Beginner investors: tips, secrets, & mistakes to avoid
To a beginner, the world of investing can seem a daunting place. There's a lot of jargon to deal with and an awful lot of investment products to understand. And what about tax, risk and costs?
But armed with some tips and hints - and also making sure you avoid some common mistakes – it's quite easy to start investing.
Before you start
There are several important factors you need to consider before investing. Firstly, why do you want to invest? Are you investing for something specific, such as for your child's education, your retirement or for a rainy day? The length of time you're investing for will help influence what investments are suitable for you.
The next thing to consider is how much risk you're prepared to take. Julian Chillingworth, chief investment officer of Rathbones, says understanding risk is very important. "We point out to clients that there's a chance they could lose half their money with some investments. If investors don't want to take any risk, they'll be better off keeping their money in the building society."
Different asset classes, such as equities and bonds, have different levels of risk, and funds will have varying levels of risk too. Tom Stevenson, investment director at Fidelity Worldwide Investment, explains: "A higher level of risk gives the potential for greater returns but also greater losses. Conversely, if an investment takes low levels of risk, it might offer limited long-term growth potential. By taking time to think about your attitude to risk, you can reduce the chances of nasty surprises further down the line."
Armed with this information about how long you're investing for and how much risk you're happy to take, you can focus on your financial goal and how much money to invest. Remember to set aside some money for emergencies, so you don't have to pull your money out of your investments early.
Andrew Merricks, head of investments at Skerritts Wealth Management, warns: "Calculate how much ready cash you need for emergencies or expenses. Then double it. Things invariably cost more than you expect."
Now it's time to think about your investment strategy. A big part of the strategy will be around whether you're investing for income or growth, or a mix of both. In other words, whether you'd like to receive some money from your investments regularly, or whether you'd like to grow your investment as big as possible and then take all the money when you eventually cash it in.
If you're after income, you might want to look for dividends, whereas for growth you might consider the emerging markets.
Make a plan containing all this information and refer to it while you're making your investment decisions, so you don't get tempted to invest in inappropriate products. And pay close attention to our tips and secrets to ensure you get your investment portfolio off to a flying start.
Top Three Tips for beginners
1. Protect your investments from the tax man
After you've spent time building an investment portfolio, you don't want to give a chunk of it away to the tax man. Use a stocks and shares Isa to shelter your investments from income and capital gains tax. There is a limit to how much you can put in an Isa – for the 2013/14 tax year, it's £11,520. You can use the whole amount for a stocks and shares Isa or part of it (up to £5,760) in a cash Isa, with the balance in stocks and shares.
2. Don't overpay
High costs can also eat away at your investments. Thankfully, there is a variety of options for investors that want to keep costs down. If you're happy to build a portfolio yourself, check out Compare Fund Platforms (comparefundplatforms.com) to find the cheapest online platform, based on what you want to invest in. If you're interested in buying investment funds, remember passive funds (funds that follow an index up and down and are not actively managed by a fund manager) are cheaper than active funds.
Merricks points out an investment trust can be cheaper than a unit trust and "you can sometimes get a similar portfolio for cheaper". Whatever product you choose, make sure you always compare the fees (such as the total expense ratio) before you invest.
3. Do your homework
Investing requires time and commitment. Chillingworth says his best advice for beginner investors is to put the hours in – do some background reading and understand what you're investing in. "If you're prepared to invest in the equity market, take the time to understand the company – never invest in a company with a business model you couldn't explain to your mother or grandmother."
Four secrets of investing
1. Understand compounding
When your investments pay you an income, such as a dividend, you can either take the money or reinvest it back into the market.
"The power of reinvesting this income is what makes equity investments so attractive and over time the compounded growth of dividend income provides the lion's share of the total return from an investment," notes Stevenson. Garry White, chief investment commentator at
Charles Stanley, adds: "Reinvesting dividends can turbo-charge your portfolio and provide greater returns. This effectively means you are generating future earnings from past earnings." Such is the brilliance of compounding, even Albert Einstein called it "the greatest mathematical discovery of all time".
2. Don't time the market
There's no point trying to time the top or bottom of the market, as you will likely get it wrong. The best method is to decide how much you want to invest each month or quarter and drip-feed it into the market. "This forces you to invest no matter what the market is doing, helping you to avoid the poor decisions most people make when trying to time the market," comments White.
By investing regularly, rather than with one big lump sum, your investments will be smoothed by a process called pound cost averaging. According to Fidelity, investing £1,000 in the FTSE All Share index 15 years ago could have returned £2,098 but if investors tried to time the market and missed the best 40 days the same investment would only be worth £380 today.
3. Be honest about what you don't know
"Investing is simple but it is not easy and over-confidence is dangerous for investors," explains Stevenson. Even Warren Buffett, one of the world's most successful investors, avoids investing in businesses he doesn't understand. He refused to invest in internet stocks during the dot-com boom because he didn't understand the business models.
4. Learn your acronyms and ratios
It's vital you get your head around investment jargon. The terms used to show how expensive an investment is include total expense ratio and annual management charge, while if you're investing in shares there are different ways of measuring their value – comparing a share price to earnings, assets or sales are widely used methods and the dividend expressed as a proportion of a share price is another good guide. To help understand some of these terms, visit moneywise.co.uk/investing/first-time-investor.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.