Investing your money: the fundamentals
Once you’ve got your financial foundations in place, you’re ready to invest for your future. So what’s the best way to invest your money?
There are three ways you can do this.
1. DIY: buying individual shares
You open a stock brokerage account, do some research and imagine you’re the next Warren Buffet!
There are so many risks associated with DIY investing. Your time is better spent on what you’re really, really good at, also known as your ‘unique excellence’, which for almost all people is not investing this way.
You may decide to use a little of your investment money to do this if you enjoy the process; I have some individual shares myself, but it’s a fraction of my overall portfolio.
DIY investing isn’t where you should start – you can make room for it after securing your main portfolio if it’s something you’re interested in.
2. Active management
You buy a fund (group of shares) which is actively managed by an individual. He or she buys and sells shares and their aim is to ‘beat the index’ by delivering greater returns than a tracker fund would (see below).
Virtually all active fund managers fail to outperform the index they’re measuring against over a prolonged period of time when you take everything into consideration, such as their fees.
However, you will see some fund managers outperform the index periodically. If you’re working with a financial adviser that sells or recommends these sorts of funds, you may be shown results from a period of time where the fund manager has done just that.
A couple of points on that:
- Make sure the index comparison is fair. For example, it would not be fair to compare an emerging markets active fund with a cash bank account (an extreme example!) – but it should also not be compared to a UK-only tracker fund. Instead, it should be benchmarked against possibly the MSCI Emerging Markets Index.
- Similarly, a UK actively managed fund should be benchmarked against the FTSE All Share for example.
- As much as beating the indices sounds exciting and entrepreneurial, the probability is that you can’t do it if you’re DIY investing, and academic research over years and years shows that in the long-term, even the professional active fund managers won’t either.
3. Index funds (AKA tracker or passive funds)
Three names that essentially represent the same thing. Rather than an individual managing your money, your investments are managed by a computer or a team and spread over a wide range of the index.
A well-known example is the FTSE 100 index tracker fund. You would own shares in all 100 companies in the FTSE 100 and you typically own them in size order: more of your money is invested in the bigger ones, and less in the smaller ones.
What’s important about index funds is that they are not all the same. Some track only the UK, some track international markets, some track emerging markets.
For me, passive funds are the best way to invest. Over time they have consistently provided better returns when fees are taken into account.
Once you’ve decided how to invest, there are a few factors to consider how you should move forwards.
How long until you need access to the capital? This is your first consideration.
- The longer you stay invested, the better. The value of your investment WILL fluctuate, and over time it will go down as well as up.
- You should only invest in the stock market if you do not plan to take out the money for at least five years, and preferably seven. This gives you time to ride out the inevitable ups and downs and see a return for the risk you are taking.
How much could your investments fall before you begin to feel uncomfortable?
- Your investment will be split between the markets (equities) and low-risk, fixed income products (bonds). More equity means more ups and downs – in a big market fall such as 2007-08 or the dotcom bubble in 2000, your equity investments will typically fall 50%.
- If you had £100,000-worth of equities, that could drop to £50,000: how do you feel? (And that’s without all the negative headlines that would accompany the crash, which can have an additional impact on how you feel.)
- This is why time in the market is so important, to ride out the inevitable fluctuations – rather than timing the market, trying to predict those ups and downs.
- The fluctuations are why you need to dilute your risk with a proportion of bonds or fixed income investments – they’re low risk, low yield. How big a proportion? As a rule of thumb, hold 100 minus your age in equities; e.g. in your 40s, you’d hold around 60% equities.
- As you approach retirement or the time you need to take your money out of the markets, consider tweaking down the proportion of equities you hold to reduce your risk accordingly.
- That rule of thumb does mean that even in your 80s, you might hold 20% of your money in the markets. You need to see greater returns than inflation, which is eroding at any cash you hold in accounts, to ensure you have enough money to see you all the way through your retirement.
Which type of account should you hold?
- You have three main choices: pensions, stocks & shares ISAs or a general investment account. For the vast majority of people, a pension is the best option to take and you should maximise your allowance before investing elsewhere. They defer tax and can sit outside of your estate for inheritance tax.
- In the age of auto-enrolment, your workplace pension is usually where you should look. But do check the charges: your investment returns must beat inflation and the charges associated with the fund.
- An ISA can trump a pension if you’re saving for a specific event, such as a wedding or property purchase, because ISAs offer easy access to your money.
You should be investing your money globally, not just in the UK. There used to be something called home bias recommended by financial advisers, but in today’s global economy that increases your risk unnecessarily.
If you look at historical data, a balanced fund of 60% equity and 40% fixed income products across international markets fell far less than a UK tracker fund during the market falls in 2000 and 2007-08 – and recovered faster, and is ahead today.
The US represents over 50% of the world’s stock market; the UK around 9%. You’re limiting your growth if you focus just on our domestic market, and you’re increasing your risk too.
A final thought on investment fundamentals: nobody knows what’s going to happen next. We don’t know if the markets will fall or grow in the short-term, so don’t base your decisions on trying to predict. Focus instead on getting your asset allocation right – your ratio of equities:bonds – invest globally, sit tight and think long-term. Those are the most important fundamentals of all.