Financial education: Part 6 – investment options
You’ve decided that savers are only getting poorer due to the corrosive effect of inflation and the best way to achieve your life goals and plot a course to financial independence, is to become an investor; financial education is the key.
DIY Investor, and sister site Muckle are not about being geeky; it aims to bring together like-minded individuals with goals to reach, experience to share and a belief in the benefits of financial self reliance.
Achieving better financial outcomes by investing a little of yourself in the process – as Benjamin Franklin said ‘An investment in knowledge pays the best interest.’
‘An investment in knowledge pays the best interest’
In this latest episode, we take a very high level look at the investment options that exist to you as a ‘newbie’ investor.
It is designed for those that want to be in control of their finances and see it as a way to enhance the quality of their life, but actually have better things to do with that life than paw over spreadsheets
A good investment tip is to invest in things you understand and here we take a look at the basic investment options that are available; the range of available investments is virtually limitless, but the four fundamentals are shares, bonds, property and cash.
We explain a little more about each one and you may care to revisit Part 5 to remind yourself how you might access them.
Or possibly as the men in red braces might have it – ‘equities’ or ‘stock’ – before going for the jugular by appending words such as ‘common’ or ‘prefs’.
Shares are really very simple; your investment literally buys you a share in the ownership of your chosen company.
There are different types of share, known as ‘share classes’ and these come with different privileges; some may allow you to vote at the annual general meeting on decisions such as the salary of the CEO.
As a fractional owner, you may get a share of the profit of the company which is paid to shareholders in the form of a dividend.
This is where it is worth spending a little time understanding the company you are considering; whilst some companies will have a track record or returning predictable and reliable dividends, others may choose to retain their profits to fund growth or perhaps pursue acquisitions.
‘dividends can be withdrawn as ‘income’ but are most effective if reinvested to buy more shares’
Shares can form a valuable part of an investment portfolio; dividends can be withdrawn as ‘income’ but are most effective if reinvested to buy more shares. In addition, the price of a share can rise over time meaning that you may be able to sell your shares for more than you paid for them – ‘capital growth’ in the parlance and a key objective of so-called ‘stock pickers’.
Share prices rise and fall all the time and the greater the difference between peaks and troughs in a share’s price is known as its volatility; this is why owning individual shares can be very risky – if the ambition is to buy low and sell high, the converse is also possible.
Shares in different sectors – mining, banks etc – may behave differently in any given circumstances, so building a portfolio with a range of different shares diversifies your risk.
The price of shares in larger companies are quoted on the stock exchange; in the UK the main stock exchange is called the FTSE and it is possible to buy a ready-made portfolio representing the whole stock market (or ‘index’) called a tracker. This investment will be as diverse as the range of companies in it.
Learn more about shares here
Bonds are pretty simple too; they are a loan from an investor (you) to a company or a government in return for a set amount of interest (a ‘coupon’) for a set amount of time (its ‘duration’) until your loan is repaid in full.
For example when Acme Inc. issues a bond for 10 years at 5%, those that buy it are lending the company their money for 10 years, which it might use to fund its growth; for example, on an investment of £10,000, Acme will pay the investor 5% per year, or £500, and at the end of the ten years, the original loan of £10,000 will be returned to the investor.
The interest payment – coupon – is agreed when the loan is made and maintained until the bond matures so bonds are sometimes called ‘fixed income’ investments; in simple terms that £10,000 has returned £15,000, but because payments are phased, earlier payments could be put to work or reinvested for the remainder of the loan period.
‘Bonds are usually less risky than shares’
The bond can usually be bought and sold at any time during the ten year period and the price will depend on how the interest rate it offers compares with interest rates more widely; if interest rates are low, the bond will be relatively attractive and the buyer will have to pay more than the £10,000 initially paid.
When a bond is issued it has a face value – the amount that the borrower promises to repay to the investor at the end of the loan; this is known as ‘par’. If a bond has a par value of £100 it may trade for more or less than this in the ‘secondary market’ – ‘above par’ or ‘below par’ according to its attractiveness to investors.
Because it offers a better interest rate than maybe available elsewhere, an investor in our fictional company might consider it good value at £105 in year four; the investor would then receive six years of coupons at 5%, but would only get £100 at the end of the loan.
The creditworthiness of the borrowing company is important; a company, or indeed country, that is seen as more risky, with a lower credit rating, will have to offer a higher interest rate to attract lenders.
Government bonds (sometimes ‘sovereign debt’) are the main way a country can raise funds without increasing taxes; the UK treasury issues bonds which are known as ‘gilts’ which are considered one of the safest investments around although rates are commensurately low.
Bonds are usually less risky than shares, because interest rates do not change on a day-to-day basis, although a shift in interest rates will affect all bonds.
Like shares, individual bonds are generally more risky than a portfolio of bonds, and it is possible to buy a bond fund representing a large collection of individual bonds.
Learn more about bonds here
Albeit that the housing market has cooled of late, the difficulty of accumulating a deposit and getting on the housing ladder is well documented, but when it comes down to property for investment, there are essentially two choices – residential, which is accessed by buying-to-let, and commercial, which is most often accessed by property funds.
Whichever you choose, a regular income stream can be achieved from renting the properties out and you would also hope that the ‘capital value’ of the property will increase as well – i.e. you are able to sell it for more than you paid for, as you would hope to do with any investment.
Because property prices have hiked massively in recent years it is easy to forget that this has not always been the case; now in some areas of the UK, and elsewhere, property prices are falling back.
Unlike ‘on exchange’ investments like shares and bonds, property is an illiquid asset; it can take months, or even years, to find a buyer for a property and longer still to complete on a sale and receive funds.
Up until that point, your original deposit and any ‘equity’ – increase in the value of the property – are locked in until you sell the house.
Interest rates can also pose a big threat; if you have a mortgage and the interest rate goes up, it might be some time before you are able to increase your rental income to cover the mortgage costs.
For those choosing buy-to-let there is also the extra costs of buying and maintaining a property, such as stamp duty, solicitors’ fees and insurance.
‘add property to their investment portfolio with less stress’
Given the complexity, and shifting tax-treatment of buy to let, those wishing to add property to their investment portfolio with less stress will find there are plenty of investment funds that will spread your risk across a number of properties and sectors.
Real Estate Investment Trusts – REITs – are companies established to invest in property; shares in them can be bought and sold on exchange and they may be the ideal way for those new to investing to include property in their portfolio.
Learn more about property investing here
See The True Cost of Buy to Let Investing infographic here
Included because every investor should ensure that they have access to a rainy day pot should the unforeseen happen; cash is held on deposit and is very secure on the basis that it is not subject to investment risk.
The biggest threat to your cash is inflation; if you have £1,000 in a savings account, at the end of year 1 you may have earned £10 in interest and your balance will show £1010.
However, with inflation at 3%, the buying power of your savings will have been eroded by that amount; the ‘real’ value of your savings at the end of that year will therefore only be £980 and the corrosive effect of inflation over a long period can be significant.
Despite the fact that interest rates have recently nudged up, it is still very difficult to achieve interest payments in excess of inflation.
In theory the only other threat to your cash is if the bank fails; however unusual, banks have failed in the past although your cash is usually protected by the financial services compensation scheme up to a maximum of £85,000 in each bank.
So, you’ve decided that investing is for you and we’ve looked at the investment types that you may consider, we’ve also looked at the account types available and the levels of input required of each.
‘There is no right or wrong answer – there is ‘right for you’ and there is ‘right for you at that particular time’
Next time around we’ll debunk ‘asset allocation’ and consider what proportion of your investment portfolio each investment type could make up.
Just as it is safer to invest in a number of shares rather than individual shares, it is safer to invest in a collection of asset types rather than a single type; ‘asset allocation’ is purely a mix of investment types intended to ensure that you have a good chance of benefitting from investment types that are on the up, but have your risk spread around should markets downturn.
For example it is riskier to invest everything in the FTSE100, rather than having some gilts and bonds as well; the type of assets you pick, and what proportion of each will depend on your appetite for taking on risk.
A slow and steady approach will typically have more fixed income, while a more growth focussed strategy will tend to have mostly shares from a range of countries, but may have some other assets as well.
There is no right or wrong answer – there is ‘right for you’ and there is ‘right for you at that particular time’ because things will change over the course of what should be a long term investment strategy.
The key is to find what works for you – Do it Yourself, Do it With me, Do it For me – just don’t do nothing!