Essential rules for first-time investors
Investing in the stockmarket for the first time can be a daunting, not to mention confusing, experience. While all investors always run the risk that the value of their investment could go down as well as up, novice investors face an even greater challenge.
From deciding whether to put your hard-earned money into a tracker fund, an actively managed fund, a multi-manager or a combination of all three, the thousands of different funds out there and wide range of different fees and charges involved can make many novice investors feel out of their depth before they even begin.
Current volatility in the global economy has not helped matters. Gloomy headlines and even gloomier trading reports have hit share prices hard, yet despite the onset of the credit crunch, investing in the stockmarket is far from a recipe for disaster.
According to figures from Lipper, over a 10-year period to the end of June 2008, the average instant access savings account grew by 16.81%. Compare this with the 39.94% return if you had invested in the average UK all companies fund and the message is clear – if you have money to spare, then investing in the stockmarket is the way to go.
Calculate the risk
Before you decide where you want to invest your money, it’s vital you weigh up the amount of risk you are prepared to take. After all, because we all have different goals when investing, your level of risk will depend on factors such as your age, how much you want to invest, what you are investing for, how long you want to invest and what sectors you want to invest in.
Many novice investors unfortunately make the mistake of following fashion and picking the current top performers. A word of warning however - last year’s winners will seldom be this year’s success story, as those who had their fingers burnt investing in the dotcom boom in the late 1990s will testify.
Matt Pitcher, an independent financial adviser at Towry Law, urges caution. "Novice investors often don’t realise that many investment managers who come top one year languish in the fourth quartile the next," he says. "It’s always a big danger chasing performance."
More recently, the biggest boom sector has been emerging markets, made up of funds investing in companies in fast-developing countries such as Brazil, Russia, India and China, the so-called BRIC countries. These economies have performed well to date and the long-term growth story is good, but they are volatile, making them a high-risk investment.
Traditionally, UK equities have proved a sensible investment for novice investors, as many of these funds invest in blue chip and medium-sized UK companies with solid growth prospects, however given the current volatility in the market it could be worth looking further afield.
"We would always suggest a novice investor, with no experience of the UK’s ups and downs, have a spread of asset classes such as global equities," says Pitcher. "This strategy can reduce the risk of volatility and shield their money from any downturn in the markets."
Once you have decided how much you want to invest and in what sector, the next big decision novice investors need to make is whether to choose a tracker or an actively managed fund. Index tracking funds are known as passive investments, and have become one of the most popular ways to invest in the stockmarket.
Investment selection is carried out by a computer to mirror the performance of a given index, so if the index rises, so does the value of your fund and vice versa. Actively managed funds on the other hand, are funds that are run by a fund manager who picks and chooses which stocks to buy and sell, with the sole aim of outperforming the market.
These funds rely on the skill of their managers, who scour the entire market for under-researched investment ideas while trying to control risk.
One of the most heated debates about investment funds is on the relative merits of choosing a passive over an actively managed fund. Passive funds can be a good starting point for those dipping their toes into the stockmarket for the first time, as they combine an easy to understand approach with lower charges than many actively managed funds - most have no initial charges and cost less than 1% to run every year.
They also take the guesswork out of the market because instead of trying to beat it, they join it. "Trackers make a good base for a portfolio to which investors can then add actively managed funds investing in particular areas," says Gavin Haynes, managing director of Whitechurch Securities. "It’s also important to remember that a large proportion of actively managed funds fail to beat the index over the longer term, and only a handful do so consistently."
However, there are several drawbacks to tracker funds. While they may provide a good deal in rising markets, when a bear market begins to bite trackers often slip down the fund performance league tables. They also have no flexibility to move into more defensive stocks to protect their investors’ capital, unlike an actively managed fund.
Actively managed funds also have the potential to dramatically outperform trackers, especially with volatility in the world’s stockmarkets increasing so substantially over the past year. "Fund managers that beat the market consistently do exist," says Philip Pearson, an independent financial adviser at P&P Invest.
"They should be strongly considered in times of volatile markets and can really add value to a portfolio over a medium to long term." The trick, of course, is making sure you choose the right one.
Diversify, diversify, diversify
With volatility in the world’s markets increasing so substantially over the past year, the ability of investors’ portfolios to absorb the impact of stockmarket slumps has never been more important. As such, many investors have been looking to make multi-manager funds the core of their portfolios. Here fund managers invest in a range of other funds, rather than individual companies which means that investors get exposure to a bigger range of sectors and stocks, which in turn reduces risk.
The fund manager will also ditch funds if they start to tumble and switch holdings to make the most of the prevailing economic conditions. In addition to offering diversification in an instant, multi-manager funds also give novice investors access to fund managers they may not otherwise have access to, as well as the ability to invest in areas of the market only available to professional investors.
However, multi-manager funds don’t come cheap – initial costs vary between 0% and 5.5%, while annual charges can be up to 2%. Nevertheless, recent research suggests that investors can really profit from the multi-manager approach over the long term. According to Investment Life & Pensions Moneyfacts, around 60% of global growth multi-manager funds have delivered top quartile performance within their sector over the past 10 years.
"Diversification through a multi-manager fund helps to reduce risk and volatility for novice investors with less stomach for a rollercoaster ride," says Richard Eagling, editor of Investment Life and Pensions Moneyfacts. "The diversification offered by multi-manager funds in today’s economic climate has certainly made them a particularly popular choice among those investors looking to sleep easier at night."
However Philip Pearson believes that multi-manager funds may not be a sensible choice for a first-time investor. "Adequate diversification can be achieved with a multi-asset fund which invests in a spread of asset classes, without incurring the additional expense of the multi-manager approach."
Regardless of the type of fund you go for, it’s always worth making sure you hold it in a stocks and shares individual savings account. Each year you can invest up to £7,200 a year tax-free in stocks and shares, or £3,600 with the remaining £3,600 in a cash ISA. The good news is that every penny earned in interest is free from the taxman’s grasp. The majority of funds can be held in an ISA and accept regular contributions from £50 a month upwards.
Thanks to something known as ‘pound cost averaging’ saving little and often can be less daunting than investing a significant lump sum and helps remove some of the worry when markets fall. This is because when markets are falling and prices are lower, your money buys you more shares, leaving you better positioned to profit when prices start climbing back.
When choosing your fund it is important to consider the charges you’ll pay the investment company for running the fund. If you go direct to an investment company you will pay an initial fee and an annual management charge, which could be 3% to 5% of your initial investment, with an AMC of up to 1.5%. This can work out expensive but the good news is you can cut this cost by buying from a discount broker or fund supermarket.
Discount brokers, such as Hargreaves Lansdown, Bestinvest and Chelsea Financial Services are essentially intermediaries that place your money for you. They often have a small or no initial charge and reduced annual management charges. "We offer a wide variety of funds and most investors will pay little or no initial charge," says Ben Yearsley, an investment manager at Hargreaves Lansdown. "We also rebate a small part of the annual management fee too."
Fund supermarkets on the other hand, such as Interactive Investor, offer an extensive range of investments with competitive fees and charges, meaning investors can spread their ISA allowance across a number of funds. Investing online is quick and easy, and, because funds can be filtered by provider, sector, performance yield and risk rating, it’s reasonably easy to narrow down your choice.
"As all investments can be consolidated in one place, investors can monitor the performance of their portfolio against certain benchmarks," explains Rebecca O’Keeffe, head of fund management at Interactive Investor.
Unfortunately, although discount brokers and fund supermarkets make it easier for you to manage your investments, and offer a degree of guidance, they do not offer specific advice, so doing your research is crucial should you choose this route. If you are uncomfortable with selecting and monitoring your own investments, or you have a significant sum to invest, contacting an independent financial adviser would always be a sensible move. To find one near you, go to unbiased.co.uk or call 0800 085 3250.
Investing in the stockmarket is always a risk - there is no guarantee that your funds will do well, and there’s always a chance that you will lose money. However, history has repeatedly proved that if you have time and can afford to tie up your money for five to 10 years it’s worth investing in equities. There may be ups and downs along the way, but you should be better off in the long run.
Investment funds that invest in other investment funds from a wide range of asset managers and are often referred to as funds of funds. Some multi-manager funds only invest in the funds of the investment house providing the fund of funds and these are known as “fettered”. An “unfettered” multi-manager fund is free to invest in what the fund manager believes are the top performing funds from across different markets and industries. Investing in multi-manager funds means your risks are spread across geographical regions and industry sectors but it also adds another layer of charges and some multi-managers also levy an out-performance fee.
There are limits to how much you can invest in any tax year. For 2011/12, the limit is £10,680. Of that, the maximum you can invest in cash is £5,340 and the balance of £5,340 can be invested in shares (individual company shares or investment funds). If you don’t take the cash ISA allowance, you can invest up to £10,680 into a stocks and shares ISA.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
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.
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.
Named after a high value gambling chip, the term is used for an investment seen as solid and whose share price is not volatile. Blue chip companies are normally household names and have consistent records of growth, dividend payments, stable management and substantial assets and are the bedrock of a pension fund’s portfolio.
This refers to a market situation in which the prices of securities are falling and widespread pessimism causes the negative sentiment to be self-perpetuating. As investors anticipate losses in a bear market and selling continues, pessimism grows. A bear market should not be confused with a correction, which is a short-term trend of less than two months. A bear market is the opposite of a bull market.
An acronym, which stands for Brazil, Russia, India and China; countries all deemed to be at a similar stage of advanced economic development. The term was coined in 2001 in a report written by Goldman Sachs director Jim O’Neill who speculated that, by 2050, these four economies would be wealthier than most of the current major G7 economic powers.
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.
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).
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%.