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 (all maturities) -1.4% -0.3% 0.7% 1.4%
UK corporate bonds (10+ years) -1.6% 0.0% 1.6% 2.6%
UK government bonds (15+ years) -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. By for now.