1. Develop an overall strategy from the ground up. Using advisers is like using recipes. They can provide ideas and help you implement them, but only you know if you want beef or fish for dinner!
2. Use lots of different products, but choose “wholesome” ones and time will do the hard work. Foods have nutritional value and health benefits; financial products have performance metrics and risk characteristics. Good stuff in = good stuff out!
In short, investment is like eating a nutritious balanced diet. Use varied and wholesome ingredients. Take advice. And voila, with time your fortune grows. So here’s my list of ingredients.
Alternative is good but – buyer beware – don’t overlook the risks!
In investing, stocks, bonds and funds are considered “traditional” assets. Property and gold, on the other hand, are Alternative Investments even though people have used them as a store of value for time immemorial. The category also includes hedge funds, investment in business (e.g. venture capital, private equity) and other commodities. What it comes down to is this: traditional assets benefit from uniformity and public trading, both of which create a large pool of buyers and sellers. Alternatives offer better returns, but they have unique features that limit the number of buyers. With lower liquidity, prices are more volatile and less transparent. Heed the risks.
Alternative Finance is a subset. Crowdfunding and peer to peer lending platforms allow investors to back small and new businesses or property development directly, bypassing the banks. It’s an exciting prospect but untested through business cycles. Many new companies will fail, so spread the risk, invest conservatively and don’t forget to research the platform. Ideally, pick one which works with institutional investors such as BlackRock or British Business Bank: they put partners through their paces. See Go with the Crowd or Go Your Own Way?
Investors are usually advised to limit alternative investments to 10% of their portfolio. In reality, homeowners are always above this level, investing in commodities is a good thing if economies are booming and holding cash or gold during a crisis is a defensive strategy.
Bonds allow governments, companies and banks to raise debt funding from a large number of investors. In return, the issuer commits to periodic payments of interest and final repayment of capital at the end of the debt term.
Whether or not the issuer is able to fulfil these obligations depends on its financial strength. For publicly traded bonds creditworthiness is assessed based on the country’s economy, the company’s business or the pool of assets that will fund payments. On a scale of AAA (Switzerland) to D (default), BBB- and higher is “investment grade”, so lower risk.
Not all bonds are rated, though. Take mini-bonds issued to fund solar and wind farms and social impact bonds used to raise financing for charitable or social programs. Investors need to assess unknown issuers, new technologies and untested projects. Risky stuff. Security – say property, the energy generation installations – can mitigate the risks, but the key is to understand who’s borrowing, why and how believable their business plan is.
Bonds are the quintessential income investment. They are stalwarts of pension fund portfolios, the idea being that interest payments will generate enough cash flow to pay retirement benefits to defined benefit plan members. The catch is you also need to grow the capital base to have a big enough pot to generate high enough interest payments to achieve this.
Cash is good. If you have it, you can invest it as opportunities present themselves. Ideally, you want to cash in on all your gains when the market is at its peak, ride out the fall with cash in the bank and put it back to work at the bottom of the cycle, so you can ride the next wave up.
Cash is bad. It creates a “drag” on your returns because you generally earn little on cash deposits. And if inflation is higher than your interest rate, you are actually losing money.
Cash is a necessity. You always need a emergency stash for life’s little surprises. Before investing, always ensure you have some readily accessible savings.
Growing companies reinvest profits in growth and research & development. But once they start sharing the profits with shareholders by paying dividends, the key is to look for steady – ideally rising – payment levels. Dividends are paid periodically. Unlike interest, they are not pre-defined, but mature companies publish dividend policy and you can always look at dividend history for guidance. Reinvesting dividends helps your money grow over time as you reap the benefits of both capital growth and return on the additional investment.
Exchange trade funds are funds, which are traded on an exchange, so you can buy and sell them as you would stocks. They track indices such as FTSE 100 or S&P 500, pools of equities grouped around a theme (e.g. solar companies or German companies), bonds (e.g. Euro corporate bonds), commodities (metals, oil, agricultural products) and currencies. You can invest small amounts to gain wide exposure or put together a portfolio of ETFs to cover any investment idea.
ETFs cost less to manage than traditional funds as they simply follow a price index. Lower costs improve net returns to investors. This is why they have become very popular, especially with robo-advisers and “ready made portfolio” brokers such as Nutmeg.
Funds invest in portfolios of stocks, bonds, properties, funds or a mix of asset types. Investors benefit from the manager’s expertise. In practice, paying for expertise only makes sense for actively managed funds, which seek to outperform the market or a particular index by taking a view on a company, industry sector, bond term, etc. Passive funds do the same as ETF – follow an index – so why pay more?
Fund strategies are diverse: income, capital growth, absolute return, socially responsible investments, retail properties, to name but a few examples. The key is to understand the strategy and pick good performers, i.e. ones that are in the top quartile of funds with a similar strategy. Before you decide, check if there’s an ETF or investment trust with the same strategy, as that might be a cheaper option.
Gold does not produce an income so some don’t consider it an investment, but it is a universally accepted store of value. You can buy jewellery or gold bars, but given security risks and cost, a more accessible way to invest a smaller amount of money is via a commodity ETF or in the stock of a gold miner. Same goes for other precious and industrial metals.
Houses, apartments and commercial property can be good investments. When rented/leased, they can provide a steady stream of income (rent) and a return of capital when sold. In this respect, property is similar to bonds. The biggest risk is getting your capital back, so the strength of the asset – its location, quality and attractiveness to tenants – is paramount for a sound investment.
When the property is the house you live in, the only source of gain is price appreciation. Unfortunately, property investment is not always “as safe as houses” … people move away when businesses close, property cycles have their ups and downs, overbuilding may cause everlasting price deterioration. Having a roof over your head is important, but your house may or may not be an investment. The question is, can it earn you money?
Bonds pay periodic coupons. Debt incurs interest. Deposits earn interest. This is the cost of using someone else’s money. The more desperate you are to borrow the more you would be willing to pay for the privilege, so beware of high interest rates – are they high because the issuer is in distress or doing something new or risky?
Also compare to the general market, as what you earn is more valuable if the market rates are lower and less valuable if the market rates are higher. Most importantly, if you want your investment pot to grow, reinvest the interest income.
Non-investment grade securities are referred to as junk bonds, i.e. bonds rated BB+ or below. While the lower rating implies weaker issuers, they tend to outperform higher rated bonds during market booms as their price tends to go up as stock prices go up.
There is also a subset of the market known as “fallen angels”. These are bonds issued as investment-grade but downgraded when the issuer falls on hard times. Some may go on to default, but the ones that improve can reap the benefits of becoming investment grade again. Perhaps not a strategy for a novice investor, but the concept is similar to investing in the stock of companies that have fallen from grace but have good recovery prospects.
KIID stands for Key Investment Information Document. This is a short summary of a security. Funds are required to produce them. Listed retail bonds have them. It sets out the fund strategy, its performance relative to the market or benchmark, its key investments and risks. In the case of bonds, it covers the business plan, the use of proceeds and details of any security provided. As an investor, you should be reading all the materials issuers provide, but as a minimum you should read the KIID.
We are living longer. Longevity risk has become a hassle for insurance companies and pension funds. It is a concern for you, too. The longer you live, the more money you will need in retirement.
Lets do a simple calculation. If you retire at 65 and live until 85, you need 20 years worth of income. Lets say you need £25,000 per annum (mind you, assuming a £10,000 personal allowance and factoring in 20% tax, that’s £22,000 net). So, £25,000 x 20 years = £500,000. Say you get the full state pension of £150 per week, that’s £156,000. Where is the other £344,000 coming from? What if you live to 90? Then there’s inflation!
Governments are curtailing what they provide, so unless you are in a generous government funded pension scheme (Lucky you!), this means you will need a bigger pension pot then previous generations. Starting to save early is key to growing that pot.
Match funding is a concept used by life insurance companies and pension funds. Basically it says you need to match the funding coming from assets you own to your obligations under debts (aka liabilities). In everyday terms, you need some ready cash for everyday expenses (current account) and emergency costs (savings account). Then you need to put aside funds (savings account) for bigger expenses (holiday, new car, tuition fees). Next up, you need to save/invest to cover big ticket items such as a house deposit and the better options become products that will not be accessed for a while to let funds accumulate, so think Stocks & Shares ISA, Lifetime ISA, Help-to-buy ISA. And all the while you need to stash cash for retirement in a “locked” pot (SIPP, pension plan, Lifetime ISA) to grow a nest egg that will generate sufficient income for 20-30 years.
Always consider wealth in net terms. It’s all very well building up a pension pot, but if you area borrowing heavily or upsizing the mortgage to allow you to do that, are you really better off? Some debt is good – it makes little sense to buy a house outright – but as with everything, it’s good in moderation. Reducing high-interest debt (credit cards, personal loans) before low interest debt (student loans, mortgage) makes a lot of sense as it plugs the money drain. It also improves your net worth as that stream of high interest future payments his a higher negative value. Ideally you want to enter retirement with the credit cards and mortgage all paid off, so there’s just day to day expenses.
Open-ended investment companies and unit trusts are the most common funds available. Being open-ended it means they issue new units every time a new investor decides to entrust their money to them and cancel units when an investor leaves them. Logically, if the fund is good at what it does, it will continue attracting investors and grow, so big funds a sign of stability.
Another factor to consider is how the price of the fund’s unit compares to the net asset value (NAV) of the underlying investments. Typically, unit prices are below NAV, i.e. if the fund had to liquidate, the sale of the underlying assets will generate sufficient proceeds to cover the units. Discounts are, therefore a good thing, but if discounts are more than 20%, you have to ask yourself it his is not a sign of distress or loss of trust in the fund manager or the strategy. It is also not good if the unit prices exceed the NAV, i.e. there’s a premium, as there is no safety margin and perhaps investors are overvaluing the managers ability while the underlying market is deteriorating. You are overpaying if you buy units at a premium, and it’s always better to underpay!
To do well, you need to pick investments wisely and reposition your portfolio if things change. Most importantly look at investments in relative terms: as percentage growth, growth versus peers or the sector, performance versus other investments in your portfolio. At the end of the day, do you really care if you have invested in the best performing bond ever if the overall return you get is lower than the FTSE 100 given that your ultimate goal is to grow your investment pot? See also Investment performance: the maths you need
Tax wrappers don’t allow all investments. Instead, they screen for qualifying investments. For instance, until recently you could not hold AIM listed shares in an ISA or property in a SIPP. The list of qualifying investments is expanding all the time. From April 2016, you can even hold P2P loans in the new Innovative Finance ISA (IFISA).
Sometimes investments cannot be held in one wrapper (ISA) but can in another (SIPP) such as US ETFs. Less liquid assets such as property and agricultural land investment may not be qualifying investments for certain platforms, but acceptable to others, so it is always worth researching if an investment product you are considering can be bought within a tax wrapper. The best approach is to select your theme and then figure out how you can best invest in it.
Socially responsible investment encompasses investing in companies and products that do not harm the environment, treat people well and focus on sustainable growth. SRI products come in many shapes and sizes. Some examples include Jupiter’s Ecology Fund, iShares Water ETF, SolarCity’s asset backed listed solar bonds, Abundance’s mini solar bond for Swindon Council, Lloyds Bank’s Green Property Lending fund, Crisis’ housing bond, Bridges Ventures’ renewable energy fund. The list is growing. See also Socially Responsible Investing
Stocks & shares allow investors to back business either privately or in the public, listed equity market. As part owner, you can share in the profit, but are also exposed to risk of loss. When it comes to listed shares, you can hold them directly, through and ISA or SIPP wrapper, through funds, investment trusts or ETFs.
When you invest in an investment trust, you are investing in a company that itself invests in something. If it is a real estate investment trust (REIT), it invests in property. Most commonly, they invest in company shares. So for example, The Biotech Growth Trust invests in biotech companies. This offers an easy way to invest in a thematic or broad portfolio, and, as such, it is an alternative to investing in a managed fund with high fees or in ETFs you may not be able to hold in your ISA or SIPP. The ultimate benefits are diversification and professional management.
Tax, commissions and fees eat away at profits. If you hold an investment such that it is sheltered from income and capital gains tax or affords you other tax benefits, do it. But don’t let principle cloud your judgement. For instance, Cash ISAs pay negligible interest, with some current accounts and term deposits providing better returns. Under new tax exemption rules which allow you (and your children!) to pay not tax on the first £1000 of interest per annum, it makes more sense to go after high interest rates outside ISAs.
Another thing to consider is when you get the tax benefit. With pension contributions, you get an immediate tax rebate from the government, but pay tax when you take money out in retirement. With ISAs, you pay tax upfront but are not taxed when you take money out. With VCTs, EIS and SEIS you get a benefit the year you invest, but it can be clawed back if you don’t stick with it for the minimum term.
UCITS (Undertakings for the collective investment of transferrable securities) are heavily regulated investment funds, which can be marketed to investors across the EU. Investors benefit from extensive investment choices, market liquidity and professional management. They are ideal for retail investors as they feature lots of protections and reporting obligations. Being restricted in what they can invest in could translate into lower returns, though.
Venture capital trusts (VCT), Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) are all UK investment opportunities with generous tax benefits such as 30-50% of your tax bill. They are the government’s way of directing retail investment to small and seed business, much like venture capital and private equity funds invest in big and distressed businesses.
However, investing in small and new businesses carries a greater risk, so they are more appropriate for the wealthier investor. Having said that, some schemes, particularly VCTs, have been running for a long time and have shown their ability to pick, support and exit businesses. This mitigates the risk as you are investing in a portfolio through a tested platform.
Create a watchlist for all the investment ideas, tips and topics you want to monitor and research before investing. This is also a good way to do a dry-run for an investment idea and implement it for real if its folding out as expected.
Create a watchlist for the investments you want to sell. Actually, this is more of target list, i.e. the price levels you want to reach and the stop loss levels you don’t want to go below. Many broker platforms allow you to put in stop loss and target sales levels. But the time horizon may be too short for your purposes. I have also found that you may get taken out on less favourable terms on an automated trade (e.g. particularly if there is a spike down) than if you put in the order.
Most people will have a variety of pots: savings account, current account, an ISA or two, maybe an old company pension scheme, perhaps a SIPP, the house, a business investment, direct investment in a company or fund, etc. You need to aggregate it all to get a full picture.
For listed securities, you can use the portfolio tools of data provider Morningstar and brokers. Hargreaves Lansdown’s lets me X-ray my combined ISA and SIPP portfolio, looking through the wrappers, the funds and trusts and aggregating exposures by company, industry and asset type (equities, bonds, etc.). This allows me to identify risk concentrations and thematic opportunities.
Over time a lot of portfolio growth can come from compound interest, i.e. interest on reinvested interest. Coupled with capital growth, the longer your investment horizon is, the more time you have to take long term views on big investment trends and avoid the pitfalls of business cycles. Introducing children to saving and starting to contribute to their investment pot early is the best way to set them up for life – be it college or a house they desire … or both. There have been studies upon studies showing that young people who appreciate the value of money and investing are better with money money and investing. Go figure!
Investing is part art, part science. The most important ingredient is a cool attitude. When markets falter you need to calmness of a Zen master to see beyond the panic selling to the long term potential. Why, dips can be opportunities to add to positions you believe in long term. In fact, the best time to buy is when everyone else is too afraid and the sellers abound. Equally as important, you need the art of Zen to relinquish good performers when the market is all abuzz, i.e. at the top of their glory.