What is an investment 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.
2. Government bonds/Also known as Gilts
3. Corporate bonds
4. Shares also called equities
5. Property – Residential and Commercial
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.