What do we mean by investing?
Investing means taking a lump sum of money (capital) and placing it into an investment vehicle (a financial product designed to achieve a particular investment goal).
The right investment vehicle for a specific investor (the person investing) depends on:
- the amount of investment risk they are willing to take; and
- their investment goals
Investment risk refers to the possibility of the value of the investor’s capital falling. The amount of investment risk an investor is prepared to take with their capital mainly depends on:
- how comfortable (or uncomfortable) they feel about the value of their investment going down as well as up; and
- their previous experience of investments
In addition, an investor needs to think about how long they wish to invest for and whether they’ll need to access (withdraw) their capital during that time.
There are three main reasons people have for investing:
- To protect their capital
For example, Jenny’s parents have saved £10,000 to help her out when she starts university in 5 years’ time. They don’t want to invest anywhere that may lead to them losing some or all of the £10,000. They need a secure home for the money.
- To use their capital to create an income
Jenny’s Nan has £30,000 that she wants to invest to increase her pension income. She doesn’t mind taking a little bit of risk with this money if it means she can earn a better interest rate than the one available from her local building society.
- To grow their capital, i.e. to increase its value and make a profit
Jenny’s brother received £10,000 on his 21st birthday. He doesn’t need access to this money and is prepared to take a risk with it if it means he has a greater chance of making a profit.
Types of investment
Once an investor is clear on how much risk they are prepared to take with their capital and what their investment goals are, they can generally choose between three main types of investments – these are often referred to as the asset classes:
By cash we mean savings accounts such as the notice, fixed-term and regular saver accounts we examined earlier. As you know, these pay interest. UK savings accounts are secure because they are protected by a compensation scheme.
One of the ways governments and companies raise money is by issuing bonds. The investor effectively lends their capital to the bond issuer (the government or company behind the bond). In return, the bond issuer promises to pay a six-monthly interest payment and, at a set date in the future, to repay the investor’s capital.
The compensation scheme that applies to cash does not apply to bonds. If the bond issuer goes out of business, the investor will no longer receive interest payments and may not get their capital back. This makes investing in bonds riskier than investing in cash. Bond issuers therefore have to pay a higher rate of interest than banks and building societies to tempt investors. Issuers with the lowest credit ratings (a credit rating indicates how likely an issuer is to go out of business) pay out the highest rates of interest and vice-versa.
An alternative way for a company to raise money is by issuing shares. When you buy a share in a company you become a part owner of that company (a shareholder). The more shares you buy, the more of the company you own. Investors buy shares in the hope that they will receive an income payment every six months – known as a dividend – and that the share price will rise over time.
If a company makes a profit, chances are they will be able to pay a dividend and their share price will rise. However, if they make a loss, they will have no money with which to pay a dividend and the share price will fall.
Shares generally make more money than cash and bonds over the long term. But, there are no guarantees.
Thinking about Jenny’s parents, her nan and her brother, which of the three investments do you think might suit their needs? What are your reasons?
With thanks to our partners over at the NMBA for content.
Up next week – RETIREMENT PLANNING!