Investing 101

๐Ÿ‘‹ Welcome to Investing 101.

If you’re new to investing, you would’ve most likely heard of people becoming obscenely wealthy or losing out massively based on a single buy. These events are outliers in the world of investing. You don’t need to fear financial ruin when starting investing – but neither should you expect to become a millionaire overnight. Done right, your progress will be slow and steady.

Before we start… โฏ๏ธ

Check our flowchart to make sure you’re at the stage where you’re ready to invest. This means having sufficient income to cover your needs and a full emergency fund set up.

If you’re not there yet, you can of course keep reading and learning, in fact we recommend it. Just don’t invest any money you need for essentials!

What is investing? ๐Ÿ“ˆ

Investing is the process of buying an asset, like shares in a company, with the expectation of profiting over time. Almost everybody holds investments, even if they don’t realise it. If you have a workplace pension, you are an investor!

Investing is necessary because the spending power of money reduces over time, due to inflation (meaning that the cost of buying goods, housing, and services goes up over time). As history shows, savings accounts pay interest at a lower rate than inflation, and so even if the cash balance itself doesn’t appear to reduce, the spending power of that money does.

The longer you hold cash savings for, the more dramatically inflation erodes their value. This is why your workplace pension is invested – over such a long period, it would be impossible to save enough to fund your retirement using cash savings. Investing your money allows your savings to grow faster than inflation.

Since 1950, investing in equities has produced an annual after-inflation return of 5.2%. However, over the short-term the values can fluctuate wildly – for example, global stock markets fell by over 20% in a single month between February and March 2020 as the COVID pandemic hit. For this reason it is incredibly important to make sure that equity investing is only used for longer-term objectives.

What assets can I invest in? ๐Ÿ›’

The best understood option by most is the buying of shares, or “equities”. When you buy shares, you are actually buying ownership of a very small slice of the company in question. You will participate in any distributions of profit (dividends) and you may expect the value of those shares to increase over time.

Other investment assets include fixed-interest securities (also known as bonds), where you lend money to a company or government, usually with the promise of regular income payments (coupons) and the return of your originally invested capital at a predetermined date.

What risks are involved? ๐ŸŽข

Investing in the markets brings many additional risks over keeping cash in the bank, which we refer to as โ€œmarket risksโ€.

These can result in significant short-term fluctuations in the value of your capital and income, meaning that if money is withdrawn at the wrong time losses may be crystallised.

This is why it’s important to have a full emergency fund before you consider investing your money, and not invest any money you expect to need within the next 5 years. Remember, you canโ€™t always control when you need access to your money.

For a more detailed examination of volatility and what it means for your investments see this Monevator post.

Investors hope to be rewarded for taking additional risks by receiving greater returns over the longer term.

Why diversify my investments? ๐ŸŒŒ

Diversifying your assets/investments is one of the greatest ways to reduce risk to your portfolio during the long term. Investing in different industry sectors, countries and bonds will ensure your portfolio is not reliant on anything in particular.

For a simplified idea of diversifying, imagine a scenario where each company we invest in has a 60% chance of growing in value, and a 40% chance of going bust.

If we invested our entire portfolio, into one company, we have a 60% chance of growth. However, a downside is that there’s a 40% chance of losing our entire balance. Scary right?

So what happens if we add in one more company to invest in? The probability that both companies go bust is only 16%. Adding a third company, reduces this value to just 6.4%. After investing in ten companies, we’ve now hit 0.004% chance of losing our entire portfolio.

Investment funds will spread asset allocations across thousands of companies at a time.

What are “passive” and “active” investing? ๐Ÿ”ฎ

A passive investment strategy involves depositing money into a global index fund. This fund will have your money automatically invested and diversified across many companies with no effort from you. The companies will be representative of the global market as a whole, so the performance of your fund will be that of the overall average of the market.

Passive investing is set-and-forget, and is one of the easiest methods for getting started, with the lowest fees.

Active investing is any strategy that deviates from this in an attempt to provide higher returns, such as:

  • Picking specific companies to invest in which you think will do particularly well
  • Investing in an actively managed fund, where the fund manager picks companies they think will succeed
  • Picking funds which cover specific sectors or regions you think will perform well, e.g. tech, renewable energy, large US companies, emerging markets
  • Market timing: attempting to buy low and sell high to make a profit

In addition to passive and active investing, there are active-investment management companies, called “Robo-Investors”, such as Nutmeg, Moneybox, Pensionbee, Wealthsimple, and so on.

These companies generally invest into passive index funds, but actively alter the weighting between them. “Robo-Investors” are known for their high fees and heavy advertising. They do reduce the complexity of investing for somebody who is starting out, but at quite a high cost. You can see what impact additional fees have on your investment returns here.

What type of investment account should I use? ๐Ÿ›๏ธ

You can buy investments inside a number of different types of account. They differ in how they’re treated for tax purposes, and in when you can access the funds you invest in them.

  • A Stocks & Shares ISA: all growth and dividends within an ISA are tax-free, and you can withdraw your money tax free at any age. This is the place to start for any goal other than a house deposit or retirement.
  • A pension: these are accessible from age 57 onwards. They are usually by far the best choice for saving for retirement.
  • A Stocks & Shares Lifetime ISA (LISA): this type of ISA is most useful if you are saving for your first home, as you receive an extra bonus of up to ยฃ1k/year to help your deposit grow. They can also be used to save for retirement (age 60 onwards) – see the wiki page for more information.
  • A General Investment Account (GIA): these can be accessed at any age. However, your capital gains (investment growth) and dividends are subject to tax, so they should only be used if you have maxed out your ISA allowance.

If you’re not sure what type of account to use, see our page on ISA vs LISA vs Pension for detailed calculations.