How to invest in 2016: the basics
Why invest when I can save?
‘A penny saved is a penny earned’ – perhaps in the heady days of high interest rates, but now, with the ‘new normal’ being near-zero interest rates, saving your money in an average bank account is akin to withdrawing half of it every decade and dumping it in the bin.
Without delving into the sticky whys and hows, it’s sufficient to know that, as of now, banks don’t need to compete for your money in the form of deposits and so the interest rates they are offering for the use of their savings accounts are poor.
There’s more potential gloom, too: inflation.
Inflation is a figure used to track the increase in prices for goods and services over time. If you’re of a certain age, you may remember Space Raider crisps being 10p. Now they’re 20p (after coming back down from 25p) - inflation at work.
When the cost of something goes up, the purchasing power of your money goes down. Most western governments target a small, consistent inflation rate year-on-year, the reasons for which are beyond the scope of this article, but the point is that while 2% inflation year-on-year looks like a small figure, over time this eats into your savings if interest rates are lower.
Simply: if you are earning 2% from your savings every year and inflation is also at 2%, over time £1000 will still buy you £1000 worth of goods. But if your bank is offering 0.5% and inflation is at 2% your money will degrade in value and your £1000 will quickly be worth less.
A quick example: if you’d slipped £100 under a mattress in 2006, it would now be worth £75.19 in terms of spending power. Of course, this is with a zero interest rate coming your way, but with some mainstream saving accounts currently promising to pay you 0.1% on your deposits, you can see the point being made.
There are other points to consider, like the tax benefits of saving into an Isa, but the short of it is that the reason for investing rather than saving in 2016 is: while savings accounts are nice and safe and investing is riskier, your money is more likely to hold its value and even increase in value with the latter. Wealthy people let their money work for them, and you can do that, too.
Is investing for me?
Before you begin investing with gusto, there are points to consider. After all, investing isn’t for everyone and certainly not compatible with all lifestyles and circumstances.
• Am I willing to lock away my money for at least 5 years – and more likely, 10+?
Investing is a long-term game and if you have expenses such as a house deposit, education fees, a large wedding etc. on the horizon then you shouldn’t invest any money earmarked for these outgoings.
• Do I already have a ‘rainy day’ fund in the form of 3-6 months’ worth of living expenses in an easily accessible account?
Despite the ineffective nature of savings accounts right now, not having a healthy amount of cash hidden away for unforeseen expenses is a dangerous way to live.
• Am I already investing in the form of a private or workplace pension plan?
If you’re already siphoning money off to a pension plan, you’re already investing – albeit into an account that you won’t be able to access until you’re at least 55. If plenty of your pay cheque is going here already, perhaps you needn’t invest aggressively.
• Do I already have debt?
Especially unsecured debt such as an outstanding credit card balance or a bank loan. If you do, then clearing these must be your priority. This is because the interest on the majority of consumer loans will far outstrip anything you can earn through investing – what’s the point in getting 4% back on your money if you’re spending 25% servicing debt?
• What is your attitude to risk?
Savings accounts don’t pay much, but they’re safe. Investing has the potential to make you rich, but you pay for this with risk. If you’re young and have disposable income to spare, perhaps you won’t worry so much about losing money through a bumpy market – after all, you’ve got decades of investing ahead of you and loses and gains are like fashion – it’s all cycles.
However, if you’re older, gambling your hard-earned and saved stash of cash on the global financial markets might make you wince. If you’re going to need your cash within a decade for living expenses, it would be wise to put your money somewhere safer instead.
What is the FTSE, the S&P etc.?
You’ve no doubt heard these acronyms bandied about with glee all over the news. There are many more, too – the Dow Jones, the Hang Seng, the Nikkei…
These are indexes. They are used to describe the health of a market economy. The best known in the UK is the FTSE100, which is an imaginary portfolio of the biggest 100 companies in the UK that are listed on the stock exchange.
If the number goes up, it means that those companies taken as a whole are performing well. It also means that, in all likelihood, any pension fund you may contribute to is also performing well, as it will be invested in these companies.
The FTSE 100 index is the most talked-about in the UK, but there are innumerable indexes. Remember that the FTSE 100 lists the largest 100 companies. There is also the FTSE 250 index (no prizes for working out what this represents) and then more specialised ones – indexes that track the stocks for companies in biotech, green energy, even ‘sin’ indexes, which chart the health of tobacco, gambling and defence companies.
You can use the general indexes to get a quick look at the health of economies and world politics. Generally, economic or political turbulence will create shockwaves in markets. For a recent example, the poor performance of Chinese stocks in the New Year has caused markets all over the world to tumble.
You can also invest your money into these indices as a whole through ‘tracker funds’ – but more on that later.
Can I afford to invest?
If you can spare even £25 a month, then yes, you can.
Once upon a time, investing required large amounts of capital, your own personal broker and access to all manner of esoteric resources and knowledge.
But now, with the advent of online access to banking systems and huge competition from trading platform companies, investing is as easy as managing your bank accounts – and it can be as cheap, too.
If you’re worried that saving paltry amounts is simply not worthwhile, take a look below to see how small amounts invested in a fund can grow to impressive numbers*.
If you had invested with the Legal & General UK 100 Index fund (Class I Accumulation**) from the beginning of 2006 until January 2016:
At £25 a month you would have £3,908
At £50 per month you would have £7,816
At £100 per month you would have £15,632
*Data provided by Adam Laird, Passive Investment Manager at Hargreaves Lansdown.
**An accumulation fund simply means that all the money you make is invested back rather than withdrawn, so instead of getting a certain percentage of cash, you plough it straight back into shares.
How tracker funds work
Tracker funds make up over 11% of all the money invested in funds in the UK. Their growth has been exponential and they have provided a doorway for millions of ordinary people to get their money working for them.
Often referred to as ‘passive funds’, they are markedly opposite to the traditional active fund. An active fund is where you pay somebody to look after your money, to research and understand the economy and buy and sell shares on your behalf. This is often expensive and – surprisingly – not a very reliable way of making money.
Tracker funds aim to follow a particular index. If you put £100 into a FTSE tracker fund, you will buy £100 worth of all the shares represented, and if the FTSE rises 2%, so will the value of your investment – you’ll have £102. If it loses 2%, you will lose 2%, too.
That’s it. The surface-level simplicity and lack of fuss with tracker funds is why it’s so cheap and easy to use them – a price war online has led to yearly fees being as low as 0.1% with some.
This isn’t to say that they’re without risk – all they do is track, and there are issues with some funds ‘lagging’ behind real index performance. If the FTSE, or S&P, or whichever fund you’re tracking performs terribly, so will your investment. You could lose money.
Why falling stock prices are good for you
The panic when stock indexes fall is palpable. This panic often leads to a mass selling-off as people gorge on the bad news and hurriedly flog their shares, desperate to recover any money that they can in the process.
It’s understandable if you’re nearing or in retirement and need that money soon. But if you have time on your side, now is the time to move.
This is because when stock markets fall by significant amounts, those shares are, essentially, on sale. By pumping more money into a tracker fund at this point you’re buying far more shares than you would be doing otherwise for the same amount!
The likelihood is that within a few years the markets will have rebounded and you’ll be sitting pretty on top of a pile of discounted shares.
Of course, if the markets continue to fall to eventually crash and MPs are spotted helicoptering away clutching briefcases stuffed with gold, the last thing you’ll be worrying about is your portfolio of investments any way. So seize the opportunity.
How do I start investing?
As mentioned before, the internet has brought access to investing to millions. All you need is a National Insurance number, a bank account and access to the internet.
The first thing to understand is that investing is done through a trading platform. This acts as an online portal where you sign up, transfer some money into a financial product offered by said platform – such as a stocks and shares Isa or Self-invested personal pension (Sipp) – info for both of these can be found here and here – and then choose where you want to invest.
Fees and charges vary, but for the everyday investor who will simply transfer a relatively small amount of money each month into big funds and trackers rather than take part in more dangerous ventures such as spread-betting and day trading (things you should only even think about with a lot of research and appetite for risk), these will be kept extremely low – under 1% and often capped at agreeable amounts.
You can try Interactive Investor (or Hargreaves Lansdown – all of the info is provided and the customer service for both is generally excellent.
Diversification should be your first priority
Warren Buffet, one of the most successful and well-known investors of all time, said: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
There’s no shame in admitting that when it comes to modern global finance, the majority of us are indeed quite ignorant. After all, it’s a sector that encompasses every single aspect of life, from politics to research and development to agriculture, education, defense, infrastructure… everything. Therefore, diversification, for those of us who don’t have the time to spend hours a day studying balance sheets and keeping up with highly specific industry news, is absolutely key.
All it means is that instead of dumping all of your money in one stock, or more realistically, one index (such as the FTSE), you split your money across different classifications of things to invest in.
For example, instead of investing 100% of your money into, say, the FTSE 100, you could split your available cash into four and choose four territories – for example, the UK, the USA, China and, if you like a flutter, an emerging economy.
Or you could be broader and invest some of your funds into stocks and shares, some into bonds (essentially a way of buying an IOU from a government or company), some into precious metals, some into commodities and some into property.
You don’t need to keep track of all of this. All it means is that if the UK starts performing badly, you’ve bet on another sector of the global economy doing better, thus mitigating your loses.
Pound-cost averaging – your second priority
This sounds technical but it really isn’t. All it means is smoothing the bumps in the rocky road that is investing.
You may have noticed that stock markets can lurch up and down with alarming violence. This is the nature of the game, and you must tame it.
Imagine putting a lump sum of £10,000 into a tracker fund. The next day, the index you’re following falls by 5%. After a while it climbs up again. Then down. You’re at the mercy of the throes of the market and start obsessing with your profits and losses. You’re completely exposed.
Now imagine splitting the lump sum into halves and spreading your payments across two months - £5,000 in August and £5,000 in September.
With the market heaving to and fro, you’ve managed to buy more shares when the index is down and prices are low, and fewer shares when prices are high.
By investing at regular intervals you’re working with average prices rather than spikes and troughs, and this sensible approach, for a lot of casual investors, is key to peace of mind. It might not be as thrilling, but it cuts down on risk.
Managing your expectations
The last point to remember is to be realistic. The internet and bookshops are more than happy to shout about the latest schemes to get rich quickly or with little to no effort.
For all but the luckiest people (think about early employees of Microsoft who had stock options invested before Windows 95 hit), this isn’t going to happen.
Likewise, obsessing over your investments and checking them every day will also lead to stress and most probably disaster as the temptation to rebalance and shift things around proves too much.
Keep in mind that investing is long-term. If you keep at it for at least a decade, dutifully putting aside sensible amounts that you can afford each month and diversifying, in all but the most extreme circumstances, such as The Great Depression in 1929, you will more than likely come out with an amount of money that makes a mockery of what you’d have gotten if you’d just saved instead.
So this year, if you haven’t started already, perhaps it’s time to get serious about investing. Take a look at what you can afford at the start of each month, and get it working for you. After all, you worked hard enough to get it in the first place.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
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%.
A scheme originally established in 1944 to provide protection against sickness and unemployment as well as helping fund the National Health Service (NHS) and state benefits. NI contributions are compulsory and based on a person’s earnings above a certain threshold. There are several classes of NI, but which one an individual pays depends on whether they are employed, self-employed, unemployed or an employer. Payment of Class 1 contributions by employees gives them entitlement to the basic state pension, the additional state pension, jobseeker’s allowance, employment and support allowance, maternity allowance and bereavement benefits. From April 2016, to qualify for the full state pension, individuals will need 35 years’ of NI contributions.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Used by the holder to buy goods and services, credit cards also have a monthly or annual spending limit, which may be raised or lowered depending on the creditworthiness of the cardholder. But unlike charge cards, borrowers aren’t forced to pay the balance off in full every month and, as long as they make a stated minimum payment, can carry a balance from one month to the next, generating compound interest. As the issuing company is effectively giving you a short-term loan, most credit cards have variable and relatively high interest rates. Allowing the interest to compound for too long may result in dire financial straits.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
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.