On the face of it saving and investing seem like the same thing. They are both things that we do with our spare money, after all. But deeper thought suggests that there is a difference between them.
Saving is almost an unconscious act where we put money into deposit accounts, or even an old jam jar on the sideboard, so that we have something for that proverbial rainy day. It is a way of giving our ordinary life a bit of security so that we don't find ourselves strapped for cash at some point.
Investing is more of a conscious decision. It is about making plans for the future so that we know we can cope with expensive events like retirement or weddings.
Question time
When you save money, your capital is secure. You are (usually) guaranteed to get back the sum you put in, plus interest.
When you invest you have no such guarantee. Your capital is at risk. In return for this, you expect to get more back than you put in, plus a little income on the side as well, perhaps. So when you consider any investment you need to ask yourself a few basic questions:
- How much extra return can I expect, and with how much probability?
- Do I really understand what I'm investing in?
- Do I appreciate the risks I'm taking and how volatile this investment could be?
Before you invest...
You need to make sure the rest of your finances are in order, before you start investing.
Firstly, you need to get out of debt. By this we mean all debts apart from your mortgage. So you need to have paid off your credit cards and any personal loans you may have. The reason is quite simple. It is unlikely you will make more from your investments than you will pay in interest on your debts. So pay off your debts first. Arguably, it will be the best 'investment' you will ever make.
Secondly, you need to put cash aside for emergencies. How much cash is appropriate will depend on your circumstances. If you have dependents, or if you are uncertain about your job prospects, then you might more put aside than others. One rule of thumb is that you should have enough cash set aside for at least three months' living expenses.
Last of all you need to be prepared to invest your money for a minimum of five years and preferably a lot longer. Although you can expect to get more by investing than saving, the value of your capital will fluctuate all the time.
If you need to get your money out in a hurry then you may not get everything back. So, if you want to use your money to put down a deposit on a house or buy a new car, then investing is not the best way to do it. If you need a guaranteed amount of money within less than five years, something like a high-interest savings account is a much more sensible option.
2. Why You Need To Invest
The first step in choosing an investment is deciding what you what to achieve. For example, are you saving to provide your kids with money or a better education? Are you investing for your own retirement or just looking to make the most of your money?
Retirement
For most people the main reason for investing is retirement. The real value of the Basic State Pension dwindles each year it seems. In the UK, the government taxes the employed and uses that money to pay out pensions. Years ago, everything was tickety boo because there were lots of employed people and relatively few pensioners. However, our population is ageing and the sums simply don't stack up anymore.
In order to relieve the pressure, pension increases are now relatively modest and the age at which we can collect our State Pension is being pushed back.
The message is clear, we can't rely on the government to fund us through our twilight years. We have to do that ourselves.
Kids
Don't you wish that you had had a lump sum when you turned 18 or 21 to get started in life? Perhaps you did and now you realise what an enormous difference that made. Investing is most powerful when you start early and you can't invest much earlier than when you are still wearing nappies.
You might want additional funds to give your kids a better education, or to pay for university fees. With forethought and planning, investing can give you this option.
Lumping It
Many of us get a lump sum at some point in our lives. It may come from an inheritance or a bonus. You want to put it to good use but, having never invested such a large amount before, you're at a bit of a loss as to what to do.
The key here is to take it slowly. There's no need to invest everything immediately. Instead, drip your money into a variety of investments so that you can get comfortable with how they work and what level of risk and return they offer.
3. What Are Your Options?
How on earth do you choose an investment from the thousands of products that are available? Skimming through the weekend papers, we are bombarded with impressive-sounding numbers and pretty pictures. Where do you start?
A little background knowledge can help clear the fog. Despite the thousands of products on offer they all consist of just four basic investments, albeit in different quantities. They are cash, bonds, property and shares.
Cash
Safe, dependable cash. You know where you are with cash. You get paid interest too -- but take off tax and then adjust for inflation and you're usually left with next to nothing.
Bonds
Bonds are essentially loans that can be bought and sold. The most common are government loans, or gilts. But you can also trade corporate bonds, which are loans to large companies. The capital value of bonds moves up and down in relation to interest rates. Over the long term, gilts and bonds should return slightly more than cash, but not by much.
Property
Many people believe that property is the best investment of all thanks to rising house prices over the last few decades. The value of your house may have leapt over the years, but don't forget all that money you have paid out to fund the mortgage!
Just how well property has done is actually quite hard to calculate however (you need to include bills for repairs and maintenance for example). In addition, it can be awkward to buy and sell -- you can't sell little bits here and there when you need the money.
Most people already have a large chunk of their assets in property, by virtue of owning their own home. So, for the purposes of this guide, we're going to ignore it from hereon in.
Shares
Shares, or equities, mean investing in a company like Vodafone (LSE: VOD), Unilever (LSE: ULVR) or Tesco (LSE: TSCO). You can buy shares in individual companies yourself, or you can buy a fund that invests in a broad range of companies on your behalf.
4. Why Shares Are Best
So which asset should you go for as a long-term investment?
Numerous studies have been done about the rates of return that each of them have produced down the years. Generally speaking, assets that have demonstrated higher returns tend to be more volatile, especially when you look at short periods. And the asset that has generated the best returns over the long term is equities.
Average returns
According to Credit Suisse First Boston, here are the average annual returns for the UK since 1900. These figures are adjusted for inflation, also known as the real return. This is because you want to compare like with like, i.e. spending power now versus spending power in the future.
| Cash | Bonds | Shares |
|---|---|---|
| 1.0% | 1.3% | 5.3% |
The numbers may look small but you need to consider the power of compounding. It's a virtuous circle, or snowball effect, meaning that even a real rate of 'just' 5% can produce a large sum, given enough time. It also means that apparently small differences can have a significant impact on the final amount.
Let's look at what would happen to £10,000 invested over 20 years at the above rates (i.e. still adjusting for inflation).
| Cash | Bonds | Shares |
|---|---|---|
| £12,200 | £12,950 | £28,090 |
We must stress however that these returns are certainly not guaranteed. These figures are the average returns from the past 110 years.
Looking at shares, in the 1980s and 1990s, returns were a lot higher, while in the 2000s they were much lower. They could be higher, or lower, over the next 10, 20 or 30 years as well. No one knows.
Still, it is worth pointing out that these performance figures include the Great Depression that followed the 1929 crash, World War II, Black Monday in October 1987, the Asian Crisis of 1998 and the two bear markets we've endured since 2000. Investing in shares over the short term is very risky, but the longer you invest for, the less risky and more profitable it should become.
Watch out for charges
At this point we should also mention charges. All else being equal, the lower the charges you pay the higher you can expect your eventual return to be. As we saw in the table above, even small percentage differences can make a huge difference to the final amount. Unfortunately, here in the UK we have a financial services industry that has a talent for both high charges and clever marketing to obscure that fact!
The industry also loves to put several layers of middlemen in between your money and its eventual investment destination. Each takes their cut and that leaves less for you. So make sure you read the small print, as all investment products have to lay out their charges in what is known as a 'Key Features' document.
5. Common Investing Vehicles
Most people use some sort of investment vehicle that invests on their behalf. Here we go through the basic characteristics of the most common ones.
Unit Trusts, OEICs, ETFs and Investment Trusts
These are all types of funds that predominantly invest in shares. Some of them may invest in a particular industry, country or region whilst others will invest in the whole market. They are also responsible for most of the colourful adverts in the weekend papers. These are the most flexible type of product, allowing you to get your money out at any time.
The charges for ETFs and investment trusts tend to be lower so, given the choice, we'd lean towards them rather than unit trusts or OEICs.
Pensions
Pension funds invest in shares, bonds, property and cash. You get tax relief on money you invest in a pension but there is a catch. In fact there are two of them.
First, you can't touch your money until you retire. Secondly, you have to use your money to buy an annuity which means you give up all your capital in return for regular income.
A pension is usually seen as the standard way to save for your retirement but in reality it is just one of the options. Unfortunately, their obscure nature and inflexibility means that the charges on them tend to be quite high.
ISAs
Strictly speaking an ISA is not actually an investment product, although it often gets confused with one. It is just a tax-free wrapper that sits around a fund like a unit or investment trust.
Like you, we quite like paying less tax. So there's a good chance that whatever we decide makes a good first investment, we'll want to protect it in an ISA.
> Read more on ISAs
With-profits and endowment policies
These products have been much criticised in recent years. And rightly so. They are highly inflexible beasts that require you to commit to investing a regular amount over a long time. That's no bad thing in itself, but if you do not manage to keep up the payments you end up paying heavy penalties.
These products are 'sold' rather than being bought. Like pensions their inflexibility and lack of clarity tends to result in high charges.
With-profit bonds attempt to smooth out the return of the stock market by awarding annual bonuses that cannot be taken away. But the largest bonus is kept right until the end and many people don't get that far.
As we saw earlier, over long time periods the stock market tends to rise so these 'guaranteed' annual bonuses offer little value. Therefore you pay a lot in charges for something that probably won't be necessary.
So where does that leave us?
What we want as a first investment is something simple and low cost. Therefore we're leaning towards a fund like a unit or investment trust, probably in an ISA. Onwards!
Why Trackers Make Sense
Having decided that we want a fund, how do we choose one?
The two basic types of funds
Funds can be split into two basic types.There are 'active' or 'managed' funds where the fund manager picks and chooses the shares on your behalf, getting paid handsomely for the privilege we might add.
Then there are 'passive' funds that merely buy the whole market or a certain section of it. These are known as index trackers because they attempt to track an index. An index measures the overall performance of a group of companies, such as the FTSE 100 (the 100 largest shares on the London Stock Exchange).
The 'active' vs 'passive' debate
Active sounds much more fun doesn't it? We all want to beat the market. By definition, before we take charges into account, half of our investment will do better than the overall market and the other half won't. When you take off charges and transaction cost, you can see that it's inevitable that most funds will underperform the market. We put that in bold, because we think it's rather important.
What this means is that, most people are better choosing a fund with low charges. And passive funds have the lowest charges. They are run by computers and computers tend to be a lot cheaper to run than fund managers. They don't eat, drink, drive fast cars, have to pay a mortgage or send their kids to posh schools.
In fact, studies have shown that over the long term (5 years+) index trackers tend to beat about three quarters to four fifths of managed funds.
Of course, there will always be some funds that do better than index trackers. The only trouble is identifying them in advance. Some people claim they can, although it's a lot more difficult than you might think. For one thing, oodles of research has shown that the past performance of a fund is no guide to its future performance.
For your first investment though, you want to keep things both simple and cheap -- and we thinks that means some sort of index tracker. So, begone managed funds!
The Benefits Of Regular Investment
Plumping for an index tracker takes a lot of the worry and stress out of investing. However, you may still be concerned that you might invest at the wrong time, for example when the market hits a temporary peak.
Tune out the noise
The trouble here is that you never know what the stock market will do next. Many column inches are devoted to predicting the short-term direction of the market, but it is all just pure speculation. No one knows which direction the market is heading although that doesn't seem to stop everyone having an opinion (unfortunately).
The best thing to do is ignore all this noise, which we appreciate is easier said than done.
The key thing to appreciate, in our opinion, is that the long-term direction of the market is upwards. You can't time your entry to perfection; the most important thing is taking part. There's an old investment saying that's worth mentioning here -- it's about 'time in the market' not 'timing the market'.Clever, eh?
Pace yourself
An excellent way of pacing your investments is by regular investment of say £25, £50 or £100 a month into an index tracker. Or even more if you like. Pretty much every fund has a regular savings scheme set up these days. Usually the costs are extremely low. Setting up a regular investment is also a good discipline, meaning that you effectively force yourself to invest every month. It's a good habit to get into.
Likewise, when you finally cash in your investment, the reverse of this strategy makes sense. Rather than taking your money out in one go, you can sell gradually. Of course, you may decide that the stock market is the best place for your money in perpetuity and that you intend to live off the dividends and let your capital grow further.
To ISA Or Not?
Earlier we said that whatever we plump for as a first investment, we'll probably want to shelter it from the taxman by using an ISA. So let's spend a little time looking at ISAs.
Double the protection
An ISA protects you from both income tax and capital gains tax (CGT).
The income tax benefits are not what they were. Basic rate taxpayers don't have to pay tax on dividends, so you only benefit if you're a higher-rate taxpayer.
The key attraction of an ISA is the protection from CGT. The CGT rate of 18% is a lot less than it used to be, but it may not feel that way when you're writing out a big cheque to the taxman. And, although you get an annual exemption from CGT (£10,100 when we wrote this guide), if you're investing regularly over a number of years, you can soon build up profits far greater than this amount.
Tax rates change
Tax rates change over time as well. So although investments aren't taxed that significant at the moment, that may not always be the case. Of course, at some stage the government could also decide to do away with ISAs as well. We think that's less likely however, as it seems a sure-fire vote loser.
It pays to protect your investments right from the very start, even if you are investing as little as £25 a month. Most funds can be put in an ISA for no additional charge so you're getting valuable protection at no additional cost. Think of taking out an ISA as free insurance against paying tax in the dim, distant future. You may not need it, but it's nice to have it just in case.
Going Beyond Trackers
Yay! We finally got there.As an first investment, we think an index-tracking fund in an ISA is a great place to start.
We'd recommend that you look at UK index trackers first and ideally, you want one with annual charges of 0.5% a year or less.Here's what was on offer in Spring 2009.
For many people, regular investment in a small number of index-tracking funds will cover a large chunk of their investment needs. However, if you want to do , then you have to be prepared to get your hands grubby.
Buying funds
The first way you can try and beat the market is by investing in managed funds. As we said earlier in this guide, only a minority of managed funds actually do better than trackers, so this is a lot tougher than you might think.
But you may decide that you want a bit more exposure to overseas markets like the US or the emerging BRIC countries (Brazil, Russia, India and China). Or you may want to focus on a particular sector like healthcare or technology.
You can, of course, get trackers that follow other markets and sectors. The ever expanding range of exchange traded funds is a good and cost-effective place to start.
One thing to beware of is investing in an area just because it's done well recently. We're hard-wired to take recent events and extrapolate them far into the future. It's a condition called, er, recent events syndrome. Many new funds are launched on the back of what's done well in the last two or three years, often just as this particular investment runs out of steam.
Buying individual shares
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As always, it's important to keep your costs down. We've partnered with Halifax to create The Motley Fool Share Dealing service. Ordinary trades cost just £10 and you can also set up a regular investment plan for £1.50.
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Finally...
One thing we haven't touched on in this guide is asset allocation, but this is something you need to consider as your portfolio becomes more substantial.
Asset allocation is the process of maintaining a broad spread of different assets. The idea is simple -- by owning assets that do well under different economic conditions, you can make your overall portfolio less volatile but without reducing your overall returns
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