How investments work - deposits

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!!