There are many people who are scared to invest their money. They prefer to leave their money in a bank or building society. While it’s true the value of your savings will not goes up or down on a daily basis, but I am going to show you why failing to invest can cost you money in the long run. And we’re not talking about a small amount of money; we’re talking about thousands and thousands of money here!
There are 5 main types of asset which one can invest in. They are:
* Cash (e.g. a savings account with a bank or building society);
* Bonds (e.g. a loan to the government or a large company);
* Property (e.g. residential or commercial property);
* Equities (e.g. shares in companies); and
* Commodities (e.g. copper, oil or coffee)
A general rule of thumb is that the riskier an asset is, the greater return you’d expect to earn from it over the long term. We’re going to talk a lot about the “long term” in this guide – generally it means 5 years or more.
Cash is generally considered to be the safest asset to invest in, but it also likely to give you the lowest return over a period of several years or more. Bonds are slightly more risky than cash but normally generate roughly the same level of return over the long-term. Property tends to do well over a long periods and the returns are quite stable. The returns from equities and commodities vary the most from year to year, but tend to have the highest return of all the investment over long periods of time.
A key point to recognise here is that if you want to earn a high rate of return, i.e. higher than you’d typically get from a savings account, you need to accept some risk. That means getting comfortable with the fact that your investments will go down in value some of the time.
When To Invest
You might just start work and you’re looking to invest for your retirement. Investing in shares can also work well over shorter periods, too.
Even over a period as short as 2 years, the chances of shares beating cash are 2 in 3. However, most people, we included, advice that you shouldn’t invest in shares for any period shorter than 5 years. The rationale here is that the chances of losing money if invested less than 5 years, while fairly small, are still quite significant.
For example, there have been two occasions in the past 100 years where shares have fallen for 3 years in succession. So you’re usually better off sticking to cash if you have definite plans for your money in the next five years (to put down a deposit on a house for example).
So when should you invest? The earlier the better, grow money now. It’s advisable to keep a portion of your money in cash, in case of emergencies. 3 to 6 months’ salary is a good guide as this is often the period that you’ll need to cover before any insurance policies you have may have start to pay out.
Once you have an emergency fund in place, the longer you give yourself to invest, the greater your returns are likely to be. So invest as soon as you can. There is a risk that you will invest just before stock market takes a tumble. There is very little you can do about this. No one knows when share prices will go to over the next minute, day or month. All we do know is that the long-term direction of the stock market is up – but it’s not a straight line!
In practice, you’re unlikely to invest all your money at one particular point in time. It’s far more likely that you’ll invest small amounts of money on a regular basis. So while you might see immediate stock market falls some of the time, most of the time this won’t be the case.
What about property and commodities?
The more observant among us may have noticed that we seem to have lost two asset classes in the last few paragraphs, namely property and commodities.
There a few reasons for this. First of all, annual return figures for shares are a lot easier to measure. Property figures are complicated by factors such as rent and how to account for maintenance costs.
It’s also a lot easier to buy and sell share-based investments, as we’ll see later. You can’t just sell one room of a house for example and property transactions can take months to complete.
The indications are that investing in property and commodities is likely to give you a similar long-term return as equities. So all three types of asset are well suited to long-term investment plans.
Property investing, via buy-to-let, is obviously very popular at the moment and benefits from the fact you can ‘gear up’ your investment by putting down a small deposit and borrowing the balance of the price. This can magnify your returns over the long term although it does add additional risk as you have to continue to find money to pay interest on what you borrow. Property does have another advantage over equities as the returns tend to be less volatile and it has been much rarer for it to fall in value over the course of any given year.
Commodities are somewhat of a curiosity. They tend to have long periods of poor returns followed long periods of good returns. After many years in the wilderness, they have recently undergone resurgence – the spectacular rise in the price of oil is an excellent example.
The best way to invest in shares
You can invest directly, buying and selling shares in individual companies. If you have the time, and lots of discipline, this can be best way to go.
Many people feel more comfortable getting a fund manager to do the investing for them. You can get funds that invest in particular markets such as the UK, China or the Asian country. You can also get funds that invest in certain types of industries, such as biotech or mining. You can get even funds that just invest in smaller companies (as there some who believe that small companies offer greater potential returns).
As a rule you pay up to 5% as an initial fee when you invest and around 1.5% each year to the people who manage these funds. There is a cheaper alternative – you can invest in funds where the decisions about where and when to invest are made automatically according to a strict set of guidelines and not by an overpaid fund manager!
Typically, these sorts of funds, called index trackers, will cost you nothing in initial charges and around 0.5% a year. Over the course of, say, twenty years these lower charges mean you end up keeping a lot more of your money.
Lower charges mean index trackers perform better than most other funds (often called managed funds). Indeed, over a period of 5 years, an index tracker is likely to beat 75% to 80% of other funds. Over longer period it’s likely to do even better.
A few words on asset allocation
Many advisers have strong views on how investors should allocate their assets, meaning what proportion they should put into cash, bonds, shares and so on. One approach is that the percentage of your portfolio that should be invested in bonds should match your age. So at age 30, you should have 30% in bonds, and at age 40, 40% and so on.
Here, we’re not overly fond of these sorts of rules. For starters, bonds have proved to be poor long-term investments, even though they have done well over the last decade or so. Secondly, constantly adjusting your portfolio to invest in this manner racks up a lot of unnecessary charges.
