Episode 13 How to begin investing

How to begin investing

In this episode I am going to look at the practical first steps for an investor in the UK. To be honest it is probably the hardest episode I have had to write so far! There are so many options and so many different starting points that it is impossible to provide a universal answer that will suit everyone. In the end I settled on looking at beginners, those who are perhaps in work and have been for a couple of years or those who have finally found they have some money left over at the end of the month and want to know what to do with it.

Remember that first of all you need an emergency fund of at least three months money in a cash deposit with instant access. You also need to keep in cash any amounts which will be needed in the next five years. That could be a deposit for a house or one of expenses like a new car or special holiday. If you are renting then look back at episode 12 and decide whether or not to save for a deposit on your own home. Only after all of that should you look at taking investment risks.

I would love to be able to see everyone get quality financial advice before they invest but sadly that is almost impossible. The cost of regulation on advisers coupled with the fact that they have not been allowed to earn commission on investment products since 2013 has driven up the price of advice. Most advisers charge a percentage of funds under management and with less than £50,000 to invest, they make less than £500 a year which, with a process of many hours,  barely covers the cost of setting up the file. The banks are talking about simplified advice offerings including “Robo-advice” but it is not the full package. I remain sceptical till convinced otherwise of its value.

I cannot give advice but I can recount a conversation that I had with my son. He featured in an earlier episode when I explained the benefits of compound interest. He was wondering about the best way to start investing.

There were three main questions to be answered,

  1. How much to save?
  2. In which investment product? and,
  3. In which investment fund?

How much to save clearly depends on a number of things, not least of which is, how much can you afford each month? But make sure that you can afford it. There is a degree to which you need to manage your enthusiasm. If you save too much you will find a day comes when you need to access your investment. With that comes the temptation to take out all of it! It is exceptionally easy to convince yourself that you will put it back in one day and justify a splurge on a holiday, car or blow-out! It’s far better to build up to it over time. Review it at least annually to see if you can afford a little more, most people can a tenner here or there. If you get a pay rise or bonus save about a third of it. That way you can enjoy most of the raise/bonus but still benefit your long term future.This is a a really important point. Commit to investing for the long term one third of every increase in income or any windfall. Not only does it increase your pot significantly over time it stops your standard of living from rising to levels that you will not be able to afford when you stop working!

 When you are tempted to access your investments, remind yourself of the reasons why you are saving it. You will of course have to save at least enough to meet the minimum contribution limits! Thankfully you can start with as little as £20 a month which should be manageable for most people.

Next, deciding on the correct product. This is pretty straightforward in the UK and there is a consensus that once you have your emergency fund, life cover and income protection insurance sorted out, any regular investments should be into an Individual Savings Account (ISA). There are cash ISAs and stocks and shares ISAs and rather than going into all the differences I have put a link here to moneysupermarket.com.

Each provider offers something slightly different. So much so, that you will quickly become bewildered trying to pick the best option. I will do my best to simplify the situation. What they all have in common is that there is no tax on the growth. That is there is no income tax or capital gains tax on the returns you make. Inheritance tax does apply but if you are rich enough to have that sort of problem you can afford an adviser to tell you what to do!

Charges: Some providers charge as much as 5.5% of your contribution on every contribution. All of them will charge annual fees which can be as little as 0.5% up to well over 1.5%. Usually the higher the fee the more active is the fund manager. I will come back to this in a minute. Costs eat in to your return so if you pay more you need higher returns so that the growth after the charges is better than a cheaper alternative.

Now we will look at which investment fund to choose. There are two broad types, active and what are called “passive or tracker” funds.

An active manager aims to outperform its benchmark by buying and selling holdings. The theory is that a good manager knows when to buy and sell and can spot bargains while avoiding companies which are likely to underperform.

A tracker aims to mirror the performance of an index like the FTSE 100 or MSCI World Index. What you should expect in a tracker is performance which is just like the index it tracks less the charges you have paid for the fund. Not all trackers work the same way. Indices are based on capitalisation so bigger companies with larger valuations represent a higher percentage of the index. In other words the FTSE 100 for example isn’t made up of 1% for each company in it. Royal Dutch Shell is about twice the size of Astrazenca so the FTSE 100 holds twice as much. Some trackers simply buy all the stocks in the index in proportion to the contribution to the index; others use investment strategies to replicate the performance of the index.

Historically average trackers have tended to do better than average active funds. I say “tended” to because some active managers have produced much better returns. The difficulty comes in knowing in advance which ones will out-perform.

If you cannot decide which one to go for, you will probably be better with a tracker. The reason I say this is because you would need the skills of an above average adviser to know which active funds to buy and to know when, and if, you should move out of them into something better. There are issues with trackers and I will cover those in the next episode.

Your decision if you don’t use an adviser will be between the different types of tracker out there. One of the market leading tracker providers offers 34 different funds. If this is your first investment you almost certainly want to avoid currency risk. This rules out all non-sterling funds and leaves you looking at UK funds.

In order to choose which tracker to invest in, you might want to know the forecasts for future returns from different assets and here they are courtesy of Blackrock one of the largest fund managers in the world market.

                                                                      5yrs        10yrs     15yrs     20yrs

UK index-linked gilts (5+ year)      -0.7%     0.2%      1.0%     1.5%                                        

UK government bonds   -1.4%     -0.3%     0.7%   1.4%

(All Maturities) 

                                                    

UK corporate bonds (10+ years)      -1.6%     0.0%      1.6%    2.6%                                                         

UK government bonds (15+ yrs) -3.4%   -1.8%  -0.2%  0.8%                                      

UK large cap equities                             4.0%      4.8%    5.6%   6.1%     

All figures are annual returns as at 19/11/2019

The current returns on assets in the UK are looking awful!!

The only positive note is Large Capitalisation companies in other words the top half of the FTSE 100 looking to achieve 4.0% a year.

You are probably wondering why things are looking so glum. Low risk assets have been bought very heavily recently and that has pushed up prices which in turn (as you will remember) pushes down the yields. Add to this the developed markets have little scope to reduce interest rates to combat the next recession, we still have not seen normal markets more than a decade after the credit crunch and then throw in Brexit and a world trade war. In nearly forty years I have never seen the like. Significant losses projected on so-called low risk assets and shares in the UK looking like the only way to get positive returns.

Next time I am going to tell you a little more about passive and active funds and explain something called pound cost averaging.

Till then thanks for listening. Bye for now.

Episode 12 Buy or rent?

I covered property last time and while I made the point that residential property is not an investment for most people, it is worth looking at the merits of renting or buying your own home before you start investing…it could make a big difference to you future wealth.

So should you buy or should you rent?

The Money Advice Service offers some help deciding and here is a selection of the main points

Benefits of owning

  • Once you’ve paid off your mortgage, your home will be yours and you won’t have to worry about paying for somewhere to live.
  • If your home increases in value, you could use the equity (its market value less the mortgage debt) to help buy a bigger home or fund a comfortable retirement.
  • You can spend money improving your home and increasing its value without having to ask a landlord.
  • Sometimes it can be cheaper to buy than rent.

Potential downsides of owning

  • It’s a big commitment – you need to be sure you can afford what you’re taking on. You will need to save for a deposit but there are other costs associated with buying such as solicitor’s fees and Stamp Duty.
  • When interest rates rise, your repayments will go up. It’s important you’re prepared for a rise.
  • It might not always be easy to sell your home, depending on what’s happening in the market.
  • You need to be sure you can afford maintenance costs like fixing a broken boiler or leaky roof. If you rent these are costs your landlord meets.
  • If you’re living with someone and split up, deciding what to do with the property can be complicated and expensive.
  • If the value of your home falls, you might be unable to sell if you owe more to your mortgage lender than your home is worth.
  • You have less flexibility than when renting. For example, selling up and moving is more expensive as you have estate agency and legal fees to pay.
  • If you’re buying a flat you might incur additional service charges which is not usually payable if you are renting.

It misses some important facts not least of which is that if you never buy your own home you will be paying rent for the rest of your life. Most mortgages are set up for 25 or 30 years, so your payments will end when the mortgage ends and you will not have to pay for housing from then on. If you get a mortgage at 35 and pay if off 25 years later you will be 60. Given that you will live probably for another 25 years that will be a massive saving v renting. Also as a homeowner your credit rating is higher, even if you have a mortgage, so it is easier to borrow money should you need to. (Check out the earlier episode for my views on debt though!!). When you rent it is almost certain that your rent will go up over time due to inflation. Since the credit crunch both general inflation and rent inflation have been subdued but nonetheless rent has risen between 3.5% and 20% depending on where you live.

Whilst the money advice service provides generic information, it omits the details that you need in making your decision.

How much will it cost to rent vs the cost of repaying a mortgage?

The average rent in the UK is now at an all-time high of £970. When London is excluded, the average rent in the UK is now £802 and average rents in London are now £1,689. (source: www.property118.com)

Going back to the point I made about mortgages coming to an end after 25 to 30 years, if you rent you will need to find £970 a month from your pension to meet housing costs. Over 25 years in retirement that comes to £291,000!

By contrast the average mortgage is currently £128,823. With an average interest rate of 2.48% that means that it would cost you about £577 p.m. in mortgage repayments. So average UK rent is £970 and average mortgage costs are £577 a difference of £393. Of course you will need to budget for maintenance and repairs.

The other fact missing from the Money Advice Service is the long term increase in property prices. According to the Halifax during the thirty years between 1985 and 2014 property prices rose by over 5% a year or over 400% in total! If you had bought a house for £100,000 in 1985 it would be valued at over half a million pounds in 2014. Little wonder that a lot of people want to get on the property ladder.

What if something goes wrong? Suppose you lose your job? If you rent you need to know that landlords will seek evictions and they hold your deposit. If you are broadly two months in arrears then notice can be served and the court will grant possession to the landlord. If you own your home with a mortgage things are a lot more complex. There are rules about what lenders must do before they take you to court and there are more options open to you. If they repossess your home, they then sell it and use the proceeds to take back what is owed. If there is a shortfall you still have to pay it, if there is a surplus you receive it.

It might help to consider the following two statistics from the Money Charity,

• 61 mortgage possession claims and 39 mortgage possession orders were made every day in October to December 2018.

• In the same period 313 landlord possession claims and 255 landlord possession orders were made every day. More renters are evicted day by day than owners and over 60% of households own their home.

On balance it is going to be far better for your long term wealth to buy than to rent. Even if there is a property crash just after you bought. Remember in Ep 1 I mentioned I was wiped out in the late 80’s by negative equity? That is where the house is worth less than your mortgage. I went through it twice. But long term the numbers stack up in favour or buying.

In today’s market if nothing changes you will save on average £393 a month which is £4,716 a year more than enough to cover the maintenance costs of the average property. Your mortgage will end after 25 years and you then save £577 a month for as long as you live – that is nearly £7,000 a year!

I would encourage you to seek professional advice before starting just in case anything changes between now and then.

What about the suggestion that you could take the deposit money and rather than putting it into a property you invested in the stock market? To answer that I am going to look at an example, let’s say you have £10,000 and could get a mortgage of £90,000 to buy a property at £100,000. If your property grows by 5% in year one you will have made £5,000 – 5% of £100,000. If you invested the £10,000 in the stock market and tried to match that return of £5,000 it would require a return of 50%. If you think that is achievable then go back to ep 1 on speculation.

Your first investment should be to look into property ownership and to educate yourself on what is involved so that you can make an informed decision for your circumstances. In my view the benefits almost always outweigh the detriments.

If you are struggling to get that deposit together – stick at it. Buying a house in your mid-30’s is still worthwhile. Especially as we are living longer and longer. Some estimates suggest that the chances of living to 100 years old for a child born today are about 1 in 3!!

In episode 2 I covered a few key ways to save and also mentioned Martin Lewis Money Saving Expert who has ideas on how to look at reducing your outgoings and increase your savings. Since then I came across Valuepenguin.com – check out their website for further help here

That is all for this episode. Next time I will start on how to being investing and what you need to do. Don’t forget that if you like what you hear – tell your family, friends and colleagues and if not tell me!!

Episode 11 How investments work – Property

In this session we’re going to look at property and at the end I’ll cover off the work of another good cause. There are two main classifications – residential and commercial. However there is a cross over when you look at “buy-to-let” property which is a residential building but rented out in a commercial venture.

If you own your own home you have not only a place to live but also an asset which has a value. Over the years I have heard many people describe their house as an investment or their “pension pot”. They intend to down-size later in life and release the value that has accumulated in their property. But in many cases that never happens. The reason is emotional attachment – their house is also their home and is associated with memories of the family growing up together. Selling it is not always that easy. Added to that is that in order to downsize you need to move to a cheaper property. In turn that means a smaller property or moving to a cheaper area or even both. After thirty years of being accustomed to the space in a larger home, moving to a smaller one may not be that easy. Moving to a cheaper area is even harder; it will almost certainly involve moving away from close contact with friends. So it is probably not wise to assume you can downsize at will and it is certainly something which needs very careful consideration.

When you buy a property you can reasonably assume that it will go up in value in the long term, all other things being equal, because it should be inflation proofed. What I mean by that is that as prices rise in general, the prices of land, building materials and so on also rise. That should lead to an increase in property prices. But there are other factors at play. Supply and demand is a big one. Population growth and net immigration increase demand for residential properties. If supply, in other words new building developments, doesn’t keep pace, then prices go up. Affordability is another key driver. Interest rates have fallen to historic lows in the last ten years. Lower interest rates mean cheaper mortgages and that means houses are easier to afford pushing up prices. For more on this check out https://housing.com/news/top-5-factors-make-property-prices-appreciate/

In the last thirty years people have been seduced into believing that you cannot lose money by buying a house. This is simply not true. In the late 80’3 and early 90’s we went through a property crash. Property prices fell by up to 50% almost overnight. When I married in 1989 my wife owned a flat in Brighton valued at £65,000. We had to move for my job a year later it sold for… £34,000. Could that happen again? It has in Aberdeen in the last five years. Property is currently very highly valued so be careful.

Moving on from residential property let’s look at buy to let.

“Landlords grow rich in their sleep without working, risking or economising.” John Stuart Mill, English philosopher and economist. No wonder people want to become landlords!

Buy to let is where someone owns a property and lets it out to one or more people in exchange for rent. Usually there is a loan or mortgage attached to the property and the owner is hoping to bring in enough rent allowing for expenses and tax to cover the borrowing costs and provide an income. Over time you would expect your rent to increase and further improve your returns. Clearly there are risks attached. If interest rates go up, that will affect the net return. Occasionally people default on their rent and it may take months to evict them. Tax changes can and have in recent years had a major impact. If you decide it is not for you after investing you need to be aware that property is not a liquid asset and that means it can take time to sell and the price can be a long way from your expectations.

One issue overlooked by many property investors is diversification. Let’s say they have a main residence worth £350,000 and a couple of buy to let properties worth £500,000 together. That is £850,000 in one asset type. If property crashes in value (as I mentioned a couple of minutes ago) that could cause a loss on paper of £425,000 overnight. That is not a problem if you can wait indefinitely for the market to recover but after the 1980’s crash it took ten years for them to recover in real terms (see graph).

Should you need to sell sooner you will crystallise a loss. But surely that is a one off? It couldn’t happen again? In 2007 at the time of the credit crunch property crashed again and in some parts of the UK it still hasn’t recovered today…

Image result for uk regional house prices historical graph

What about commercial property? Commercial property includes office blocks, shopping malls, warehouses, hotels and residences (nursing/care homes, student accommodation). Generally these will cost a lot more than the average investor can afford. Even if you can afford one you will suffer from lack of diversification because you won’t be able to spread your risk over different types of property or different geographical areas.

As an investment commercial property generates rental income which is usually predictable because the leases used are longer term, typically 5-15 years, than those for residential property. The rent reviews are upwards but occasionally tenants may ask for a period of rent reduction during unusually difficult trading periods. In addition to the rental income you would expect property values to go up over the long term. As a very broad rule of thumb about two thirds of the returns from commercial property are from rent and one third from capital growth.

Just like residential properties commercial properties are illiquid and in fact are even more illiquid because they take longer to sell. Because of this, commercial property needs to be a very long term investment. In turn you need to be thinking a long way ahead if you are putting a property portfolio together. For proof look no further than the average high street. Shops are struggling to compete with online retailers and many large firms have asked for rent reductions from their landlords. It is difficult to see what will reverse this trend and as such the attraction of retail high street premises is diminishing.

It is beyond the wildest dreams of most investors to own a portfolio of property that is sufficiently well diversified to avoid this sort of risk but it can be done through investment funds. An investment fund is something we will spend more time on in the near future. For now it is enough to say you would be adding your money to thousands of other investors with a professional fund manager making the investment decisions about which property to buy or sell. You will obviously want to know what your share of the fund is worth on a regular basis so the manager needs to value the underlying properties.

Commercial property is not normally valued using a surveyor but an index. If you have a large fund investing in dozens  or properties, you can’t really have a team of surveyors popping round every week to come up with the latest values. So an index is used which gives a value based on the rental yield of the property. So if a property has a rental income of £100,000 a year and the index says that the yield for that type of property is 5% then the property will be valued at £2,000,000 because 5% of £2m is £100,000. As an investor you get what are called units to identify your share of the fund and the unit has a price which changes with the ups and downs of the underlying investments.

So far all well and good but…there is more to it than that. Let’s say the fund has £1bn, and of that, £20m is in cash for expenses, paying out people who want to cash in and new purchases of properties in the future and suddenly… lots of investors want their money back. Let’s say the total withdrawal requests are £50m in a week. Where will the fund get the cash to pay them? It cannot sell the properties quickly enough to meet the demand, there aren’t too many buyers out there looking for office blocks or warehouses who want to buy them right away. Even if there were a ready buyer they would know the fund needed the cash and the fund would be likely to get a very poor offer. Instead, managers of property funds reserve the right to restrict withdrawals from property funds – usually by refusing to pay out for a period of time. This gives them a breathing space to raise the cash needed. Although it can seem harsh to investors who are trying to exit it protects those who remain invested. The Financial Conduct Authority (FCA) has been looking at this issue following suspensions of dealings applying after the Brexit Referendum in 2016.

Now for the latest good cause. It is https://uk.charitywater.org/?utm_medium=ppc&utm_source=adwords&utm_campaign=uk_brand&utm_content=adwords_2&gclid=Cj0KCQjw3JXtBRC8ARIsAEBHg4mZpiyhKdarJC4iX8JmzJjOH8XJb58QW_Su5KEA4USxDud34NydRKUaAu6gEALw_wcB

Charity Water is funded by private donors for its running costs so all of the donations received go to the cause. They have funded over 40,000 projects providing clean water to 10 million peoplein developing countries  in just 13 years. You can volunteer, raise money or donate at their website.

That’s it for this episode. I hope you enjoyed it and as always if your did – tell your friends, family and colleagues…and if not then tell me through the contact page at Poundsshillingsandsense.com

Till next time – thanks for listening.

Episode 10 – How investments work – Shares 2

Last time we looked at Steve Wood and his timber business. We saw how shares can you lose you all your money when a business becomes insolvent. We also saw how you can make money through dividends, which are how companies usually distribute profits. Finally we looked at how the share price goes up if dividends go up over the long term. As long as the company you are invested in makes profits and those profits keep going up you will do well, you will enjoy the dividends each year and at a later date you will be able to sell your shares for a higher price than you paid for them.

Investing in shares is not complicated if you take a long term view. You need to be looking at the company’s profitability both now and in the future. That means looking at what affects profitability.

Let’s start by looking at what affects a company’s profits.

In very simple terms profit is what arises when you manage to sell goods or services for more money than they cost you. In simple terms again, turnover less costs = profit. Anything which reduces your expenses as a business is good for profit as long as it doesn’t lead to you reducing your turnover! And anything that increases your turnover as a business without significant increases in expenses will improve your profit.

Let’s look at some examples. Airlines have big overheads with the high cost of buying planes and buying vast amounts of fuel. Some estimates put the cost per hour at $10,500 dollars in fuel costs for an Airbus 320. If you can buy planes that are more fuel efficient you will be able to reduce the fuel costs and therefore increase profits. That is just good business sense. But say you’re running an insurance company and you cut expenses by making your customer service team redundant, that may be bad for business. It could lead to unhappy customers, loss of reputation, fewer customers and eventually lower turnover and lower profits. I know – I watched this happen first hand over the last twenty years!

Increasing turnover without massive increases in expenses is often harder than cutting costs because the business needs to grow its market. An example of a company that did this very well was Colgate-Palmolive, when China opened up they went in. A market of over 1 billion people who value clean teeth, bright smiles and think red is a very lucky colour. As the Chinese market developed from agricultural dependency and modernised, a lot of people had a little more money to spend. One of the few new products they could afford was western toothpaste. Colgate with its red packaging only needed to increase its sales and marketing teams and increase production to meet demand. Did it work? Well since 1994 its share price has gone from $7 to over $70.

There is a saying in investment “It is better to be in a bad stock in the right sector than the best stock in a bad sector”. What that means is, if you invested in say the best performing airline and oil prices rocket you will struggle to as well than if you invested in say a poorly run semiconductor manufacturer just as the price of copper, silicon and other raw materials collapsed. (They are essential in making semi-conductors). So as well as looking at the company you need to look at the market it operates in and look for themes that will affect your investment.

Here is a list to consider,

  • Water purification
  • Transport
  • Fossil fuels
  • Car manufacturer
  • Pharmaceuticals
  • Robotics
  • Banking
  • Airlines
  • Holiday companies
  • Food production

Some of these areas are going to suffer in the next thirty years. Others are going to be around for a very long time to come. Car manufacturers who make diesel cars are likely to face a tough time, those who make hybrids and electric alternatives are going to do better. That doesn’t mean that you rush out and buy Tesla shares by the way. Food production is a stable market for the next generation and beyond although food tastes do change. Pharmaceuticals is an area that we are going to need for many decades ahead, there are plenty of illnesses and conditions that need treatments and solutions. Fossil fuels may be safe for a few years ahead but may not exist in fifty years from now. Banking is changing but people are still going to need to save and borrow, how they interact may move from bricks to clicks though. Holidays are unlikely to disappear any time soon but how we holiday is changing. For instance, AirBnB and bucket shop airlines have had a good run but many cities around the world are tightening up on AirBnB properties.

If you think you can pick a share and make money then you probably don’t need to listen to this podcast. For the rest of us, and yes that does include me, picking individual shares is not a skill we have. You need analysts, researchers and up to date information. That comes at a hefty price in professional fees. Without it, you will be making educated guesses at best. In the US there is a report each year for the last 25 years comparing the success of professional and amateur investors against market benchmarks called the Dalbar report . It shows that amateurs underperform significantly and consistently.

Warren Buffet has been described as the most successful investor in history and is often quoted by fund managers and financial advisers. He said in the New York Times[i]:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

What is he saying? Essentially in the long term, share values will rise because the economy will expand. In the short term there are setbacks, recessions, crises, wars; but in the long run they don’t last forever.

In the same article he said,

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now.”

So if the greatest investor in the recorded history of the world doesn’t know what is going on in the short term, but thinks that in the long term the value of shares will rise, it is well worth listening.

Shares and interest rates

We’ve seen with the other assets that we’ve looked at that they’re keenly linked to interest rates. To some extent the same is true for shares. Let’s go back to the FTSE 100, those big name companies, and assume that the dividends they pay provide a return of 3.0% of their current share price. If interest rates on deposits suddenly shot up to 12% a year would that impact on share prices? It certainly would. Investors would receive four times as much income from deposits and the income from shares would look less attractive. In that situation you would expect the price of shares to fall until the market found its new level because people would sell. In reverse, if the FTSE 100 companies continue to increase their profits (and dividends), say doubling their pay-outs, then the yield from the dividend would go up to 6%. If interest rates don’t change, then you would expect to see the share price go up because shares would be, relatively, more attractive to investors and they would buy them.

If only life were that simple!

In reality markets don’t react directly to movements in interest rates. There is a trend over the very long term (see the graph below).The reason for that is that movements in interest rates affect companies in different ways. Banks for example tend to do better when interest rates rise because their margins increase. Conversely companies with large debt will pay more for it when rates rise and that is a straight hit on their bottom line.

In reality it takes a long time for a company to double its profits, which means it takes time to see the growth in the share price and dividend. Similarly, it takes time for interest rates to go up significantly generally they don’t jump up by several percentage points in a single day.

Don’t be obsessed with trying to predict what will happen in the short term to interest rates or any other factor that affects share prices. It will lead you to start speculating!


[i] Warren Buffet, Op-Ed contribution. [online] Available at:

<http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=0>

Episode 9 – How investments work – Shares

 

How investments work – Shares

 

Since the last episode Pounds Shillings and Sense has been hosted by Feedspot as one of the top 75 investment related Podcasts. So a big thank you to them and to you for making that happen!

We are still working through this section about the different assets you can invest in and how they work. In this episode we are looking at shares. What does it mean to invest in shares? To answer that we need to look at what a company is and what a shareholder is and how money is made by investing in shares.

So what is a company? You may never have stopped to think about it so to make it clear I checked the Government’s website, www.gov.uk. It provides the following description of a company:

A limited company is an organisation that you can set up to run your business – it’s responsible in its own right for everything it does and its finances are separate to your personal finances.

Any profit it makes is owned by the company, after it pays Corporation Tax. The company can then share its profits.

Ownership; Every limited company has ‘members’ – the people or organisations who own shares in the company.

Directors are responsible for running the company. Directors often own shares, but they don’t have to.

Let’s start by translating what that all means. A company is responsible for its own affairs and its finances are separate from those of the business owner. If you are the business owner, that is good news; because if the business goes bust and owes money, you are not usually liable for the debt. (There are some exceptions depending on the debt where a director can be liable).

When a limited company business goes bust and has insufficient assets to meet its liabilities it is in the same position as an individual going bankrupt. Bankruptcy for companies is called insolvency and when that happens, an insolvency practitioner is appointed. Their job is to

  • Settle any legal disputes or outstanding contracts
  • Sell the company’s assets and use the funds to pay the creditors
  • Make payments to creditors
  • Complete all the relevant paperwork
  • Pay the final VAT bill
  • Settle the liquidation costs using funds raised through the sale of company assets

The creditors are not paid out equally as there are rankings of creditors to decide who gets paid first. The order of preference is,

  • Secured creditors who have a legal right or charge over the property. This called a fixed charge and can be made over various assets such as machinery, vehicles and equipment. 
  • Preferential creditors – mainly employees in respect of their unpaid wages or unpaid pension contributions.
  • Floating charge creditors – a floating charge is one that is secured against other assets in the company such as fixtures and fittings, stock, raw materials and cash. A fixed charge on such assets would be impractical – taking security for every chair and desk would be a nightmare
  • Unsecured creditors – these are creditors who have no security and include the likes of trade creditors, suppliers, HMRC for VAT (of course they were never going to be last on the list!)  and then others.
  • Connected unsecured creditors – refers to where directors or employees have provided loans to a company on an unsecured basis. Usually it is by family members or spouses.
  • Shareholders are at the back of the queue.

Of course it’s bad news if you had lent money to the business; you cannot sue the business owner for your loss. Your only recourse is to rely on the insolvency process finding enough assets in the business to pay out something to you. Remember in the last episode I mentioned about corporate bonds being sold as deposit accounts to unsuspecting investors? That is exactly what happened to them.

As a shareholder or investor in the company’s shares you would rank below corporate bond holders in the insolvency process. You get back what’s left, if anything, after everyone else has been paid. In some cases you could lose your entire investment. No wonder people are nervous about investing in them.

When you buy shares you are puting your faith in the directors to run the business profitably.

Let’s run through an example of how someone might set up a business as a company and why. Steve is setting up a trading business, Steve Wood Supplies. He wants to ensure that his personal wealth is kept separate from the business but he is looking to put £100,000 of his own money into his company. He doesn’t want to risk his house or other assets and for that reason chooses to set up a private limited company, Steve Wood Supplies Ltd. He will own all the shares and the £100,000 will be his share capital which he will use to pay bills, buy stock, and pay rent. He is confident that he will be bringing in business long before the money runs out. For Steve the limit of his liability is £100,000, because the company finances are separate from his personal finances. No-one can take him to court to make a claim on his own wealth.

Steve starts to trade and soon has his first orders. He is buying and selling timber around the world. He buys it at a cheap price at source in South America and arranges shipping, insurance and delivery to sawmills in Europe. The timber sells for a higher price in Europe, which includes a profit margin of 25% for Steve’s company. In the first year he has made a profit of £10,000, after paying himself a salary, which he takes as a dividend. A dividend is a way of distributing the profits the company has made, each share receives the same dividend payment.

 In year two he has a similar trading year and takes another £10,000 dividend. The following year Steve has increased his profit to £20,000 and is doing well – his dividend is now double what it was in his first year.

In the first year, Steve made a return on his £100,000 investment of £10,000 in the form of dividends, that is, a 10% return on his capital. By year three he has received £40,000 in dividends.  If he carries on at the same rate he will soon have had all his original investment back.

In year five there is a recession in the wood trade and Steve has his first bad year when he breaks even, making no profit. He cannot afford to pay himself a dividend but learns a valuable lesson; rather than taking all the profits out each year, in future he will hold some back in reserve, so that if he has to go through another tough trading year, there will still be money in the company to provide a dividend.

Ten years later, Steve is making steady profits. The dividend he receives is now £30,000 each year and he has reserves in the business to pay out for two years (£60,000) if there is a downturn in trading.

Let’s try and put a value on Steve Wood Supplies Ltd. He has £60,000 in the bank, he has orders which he is meeting that will generate another £30,000 in the next twelve months and he has assets (car, computer, office furniture and stock) of £10,000. The total assets of the business are worth £100,000 (60,000 +30,000 + 10,000 = 100,000) so the business could be worth £100,000. If you were to buy it, though, you could afford to pay Steve a salary and still expect to generate the same levels of trading in the coming years. The profits from those future years can also be factored into the value. Let’s say they are worth £80,000, so the total value of Steve’s business is £180,000. If he has 100 shares then each one is now worth £1,800 (100 x £1,800 = £180,000). Lucky Steve!

What would the return on your investment be if you bought the company? A purchase price of £180,000 would provide you with the dividends of £30,000 each year. If that were expressed as an interest rate it would be 16.67% a year. Not bad!

If only investment in shares were always that simple and profitable!

There is one aspect of the returns we haven’t covered in this example. That is what happens to the share price?  If the profits keep going up and up, it will affect the value of the shares. Without going in to too much detail, what would happen if Steve’s business kept increasing profits every year? Increased profits mean increased dividends.  If you bought the business for £180,000 and the dividends continued to rise over the next ten years to say treble their current level that would be £90,000. That would equate to a dividend yield of 50%. In reality that is highly unlikely to happen, because the value of the shares would go up accordingly.

That is probably enough for one episode so make sure you tune in to the next one when we will continue the look at shares.

As always if you like what you’re hearing tell your friends, family and colleagues and if not – tell me!! The contact page is at www.poundsshillingsandsense.com

Till next time thanks for listening and goodbye!

Episode 8 How investments work – Corporate Bonds

I hope you are having a good summer! I have been making the most of the good weather (when we get it in Scotland) and been hacking round the golf course and sea-kayaking. Even managed a sighting of dolphins near Bass Rock.

This episode is on corporate bonds a nice and easy one now that you have got your head around gilts! As I said last time – gilts are great, guaranteed without limit by the UK government but …at the moment offering low returns and in all probability will lose money in absolute and real terms in the foreseeable future.

If you go up the risk scale of investments above gilts the next asset you come to is corporate bonds and that is what we are looking at in this episode. As always there is a transcript of the podcast on the web at poundsshillingsandsense.com.

Just as governments need to borrow money, so do businesses. They can, of course, go to the bank and ask for a loan, but they might be charged high interest rates it can be cheaper for companies to raise funds directly from investors. That way the investor can get a higher interest rate than from deposits and the company can pay lower interest rates for its borrowing by cutting out the bank in the middle.

Corporate bonds are similar to gilts because they are fixed interest investments, the rate will not vary after it has been issued. They have a maturity date when you will be repaid and just like gilts they are tradeable after they have been issues and behave in much the same way. The interest is also called a coupon and it is based on the face value or nominal value of the bond not the trading value of the bond.

With corporate bonds instead of lending money to the Government as you do with gilts you are lending money to a business. Whilst the government guarantees to repay you companies do not! This is where they differ from Gilts. So remember what I said in the last episode about higher risk means high rates and lower risk means lower rates. Corporate bonds are more risky but not as much as shares.

Corporate bonds can be secured or unsecured. A secured corporate bond is backed by a specific asset and that means it is more protected than an unsecured one which has not such protection. If a company goes bust it must repay its debts first in the winding up process. This means that corporate bond holders rank ahead of shareholders in having a claim against any assets. Hence bonds are less risky than shares.

If you were lending money to a business that had no assets like a tech company and it had a management team with a poor track record of delivering profit… it might not be the safest thing to do with your kid’s inheritance. If on the other hand the business was a global multinational company employing hundreds of thousands of people and had a “triple A” credit rating (see below) that would be different.

You need to look at the specific terms on each bond to understand the terms and conditions.

Gilts are backed by the Government, while corporate bonds are backed by the company. Therefore the credit-worthiness of the company is vitally important. You are risking not just your interest but also your capital, as a company might “default”, that is, fail to pay the interest in full and in extreme situations fail to pay you back your money. The shorter the term of the corporate bond, the lower the rate of return because there is a lower risk of default. You need to be careful about who you lend money to, which is why credit-worthiness is really important and it is measured by credit ratings agencies. This is much the same as you having a credit score. If you have borrowed money and repaid it – that improves your credit score. Having assets which can provide collateral also improves your credit score. In fact the best credit ratings are usually given to people who have absolutely no need to borrow. I remember a good friend of mine who had always been prudent with his finances, never borrowed, never had a credit card, never had money problems, saved up for anything he bought – could not get a credit card because he had no credit score!

In the nineteenth century there were a lot of companies building railways in North America and investors wanted to avoid losing their money if these companies went bust (which a number did). Henry Varnum Poor published analyses of the financial health of railway companies. The information he provided allowed people to assess how creditworthy the businesses were and this gave birth to the first credit rating agency. It eventually became Standards and Poors.

Today there are three major agencies: Standard and Poor’s (S&P), Moody’s and Fitch. They each provide a ranking of credit-worthiness. You will probably have heard of “AAA” credit ratings, which are the highest credit rating that can be given. Both countries and companies are credit-rated. The former are called sovereign credit ratings and the latter are corporate bond ratings. The S&P AAA rating means that the country or company has an “extremely strong capacity to meet financial commitments”. What does that mean? It means that it is very safe, but not guaranteed. The ratings are not an indication that you should buy (or sell) investments. There are a range of credit ratings: AAA, AA, A, BBB, BB, B, CCC, CC, C and D. In the world of investment, BBB and above are termed “investment grade”, while ratings below that, i.e. BB to D, are termed “junk” status. The lower the credit rating, the higher the interest rate that the company or government needs to pay to encourage investors to lend them money.

If you are lending money to a company with a credit rating of AA you will not get as high an interest rate as you will from lending money to a company with a credit rating of BBB. A loan to a company with a BBB rating is higher risk and that risk is compensated for with higher interest. Clearly, though, you would expect a company with an AA rating to be safer than one with a BBB rating and you would run less risk of losing your money. But be warned credit ratings are not guaranteed, just “best guesses” – Standards and Poors rated Lehman Brothers as A – investment grade up till six days before it collapsed.

Hopefully, you remember our friends the FSCS (Financial Services Compensation Scheme). They pay compensation if a bank or building society goes bust. There is no such protection for corporate bonds.

A lot of people have found out this lesson the hard way recently. Over the last few years a number of companies having been marketing their corporate bonds in similar ways to bank and building societies marketing their deposit accounts. It hasn’t helped that the word “bond” is used to describe fixed interest deposit accounts as well as loans to companies. It was almost inevitable that this would lead to confusion which would be exploited. With interest rates at historic lows people were offered returns of 8% a year or more. You cannot get a quart out of a pint pot. You cannot get returns better than shares, which are risky, by investing in a safe, risk-free investment. It just doesn’t happen. The higher rate tells you that there must be greater risk so you absolutely need to do your homework or better yet, talk to a qualified adviser.

If you can lose your money by investing in a corporate bond, then why not stick to gilts? They are, after all, backed by the Government and as guaranteed as you can get. The answer is to compare the gross redemption yields on offer between gilts and corporate bonds. Once you have the yields to compare you can assess whether or not the additional return from a corporate bond is worth the additional risk. In general a triple “A” government bond will never pay as high a return as a triple “A” rated corporate bond. The difference is called the “spread” – it is the “gap” between the returns on gilts and corporate bonds. You might call it the “risk premium”.

Hopefully you remember from the last episode that you can make a profit on gilts if interest rates fall after you have bought them. As interest rates go down fixed interest investments tend to go up in value. This applies to corporate bonds as well. But there is also more potential to make capital gains on corporate bonds if a company is re-rated. If a BBB rate company issued a bond paying 6% interest when AA companies were typically paying 4% and then that company had a magical upgrade from Standard and Poor’s making it AA, you would expect the price of that corporate bond to go up and the yield to fall. Conversely, if a company is downgraded, then the capital value of their corporate bonds would fall. Credit ratings of countries do change but they do so far less often and rarely in big jumps so those sorts of gains and losses are much rarer on gilts.

In normal circumstances government bonds/gilts are easily bought and sold – there is never a serious issue of no-one wanting to buy them. With corporate bonds it can be different. There may be occasions when a company is facing a tough trading environment and few if any potential investors want to buy their bonds. This can result in what is called a “liquidity” problem – in other words you may not be able to sell your bond at anything like a sensible price. I covered this in the episode on “What an investment is actually worth” so if you have forgotten – you might want to refresh your understanding! There is a library now of past episodes on the website to help and the transcripts are still there to read at your leisure.

As always – if you like what you’re hearing tell your family and friends and if not – tell me!

I am still looking for people to interview – if you think that could be you then get in touch through the contact page!

Next time I will cover off shares and how they work, till then thanks for listening

Episode 7 How investments work – Gilts

Today we are going to look at Gilts. They are the only guaranteed investment you can get. As such you should always check against them when someone advertises or promotes any guaranteed investment. Back in my earlier career there was a firm called Barlow Clowes who offered a fund in Gibraltar advertising returns of 15% guaranteed. At the time Gilts were yielding 12%. It simply did not add up. No surprise that it was proven to be a scam. If anyone offers you an investment that is guaranteed then check the gilt returns

So let’s look at how they work, why they are guaranteed and whether you might want to invest in them.

When a government’s tax receipts are not enough to cover its spending it needs to borrow money. This is done by the Debt Management Office. They issue gilts which investors can buy; the investors are lending money to the government. They will want to see something in writing that proves they have made the loan, what the interest rate is and when they will get their money back. The piece of paper that does that is a “Gilt”. (The term Gilt is historic and comes from the days when they were described as “gilt-edged securities”, which in turn is because the piece of paper had a gold band on the edge.)

As Gilts are loans it is important to understand what that entails.

If you were lending money to a complete stranger you would want to see some form of security in case the person failed to pay you back. You would also want interest on the loan until it is repaid as compensation. Whilst your borrower might have the best of intentions to repay you things can go wrong. Being unexpectedly redundant, for example, can change priorities dramatically. The security (or collateral) is something of value that is usually worth at least as much as the loan so that, if you never see your money again, you can sell it and recoup your loss. Banks and building societies take your home as security when they give you a mortgage for this very reason. They take a legal charge which means you cannot sell the property unless they agree to it. If you default they can go to court and take possession of your property and sell it.

When looking at borrowing and lending remember – the higher the risk the higher the interest rate and the lower the risk the lower the interest rate.

When you lend money to the government though, it is slightly different. The government is not going to be made redundant and if it needs more money it can always raise taxes. In other words, your money is pretty safe if you lend it to the UK government; historically the UK government has never failed to repay its debt, both interest and capital.

The people who raise money for the government are known as the Debt Management Office (DMO). Their website offers the following description:

Gilts are marketable sterling government bonds issued by the DMO on behalf of the UK Government as part of its debt management responsibilities.

It doesn’t really tell you what you need to know. If you follow the links on the DMO website it leads you to this:

Conventional gilts

Conventional gilts are the simplest form of government bond and constitute the largest share of liabilities in the Government’s portfolio. A conventional gilt is a liability of the Government which guarantees to pay the holder of the gilt a fixed cash payment (coupon) every six months until the maturity date, at which point the holder receives the final coupon payment and the return of the principal. The prices of conventional gilts are quoted in terms of £100 nominal. However, they can be traded in units as small as a penny.

A conventional gilt is denoted by its coupon rate and maturity (e.g. 4% Treasury Gilt 2016). The coupon rate usually reflects the market interest rate at the time of the first issue of the gilt. Consequently there is a wide range of coupon rates available in the market at any one time, reflecting how rates of borrowing have fluctuated in the past. The coupon indicates the cash payment per £100 nominal that the holder will receive a year. This payment is made in two equal semi-annual payments on fixed dates six months apart (these payments are rolled forward to the next business day if they fall on a non-business day). For example, an investor who holds £1,000 nominal of 4% Treasury Gilt 2016 will receive two coupon payments of £20 each on 7 March and 7 September.

If you struggled to understand what that all means I think you’re probably in good company. Remember in episode 1 I said my world was full of bullshit – there is the proof!

So let me try and simplify it.

A diagram might help a little bit…

HM Government Pays 4% a year and  £100 in 2021          

(Note the gilt edge)

You lend the government £100 until 2021 which they guarantee to pay back to you. Between now and then they will pay you 4% interest a year (known in the investment world as the “coupon”) on the £100 you have lent them. 4% of £100 is £4 and it is paid in two instalments each year, so you get £2 every six months.

Gilts are “fixed interest” investments, which means that the interest rate they pay does not change even if the Bank of England changes the base rate. Any changes in base rates will affect the rates offered on new issues of gilts, but it cannot change the interest rates on the ones that are already out there. This is like fixed interest accounts at banks and building societies. But there is a significant difference – bank and building society accounts  are not “tradable”. What does that mean? Simply that you cannot sell your bank account to someone else. You can, however, sell your gilt to someone else because it is “tradable”. And that makes gilts really interesting investments!

Let’s use the example earlier with a rate of 4% and a value of £100 that will be paid back to you in 2021. That 4% is fixed and is based on the £100. If you held that investment for a full two years you would receive £8 in interest payments (two times £4) and £100 return of capital, giving a total return of £108.

Let us suppose that when you bought the gilt the best two-year interest rates offered by the banks were 4% a year, the same as the gilt. (The only difference between the two investments is that one is guaranteed by the government without limit and the other is protected up to £85,000)

However, just 2 seconds after you bought your gilt, our chums at the Bank of England decided that inflation was under control. They reduced base rates, causing a drop in interest rates on two-year deposits to 1% a year. A new investor will now get £1 a year for two years on his £100 deposit at the bank, a total of £102 back, whilst you are still looking forward to getting £108 over the same period.

How much would someone be prepared to pay you to buy that gilt from you?

Would he pay you, say, £104? Let’s look at what he would get.

£104 invested today would give him two lots of £4 interest (be aware the interest rate is based on the £100 nominal value on the gilt, not on the amount he pays for it) and £100 return of capital after two years. Dave is going to lose £4 of capital in two years’ time but he doesn’t care because he is going to get £8 of interest. He makes a return of £4 (£8 minus the £4 loss) which is double the £2 he would receive from the bank.

Would you sell it to him? You might! You would make a profit of £4 in a day rather than waiting a year to see that return if you didn’t sell. But then where would you invest your £104 tomorrow that would give you a total return that equalled £108 over two years?

In the world of investments everything finds its own level, just like water running downhill. In the example above, you would expect to find a price which satisfied both you and Dave somewhere between £104 and £108 where you would both be happy. Before you go rushing out to buy a portfolio of gilts we need to look at what happens if interest rates move the opposite way.

What would happen if interest rates went up the moment after you bought the gilt above, and the bank now offers 8% a year for a two-year fixed deposit? Now an investor is looking at a total return of £116 over two years (two lots of £8 plus his money back) while you are looking pretty glum at the same old £108 return over the same period. Would you sell your gilt for less than you bought it for?

Would you sell it for £96? You might! You would lose £4 to start with (£100 paid for the gilt less £96) but you could then invest your £96 in the bank and get 8% a year, which on £96 would be a return of £7.68 a year (Yes trust me 8% on £96 is £7.68). Two years of £7.68 is £15.36; add that to your £96 and you would have a total return of £111.36, well above the £108 you were stuck with a minute ago! Sometimes making a loss is a good thing in the long run.

There are two ways of looking at gilts as an investment. You can buy them and keep them until they mature or you can buy them and hope to sell early for a profit. Buying and keeping hold of them means you know exactly what you will receive from your investment. If you buy and hope to sell early, you run a risk that you will not be able to make an early profit and will be forced to hold until the maturity date.

As we saw above the value of a gilt can get quite confusing – it is worth £100 on paper when it matures, but then it can end up being worth more or less than that once it starts trading. How on earth do you know the value of a gilt once it has started to trade? How will you know if it is good or bad value? The answer lies in what is called the “gross redemption yield”. This shows the annual return you would get if you bought the gilt today and held it until its maturity date as an annual return. It takes account of the £100 you will get back, the price you pay today to buy it and the half-yearly payments of interest that you receive. In short, it provides a number which you can compare to other interest rates on deposit and savings accounts.

I have put a couple of example at the end of this script.

Gilts may sound fantastic and they are but…at the moment the returns are pretty low and you will almost certainly do better with a deposit account (as long as you remember the £85,000 compensation limit there is nothing to choose in terms of risk).

Next time we look at corporate bonds – the next investment up the risk ladder.

Remember – if you like what you are reading share the message!

Gross Redemption Yields

It might help to look at a couple of examples of how this works.

Example 1

Suppose you had a gilt which will pay back £100 in two years’ time and meanwhile an interest rate of 4.5% a year. It will cost you £102 on today’s market to buy it. The total return you get isn’t 4.5% because you will lose £2 when it matures. The gross redemption yield takes all that into account and in this case it is 3.45% a year.

Example 2

Suppose you were looking at the same gilt as above, but instead of it costing you £102 it cost £95? In that case you will make a profit of £5 in two years’ time and receive a return of 4.5% a year in the meantime. The gross redemption yield in this case is 7.28% a year. There are calculators online that will work all this out, which you can use free of charge – just type gross redemption yield calculator into your search engine.

The gross redemption yield allows you to easily compare the value of a gilt against a deposit account. In example 1 above, suppose you could find a deposit account paying 4.0% fixed for two years. You can see from the gross redemption yield of 3.45% that the gilt would pay you less. Even though the rate is 4.5% a year, the £2 loss of capital reduces the equivalent rate to 3.45%.

In example 2 above let us assume you found a bank offering a fixed interest deposit paying 6% a year. The rate looks much better on the face of it than the 4.5% from the gilt, but adding in the profit of £5 in two years’ time means the total return of 7.28% is much better.

Episode 6 How investments work – Deposit Accounts

How investments work – Deposit Accounts

I finished episode 5 with no clear idea what I would cover in this one. Thankfully I made a decision and it is…

How do investments work?

Last time I covered what an investment is worth and gave a brief description of the main asset types. Now we’re going to look at them in more detail and see what makes each one tick. Not understanding an investment and how it works is a sure way to having problems. We’ll start with deposit accounts and go on in future episodes to look at other assets.

It is essential you understand how an investment works – it helps avoid being taken in by scams…

My back has been causing me problems for a long while and I now see a really good Osteopath. Last week we were talking about a friend of hers who had invested in a seemingly fantastic scheme. Here is how it was described,

  • You don’t actually invest your money, you lend it to an investment company
  • It is not a regulated investment
  • The adviser claims that the money you lend is never at risk
  • Only the interest is invested and the returns are over 19% a year guaranteed
  • Returns are paid every month and you can get your money back in thirty days
  • It is only available to selected investors and the guys behind it normally only deal with billionaires
  • The person who “invested” in it doesn’t know precisely how it works, it is all based on trust

Sounds like an advert for a scam from the FCA doesn’t it?

Let’s look at what has happened. The arrangement is not an investment so it is not covered by the various investment protection schemes. It is an unsecured loan to a limited company. When I checked the advisers who recommended it, neither one is authorised by the FCA. But as the arrangement is not an investment as such they probably don’t need to be. The company they work for has very little in the way of assets. The only guaranteed investment is gilts and they are paying nothing remotely close to 1% a year let alone 19% a year.

There was much more but I won’t bore you with it. By not understanding the investment the person in question may have lost a substantial sum of money.

I have reported the scheme in question to the FCA.

You need to understand what you are investing in before you commit your money. If you are using a regulated adviser then make them explain it to you until you understand.  Too many investors take too much on trust and find out the hard way what they should have known at the start. It is true of some advisers as well!

Let’s look at deposit accounts. You put your money with a bank or building society and they pay you interest. What more do you need to know…other than how much interest they will pay?

What does the bank do with it? It lends the money to people who want to borrow and it lends it at higher rates of interest than it pays you. In previous episodes I have mentioned the current rates available – Cash ISAs 0.84%, Instant access accounts 0.20% – 0.60% and five year fixed rate deposits paying around 2.5% a year. Current lending rates are 4.33% for a mortgage, 8.0% for a personal loan and 19% for a credit card. Quite a big difference isn’t it? Before you start ranting at the banks making huge profits I would point out that they have to allow for bad debts. When people don’t pay their loans back the bank may be caught out. At the heart of the credit crunch was exactly that problem – loans made to people who could not afford to repay them. And that is why you need to keep no more than £85,000 in any one bank or building society. If they mess up the lending your money is at risk and the protection you receive is limited to that amount.

Because most people consider deposit accounts as the first port of call for investing their money the returns available are effectively a benchmark for any investment decision. You need to ask yourself, “is the return for risking my money good enough to make me take my money out of a secure deposit account?” I cannot overstate the importance of this – it will affect any decision you make about any investments. Let me repeat that, you need to ask yourself, “is the return for risking my money good enough to make me take my money out of a secure deposit account?” 

But interest rates vary – they go up and down. We’ve had low interest rates for so long that people forget! Ten years ago you could have got around 5% a year for a cash ISA today it is less than 1%. Why do rates change?

The short answer is that interest rates change because the Bank of England Base Rate changes them. It sets the base rate. High street banks then set their interest rates by reference to the base rate. Today it is 0.75% but in my lifetime it has been as high as 17%. When I lectured and spoke at events to members of the public and made that statement it was pretty difficult for many younger people to believe.

Why is the base rate only 0.75% now and why was it 17% in the past? The answer is inflation. Today inflation is quite low but back in the 1970’s it was running at over 24% a year. It is difficult to take that in unless you lived through it. To put some colour to it – you got paid say £10,000 a year and by the end of the year it was effectively worth £7,600. It is a pretty miserable situation to go through.

The government has set a target of 2% inflation in the UK (using Consumer Prices Index as the measure).  The Monetary Policy Committee of the Bank of England has the job of making that happen. It tries to avoid high inflation and avoid recessions. One of the major tools the Bank uses is interest rates. If rates go up, people have less money to spend so they cannot afford higher prices and inflation should be controlled. If rates are too high for too long then that can be bad for business and the economy contracts. A 2% inflation rate is seen as sustainable – it allows the economy to grow without severe swings between boom and bust.

Inflation is key to understanding what will happen to interest rates. In turn what happens to interest rates affects your choices as an investor. Suppose you can earn 2.5% a year on a fixed term deposit (as you can right now), would you be tempted to invest in gilts that would give you around 0.5% a year for the same period? You shouldn’t! Surprisingly there are a lot of people invested in gilts giving those returns.

What if gilts were paying 3.0% a year? If they were, you would be getting a higher return from them than you could get on a deposit and gilts are guaranteed by the government. Now that would be much more attractive

The bank of England takes a two to three year view on inflation rather than quarter to quarter or month to month. They are interested in the longer term rather than short term fluctuations.

As an investor you will be impacted by what happens to inflation because of its effect on interest rates. Because investment means looking at the longer term, you need, like the Bank of England to be looking at two or three years from now. So what is going to happen to interest rates? Even Mark Carney the governor of the Bank of England isn’t sure – he has changed his views several times in recent years on whether interest rates are likely to change.

Probably the best indicator is to look at what might make prices go up. Higher wages mean that people can afford higher prices. For over ten years, following the credit crunch, we saw static of falling wages in the UK and that helped to keep inflation under control. But now we are seeing wage growth in real terms, people are getting pay rises above inflation. Prices are also under pressure to go up. Brexit has had a major impact on exchange rates. Before the referendum we were getting 1.4 dollars to the pound and 1.3 Euros. Today that is down to 1.26 dollars and 1.12 Euros. Because we import more than we export that means that businesses have to pay more to bring in goods and raw material from abroad. That creates pressure to push prices upwards. So too do upward movements in the oil price. The latest inflation figures due out this week are expected to show a rise and a big cause of that has been the increase in cost of petrol at the pumps in recent months.

On balance it looks like interest rates are going to go up. How far and how soon is a mrent crude every day or watching the latest inflation reports each month. All you need to know is that inflation affects interest rates and interest rates affect whether or not you will want to invest.

Next time we’ll look at gilts and how they work – till then thanks for listening!!

Episode 5 What is an investment actually worth?

Hello and welcome to something that has nothing to do with Brexit or leadership challenges in government. But…if you’d like to know the impact of these events on investments then get in touch through the contact page on www.poundsshillingsandsense.com

Last time I covered risk and investment. In this episode we will look at what your investment is worth. In other words how it is valued. You might be thinking that this is a bit odd but it’s vital to understand this. It may not be as straightforward as you think and you don’t want surprises when you try to cash an investment in only to find out that it is not worth what you thought it was.

In order to understand value of an investment I need to explain the broad categories of investment assets that there are out there.

  1. Cash
  2. Government bonds/Also known as Gilts
  3. Corporate bonds
  4. Shares also called equities
  5. Property – Residential and Commercial
  6. Commodities

I plan to go through these in the coming weeks but for today’s episode I will give just a brief description of each one.

Cash is easy – it refers to deposit accounts and I imagine you don’t need me to explain them to you.

Government Bonds or Gilts are investments that exist because the government needs to borrow money from time to time. When it does, it provides the borrower with a written promise that it will pay back the loan at a certain date and the interest that it will pay for the loan. That written promise is a ”bond” and a while back in history the paper it was written on had a gilt edge to it, hence the term “gilt-edged security or Gilt”.

Corporate Bonds are very similar. Sometimes it’s cheaper or easier for a company to borrow money from investment markets than banks. When they do they issue a bond in the same way as the government.

Shares or equities are not loans but actual ownership of a part of a business. There are private companies and public companies, public companies are listed on a stock market where they can be bought and sold whereas private companies are not.

Most people, especially in the UK, understand residential property. It is a bricks and mortar building which is suitable for people to live in. The owner and the residents of the building may not always be the same people. The buy to let market is one example where someone buys a flat or house specifically to rent it out to someone else. Leasehold property is another example; while the concept doesn’t exist in Scotland it is common in the rest of the UK. Under the lease the leaseholder owns the right to live in the building for a specific period but the bricks and mortar are owned by the freeholder. The lease can be bought and sold in much the same way as any other property.

Commercial property refers to offices, shops, warehouses, factories and so on. Most investors cannot possibly afford to buy these but they can benefit from them by investing in funds. The fund is where a group of people put their money together and a professional manager makes the investment decisions about which properties to buy and sell.

Commodities are not commonly held by most people who invest, but you do need to be aware of them. The dictionary says that a commodity is a “raw material” or a “useful or valuable thing”. For our purposes I am going to say it includes gold, bitcoins, diamonds, copper, coffee beans and a list so long I cannot cover it all. But you get the picture. A commodity doesn’t pay any income and the returns are entirely based on the price going up. I won’t be referring to them again in this episode.

Those are the assets you can put your money into, now on to how they’re valued.

Cash should be straightforward shouldn’t it?  Your money is worth what it says when you check your balance… or is it? Remember the credit crunch? In the middle of the panic I was at a team dinner in London. One of my colleagues had recently sold his house and put the entire proceeds – £240,000 into one bank. That bank was looking like it would be the next one to fall. He was trying desperately to transfer his money on his internet banking facility but found it was limited to £20,000 a day. He looked as worried as anyone I have ever seen. You are currently protected by the Financial Services Compensation Scheme up to £85,000 per bank per person. If you have more than that amount in a bank or building society account it could be lost if the bank goes bust. Do not put yourself in this situation. Spread your money around several  banks and building societies – each one has the protection of £85,000. But surely the risk has passed? The credit crunch was ten years ago and the banks are in good shape now? Only two weeks before this recording a tweet appeared in my feed from someone worried about their bank collapsing.

I have often been asked if any investment is guaranteed in full. And the good news is that there are some. They are the gilts I mentioned a minute ago – guaranteed by the government, the least risky investment you can get. The bad news is that they are not paying very much at the moment and you will get more return from a bank or building society in most cases. In fact for investors today some gilts will actually be likely to lose you money – more of that in future episodes.

All other investments are at risk…that means that their value is uncertain from one day to the next. I’m now going to look at values.

Most people are familiar with how the housing market works in terms of values so I will start with that. If you want to know the value of your property you can go online and get data about similar properties in your area that have sold recently. Or you could ask an estate agent to value your property – they do this by measuring the floor area and multiplying by a factor. Either way you know that it is not necessarily what you will sell your house for. It is only an indication of value. You might call it “market value”. The true value will be what you get for it. In turn, what you sell it for depends on how much of a hurry you are in. Not everyone is in the fortunate position of waiting for the right offer. When you have to sell quickly the price will usually suffer. When properties are repossessed the bank or building society will look to get rid of them as soon as they can, even though they know the price will be quite a bit lower than they could get by hanging on.

Your investment is worth what someone pays you for it.

So let’s look at the different investments. I said a moment ago that gilts were guaranteed, and they are, but only if the government buys them from you or redeems them. If you choose to sell them to someone else, they are worth what someone pays you for them.

Corporate bonds are usually quoted daily on the market and that is their “market value”. But if the company is going through a tough time and issues a profit warning or is re-rated by a credit agency then that price can alter dramatically. Ultimately your holding is worth what someone will pay you for it.

Commercial property is not normally valued using a surveyor but an index. If you have a large fund investing in property, you can’t really have a team of surveyors popping round every week to come up with the latest values. So an index is used which gives a value based on the rental yield of the property. So if a property has a rental income of £100,000 a year and the index says that the yield for that type of property is 5% then the property will be valued at £2,000,000 because 5% of £2m is £100,000. As an investor you get what are called units to identify your share of the fund and the unit has a price which changes with the ups and downs of the underlying investments. So far all well and good but…there is more to it than that. Let’s say the fund has £1bn, and of that, £20m in cash in it for expenses and new purchases of properties in the future and suddenly lots of investors want their money back. Let’s say the total withdrawal requests are £50m in a week. Where will the fund get the cash to pay them? It cannot sell the properties quickly enough to meet the demand, there aren’t too many buyers out there looking for office blocks or warehouses who want to buy them right away. Even if there were a ready buyer they would know the fund needed the cash and the fund would be likely to get a very poor offer. Instead, managers of property funds reserve the right to restrict withdrawals from property funds – usually by refusing to pay out for a period of time. This gives them a breathing space to raise the cash needed. Although it can seem harsh to investors who are trying to exit it protects those who remain invested. The Financial Conduct Authority (FCA) has been looking at this issue following suspensions of dealings applying after the Brexit Referendum in 2016.

As I said toward the beginning shares can be public or private. You can go to a whole host of places on the internet to check out public company shares. But is that the price you will get when you sell or pay when you buy? There are two prices – a buying and selling price inexactly the same way as with second hand cars. The price can vary from minute to minute and you will only know what price you get when you place the order. However it will normally be pretty close to the quoted price. When you buy or sell your shares you are usually dealing with what is called a “Market maker” a big financial institution that is FCA regulated. The market maker will hold shares the most popular companies in the major indices. When you buy you buy their holding and when you sell you sell your holding to them. The difference in the buying and selling price is how they make their money.  With private company shares the prices are not quoted on a public market. This means that few if any of the market makers will hold them. In order to buy or sell them you need what is called a “matched trade” someone needs to be willing to buy or sell the shares you are interested in. As a result the price can change substantially – if I hold £1000 of shares in a private company and you tell me you want to buy them I might just increase the price because I know there are few places you can get them. Supply and demand has a big effect.

Episode 4 Risk and Investment

Hello and welcome to episode four of Pounds Shillings and Sense with me, Richard Leeson.

Before we get started I want to say thank you to Andy Robinson for getting in touch on Linked In and suggesting that I host Pounds Shillings and Sense on Spotify.  A great idea and one that has now been put in place.

In this episode we’re going to look at risk and investment. Risk is probably the biggest reason why people don’t invest properly. For many people the fear of losing money makes them shun investment at all. Others lose money because they don’t manage risk properly, they take chances without even realising that they are doing so. You will never eliminate risk from investment but you can minimise its

impact and affects. You need to deal with the fear that risk causes but you also need to understand the nature of the risks you might be running and plan for them.

John Shedd, an American author, made an observation about risk in our lives. “A ship in harbour is safe, but that is not what ships are built for.” Risk is inevitable in life and that includes investment. We can sometimes let fear rule our lives and allow it to stop us doing what is right for us. Some reports suggest that for many people, fear of speaking in public is greater than fear of death. That is completely irrational – if you are asked to give a eulogy at a funeral, most of the congregation would rather be in the coffin than standing where you are!

How do you overcome that fear? The late Susan Jeffers, an American psychologist, said in her book that the way to deal with fear is to “Feel the fear and do it anyway”.  She offered this advice – when fear grabs hold of you, tell yourself “I’ll handle it”.

In investment trying to avoid risk actually causes you harm and opens you to a really big risk that you may not have thought about, inflation. Inflation is the first risk you need to be aware of. It can erode the value of your money more surely than anything else. Let me explain.

When you try to avoid losing your money by “risking” it in the stock market you inevitably end up putting it in a bank or building society because you think it won’t be going down in value.

Let’s look at what happens when you do that…

Remember in the first episode I gave you the returns on deposit accounts? The best rates for instant access accounts are now about 1.5% (usually including bonuses which you lose if you withdraw funds before a 12 month period). The best rate may not be what you are getting – If you are with a well-known high street bank you may be getting as little as 0.20% to 0.60% depending on how much you have in the account.

To avoid your money losing its purchasing power you need to at least match inflation. Inflation is the increase in the cost of living. As prices for goods and services rise – you need more money to buy them. The rate of inflation measured by RPI (retail prices index) in March 2019 was 2.4%[i] a year. If you are getting less than 2.4% interest on your savings your money will buy you less in the future than it does today.

Let’s assume you are saving in an average cash ISA earning 0.84% a year at the moment. With inflation of 2.4% this means your money will have lost 1.56% in a year, which may not sound like much. £5000 would be then worth £4,922 – £78 less. Would you be happy to take £78 and set fire to it? Of course not! But by ignoring the problem of inflation that is exactly what you are doing without realising it. And the longer you leave it the worse it gets!

If nothing changes over the next five years, and inflation and interest rates stay the same, your £5000 would be worth £4,622 a loss in real terms of £378. Over 20 years prices have risen by 72.8% and over 30 years by a staggering 157.6%!

If you go to my website www.poundsshillingsandsense.com you will find a link to the Hargreaves Landsdown website inflation calculator. You can put in your own data and see what inflation looks like over various periods going back in time

Inflation is a much used term and there are two main measures of it RPI and CPI. There are two main differences – what they measure and how they are calculated. RPI includes cost of council tax and mortgages for example, which CPI doesn’t. The formula is different – RPI is a simple average – if there are ten items being measured then you add up the prices of the items and divide by ten. CPI is calculated by using a geometric mean. If you want to know more check out the ONS on the web. In short CPI will be about 1% lower than RPI. But these indices are not reflective of everybody’s spending. They don’t measure the price of everything. What you spend your money on and what I spend my money are very different. People in their nineties probably aren’t buying computer games and those leaving university won’t be buying houses. You may find your personal inflation figure is much higher or lower than CPI or RPI.

You absolutely need your money to be inflation-proofed or you will be losing value. By not investing you run a big risk. But there are of course risks associated with investing, and you need to be just as aware of those as you now are about inflation risk.

Timing risk

This is the risk of buying or selling at the wrong time. Buying into an investment just as the price plummets or selling an investment just before the price soars. Generally the markets move fractions of a percent from one day to the next. Occasionally there are periods where the swings in price are much greater in 2018 the FTSE100 fell over 3% in a single day. Scary? Over ten years you might expect to achieve 70% growth on the FTSE 100 in the past. Losing 3% brings it down to 67%, still a much better return than cash deposits. If you are still worried you can offset this risk by buying or selling in stages, say two or three investments of half or a third of the total. That way if the market falls just after your first investment you can buy the same stocks cheaper with your second investment.

Horizon Risk

Linked to timing, it refers to how long you invest. The shorter the period the greater the risk. The longer you invest the lower the chance of losing money. If you had bought into the FTSE100 at the start of 2008 you would have lost 28.3% in a year, the following year you would have made 27.3% followed by 12.6% the year after. You need time to even out the ups and downs of movements in markets.

Impact Risk

This is really about how bad things will be if you get it wrong. I know of a fund manager who stood up in a presentation and declared that all of his money, all of his wife’s money and all of his father-in-law’s money was invested in his fund. He was trying to demonstrate his commitment to his investment skills. Instead he demonstrated that he didn’t understand impact risk. If it went wrong the outcome would devastate the finances of three people in the same family.

Concentration Risk

This is closely linked to impact risk. Holding all your money in one investment or one asset is risky. It is easily dealt with and you have probably already jumped to the answer “don’t put all your eggs in one basket”.

Market Risk

Sometimes things happen that affect an entire market, such as rising interest rates and currency movements. You cannot eliminate it. A good fund manager will take account of it in building a portfolio of investments.

Credit Risk

This covers the possibility that the company or government you invest with default and you lose some or all of your money. Remember the Greek debt crisis – when they talked about “haircuts” that was a way of saying the Greek government would not pay back all the interest or capital on the money investors had lent to it. Credit rating agencies offer some help by rating the creditworthiness of governments and companies but they don’t always get it right. Two of the big agencies, Standards and Poors and Moodys, both rated Lehman Brothers as an investment grade stock a week before it collapsed in the credit crunch!

Currency risk

This is something we have seen a lot of since the Brexit referendum. It is the chance of losing money because you invested in a foreign currency and the rates have moved. It doesn’t just mean turning your pounds into Euros or dollars it also affects you if you invest in assets that are priced in a foreign currency. For instance if you buy into a fund that invests in Europe, the underlying shares will be valued in Euros.

Liquidity risk

This is an important one and not very well understood. It is the risk that no-one wants to buy your investment from you when you want to sell it. When that happens supply and demand drives the price down – significantly.

Foreign investment risk

This covers risks associated with political instability and governance. If you had invested in Ukrainian stocks before the Russian army crossed the border you would have had a tough time. And not every stock market in the world is as well-regulated or supervised as the London Stock Exchange. You may find some companies abroad are not willing to issue profit warnings when they should.

As we progress through I will refer back to these risks and tell you what to do to reduce the chance of losing money.

The first step is to avoid inflation risk and only keep as much in deposit accounts as you need to cover your emergency fund, that 3 – 6 months of cash you need to have just in case.

That is probably enough to take in for one episode so that leaves a little time to talk about another good cause. This time it is MND Association – Motor Neurone Disease is a fatal rapidly progressing disease that affects the brain and spinal cord of about 5,000 people in the UK at any one time. There is no cure. One in three who are diagnosed die within the first year. Please check out https://www.mndassociation.org/about-us/key-facts-and-information-about-mnd/


[i] Source Office of National Statistics