies like a broken car or boiler, or keep you comfortable if you lose your job, or become ill.

    If you don’t have this already, it is best to save it first, before you consider any longer-term investments.

  • Can you afford to lock your money away for a longer period? If the answer is no, then savings are your best route.

  • Can you afford to lose money if the value of your investments goes down? The value of investments can fall as well as rise, and it is important that you are comfortable with the idea that you may lose money.

WARNING! Investing is not a ‘get rich quick’ scheme

Investing is a long-term business. It should never be seen as a way to ‘get rich quick’. If you are thinking of ‘a quick investment’ in ‘a sure thing’ as a way to boost your household income rapidly, then don’t.

Before you invest, you also need to understand your attitude towards financial risk.

Understanding and Managing Financial Risk

Financial risk is defined as the possibility of losing money on an investment.

Every investment carries some level of risk, because it is always possible to lose at least some money on it. A very risky investment would carry a much higher chance of losing all your money.

However, the concept of financial risk is inextricably bound up with the idea of reward. A riskier investment will have a much higher potential pay-off, to compensate investors for the potential risk. In other words, if you are prepared to accept a higher chance of losing your money, you could also make a lot more.

Risk = Probability

Risk is simply a word used to express a specific probability: whether you will lose money on an investment.

Potential investments range from very low risk right up to very high risk. A high-risk investment carries a higher probability of losing money than a low-risk investment. Low-risk investments include putting cash into a savings account, or buying government bonds. There is a very low chance that you will lose money—but it is still possible. There could be a run on the bank. High inflation but low rates of interest could also mean that your money loses value, even if you still get back what you put in.

Higher risk investments include investing in shares traded on the stock market. The risk is higher if you invest directly in specific companies—and even more if you invest in young companies and start-ups. However, you can mitigate the risk by investing in funds that group different categories of investment together.

In financial terms, risk cannot be separated from reward.

An investment that carries a higher risk will also carry a higher reward. The issue is what level of risk you are prepared to accept for the level of reward.

Risk is not inherently bad

Many people see ‘risk’ as inherently bad: the thing that will lose you money.

However, risk is not inherently bad, or inherently good. It is simply a probability.

Attitude to Risk

Attitude to risk is a highly personal thing.

Some people are happier with a much higher level of risk because of the potential reward. Other people prefer to keep the risk low, recognising that their rewards will also be lower.

Attitude to risk can also change over time.

Sometimes you may be happier with a higher level of risk because you have longer to recoup the potential losses if something goes wrong. For example, if you invest in a pension fund in your 20s, you may be happier for the fund manager to take more risks in managing the money than when you are in your 50s, and expect to want the money within the next 10 years.

There are two keys to safe and confident investing.

  1. Understand your personal attitude to risk—and ensure that any independent financial adviser or fund managers that you employ also understand your attitude.

  2. Manage your financial risk across your portfolio. In other words, don’t think about risk so much in terms of each individual investment, as across your portfolio (collection of investments) as a whole.

Managing Risk Across Your Portfolio

Each investment that you make carries a certain risk. However, when you hold several different investments, you also have an overall level of risk across the whole portfolio.

This means that it is possible to invest in a few high-risk ventures, such as start-ups—but balance this by also holding some very low-risk investments such as government bonds.

Funds use this principle. Instead of holding individual stocks and shares, they hold ‘funds’, which are groups of stocks and shares selected by a fund manager. This allows them to balance the risk against the reward, and keep the overall risk level of the portfolio at the required level.

WARNING! ‘Wrapping’ is still risky

Wrapping up high risk and low risk products together is a statistical ‘fix’ for a problem.

It does NOT remove risk entirely.

The high risk products are still very risky. It’s just that there aren’t very many of them included in any package or ‘wrapper’, so the loss to any individual investor is limited.

This was the problem with the US sub-prime mortgage market a few years back. Banks had developed a process to lend to people who were considered at high risk of default by ‘wrapping’ these mortgages up into ‘packages’ with less risky investments. Overall, the package looked reasonable, and the banks were able to raise funds against them. However, once large numbers of people started to default on their mortgages, the problem became very apparent, and the value of these investments dropped dramatically.

Types of Investment

There are four main classes of assets in which individuals can invest:

  • Cash, for example by putting money into a savings account;

  • Shares, where you buy a stake in a company;

  • Bonds, also known as fixed interest securities, which are promises to pay issued by large companies or governments; and

  • Property, both commercial and residential, and including land.

    Buy land, they aren’t making it anymore.

    Attributed to Mark Twain, used as a marketing slogan by ethical clothing company Howies

It is possible to invest in any of these classes of assets individually.

For example, plenty of people buy flats or houses to let, with a view to making money on the investment. Others dabble in the stock market, buying individual stocks and shares.

However, it is perhaps more common to invest in funds.

These are pools of money from multiple investors that are brought together and managed with a view to growing the fund. There are several different types of funds, but generally speaking, a fund will hold several different types of investment, including all the classes above. You can also invest in a ‘fund of funds’, which is a fund that holds investments in other funds. This is a very good way to balance the level of risk across the portfolio, because no fund will be exposed to a lot of risk.

Fund Manager or Self-Investment?

There are now plenty of online platforms that enable you to make and manage your own investments (and there is more about this in our page on Online Banking and Other Financial Services).

However, should you manage your own investments, or use a fund manager?

If you use a fund manager, you will have to pay fees, and these will eat into your returns (the profits on your investments). Self-investment will save you any fund administration fees, and give you the fun of doing your own research and making your own investments. However, it will also mean that you make your own mistakes.

Overall, research shows that managed funds consistently outperform individual investors.

The bottom line is that if you want to make money, you will be better off paying someone to manage your investments.

Whatever route you choose for investing, get advice first.

Before you invest, it is a good idea to get advice from a good independent financial adviser.

They will be able to help you select the right classes of assets, or recommend one or more suitable funds that will match your investment objectives and attitude to risk.