What Can I Invest In? (Investing For Beginners 1)
If you have been convinced of the benefits of investing, perhaps by my article on how you can benefit from Einstein’s so called ‘eighth wonder of the world’, but don’t know how to get started, then this introduction guide is for you. It can be hard for investing beginners to understand all the terms and know what they should invest in. By the end of reading, you should understand the different options you have to invest in. I will also introduce you to one of the most important things to consider when deciding what to buy, the relationship between risk an potential returns.
Know your options:
Shares (also known as stocks or equities)
Buying a share means buying a small part of a company. Just like anything else there is a market for, the price of a company’s shares will depend on their demand. Demand is determined by investors’ feelings towards the company or its industry as well as sentiments about the wider economy.
A company may use their profits to pay out dividends to shareholders. Dividends help add to your returns but should not be seen as a reliable source of income.
Bonds
Bonds are issued by a government or a company as a way for them to borrow money. They are similar to a regular loan in that the government or company must pay interest periodically to whoever holds the bond. Each bond has an end date when the loan must then be repaid in full. Bonds are generally seen as less risky than shares and their price will be less volatile, but they are likely to give you a lower rate of return.
Funds
Funds are a collection of different investments. For instance, an equity fund will be a collection of shares in many different companies. Many funds are multi asset-funds. These kinds of funds hold different types of assets (or asset classes) like shares, bonds, property investments and more in an attempt to balance risk and return; some funds are even a collection of several different funds. Funds are generally less risky than individual shares because rather than relying on the success of one company risk is spread over several companies and other assets.
When buying a fund, you are pooling your money into a big pot which is used to buy investments. How your money is invested depends on which type of fund it is.
Active funds try to beat market returns
Investment decisions in active funds are made by a fund manager. The manager will have a strategy but will be free to buy and sell assets to try and make the best returns possible. However, less than half of active fund managers manage to do so in most years and even fewer manage to do so over the longer term.
Active funds require intensive research by their analysts, and they must pay transaction costs when they buy and sell assets. They are therefore usually expensive to hold. It is important to remember that a cost of a fund is one of the most important determinants of its performance, and a difference of just tenths of a percentage point in cost can add up over time.
It is also important to remember that the past returns of a fund do not indicate its performance in the future. In fact, it is statistically very unlikely that an active fund performing well in one market period will continue to do so in the next.
Passive funds try to match market returns
Passive funds do not trade very frequently. They will follow a set investment strategy and make periodical readjustments to keep to that strategy. For this reason, they tend to be much cheaper to hold as they require less time and effort to operate.
Passive funds tend to hold many more companies and other assets than active, although this will vary from fund to fund. This generally means the risk investors are taking is more spread out and is likely to be lower.
Many passive funds simply try to replicate a market index, which will be the top companies in a certain market, such as the UK, or the whole world. Companies will be weighted by what investors call ‘market capitalisation. This means the value of a company relative to the rest of the market. For instance, the FTSE 100 is the top 100 companies in the UK. If the total value of all the companies in FTSE 100 was £100 but the value of the top company in it was £10, then that company would make up 10% of the index.
Understanding Risk and Return
One of the most important lessons when investing is the relationship between risk and potential return. In general, there is a positive relationship between risk and potential return, meaning the greater risk of incurring losses you are taking, the greater the potential return if things did go your way. For instance, when buying a ticket for the national lottery, the risk of losing your money is very high, but the potential returns from a jackpot win are huge.
Different asset classes have different risk levels, and therefore different potential returns. This is demonstrated on the graph below.
The risk and potential return of different asset types
Although the graph is generally true, there will be exceptions to the rule. For instance, depending on a government’s financial situation, their government bonds may have a greater risk and/or return than bank deposits. Some mixed asset funds may be very adventurous and only invest in higher risk assets, this kind of fund would probably involve a higher risk than a simple index tracker equity fund.
Next up
Now you know your main options for investing, and a little bit about one of the most important relationships you need to understand when investing, between risk and return. However, you may be wondering where you should go to actually buy investments in the first place. It is also important to realise that investing may have tax implications, some of which can be avoided. These topics will be the subject of my next article.
Risk warnings
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, platform or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
This article was produced for educational purposes and aimed at UK residents.
Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
Share this content
