Most people have heard of “the markets”, but unless you’ve already been exposed to them it’s not obvious how to get started.
In this guide I will go through a few of the key concepts and terms, as well as give an overview of a few different types of investment.
Some basic concepts
These might seem a bit boring and/or complicated, but they are an important foundation.
As an individual you will trade in financial markets through an investment/brokerage service, which is a specific type of financial service.
Financial service providers will offer you different types of account to hold your assets within. These accounts will have different features, which largely boil down to how your assets will be treated for tax reasons, and any associated restrictions on when you can access the assets you put into them.
For example an Individual Savings Account (ISA) will shield your profits from tax, and a pension account will give you tax relief on contributions but prevent you from withdrawing anything until you retire. Occasionally you might see these referred to as wrappers for your assets, as they sit within these accounts.
You own the assets within these accounts, however they are managed by the service provider. If the provider went under, you would still own the assets. Most providers charge you a percentage-based management fee for the service as a whole, as well as transactions fee whenever you make either a purchase or sale of an asset.
For the sake of this guide, I will only talk about execution-only services because the others are more expensive and require much higher minimum amounts to invest. For execution-only the provider only executes the trades, the client (you) makes all the decisions.
Types of account
There are three main types of account you can open, which are also sometimes called wrappers:
- General Investment Account (GIA)
This is the bog standard account with no complications. You hold, buy and sell assets. No preferential tax treatment. You should be mindful of dividend and capital gains taxes. - Stocks and Shares Individual Savings Account (ISA)
ISAs are sheltered from tax, so for investments in this account you don’t have to worry about dividend or capital gains taxes. You have a shared allowance of £20,000 per year to invest across all of your ISA accounts. The actually allowance can change year-to-year, but as of 2020 it is £20k. - Self Invested Personal Pension (SIPP)
These are pension accounts that let you choose your investments. Money into these accounts are eligible for tax-relief — money back in on top of your deposit (basically an income tax refund). Money in here is sheltered from tax as well, and can be withdrawn after you retire. Withdrawals after retirement are treated as standard income as far as tax is concerned (as if you were being paid by an employer).
There are many different types of ISA tailored for different uses. There is a Lifetime ISA for saving for a deposit on a house, or a Junior ISA for children, or the Cash ISA for simply holding cash with a standard interest rate.
Your long term goals and current tax status will determine which account is the best choice. In most cases, for most people, you will want some kind of ISA.
Types of Investment
Okay, we now have an account. What should you invest in? That is not something I can tell you! I can however tell you a little about your options.
Each individual investment has a different risk associated with it, it is your job as an investor to understand those risks and pick investments within your risk tolerance.
Here is an overview of each investment type, and what it means in practise:
- Stocks
individual ownership stakes in individual companies, represented as shares - Funds
actively managed pools of money and assets, represented as units - Exchange Traded Funds (ETF)
funds traded on exchanges as shares, used to passively track an index (basket of stocks or commodities) - Bond
represents debt to a company or government, to be paid back at a fixed point in time - Investment Trust
similar to an actively managed fund, but in the structure of a company so traded as shares on exchanges
How does an investment earn you money?
There are broadly two ways — income or growth.
A stock can pay you income via a dividend, the payments companies make back to their owners from their profits. The value of the share can also fluctuate, so you can also make money by selling it for more than you bought it (remember to factor trading fees in!).
A bond pays income via an interest coupon, and the principal value (i.e. original loan value) upon maturity . Bonds can also fluctuate in value, so you can make money by selling it for more than you bought it for.
A fund can pay you income (underlying interest and dividends etc), or “accumulate”. This is when a fund uses the income to buy more assets within the fund itself. As a funds value is tied to the underlying value of the assets it holds, buying more assets with this money increases the value of your share of the fund. In general funds aren’t day-traded like shares for value fluctuations, as they tend to be less volatile.
Lets talk about risk
Investing is risky. There is no guarantee you will get your money back.
Investing is risky. There is no guarantee you will get your money back.
Investing is RISKY. There is NO guarantee you will get your money back.
Hopefully that has sunk in. Picking an individual investment (stock/bond) is incredibly risky — you have to do a lot of research and have a strong understanding of financial instrument you are purchasing.
Companies occasionally collapse, and if that happens your share will be worth nothing. A share is only worth what someone will pay you for it when you need to sell.
Bonds can be defaulted on, and all have their own unique terms. They are complicated, and like stocks require a lot of research.
Investing is risky. There is no guarantee you will get your money back.
This is why it’s incredibly important to diversify. The more places your money is split across, the lower you exposure to each individual risk. It also insulates you from fluctuations in individual investments — outside of market-wide downturns the ups and downs of specific investments should balance out a bit (in theory anyway!).
Funds to the rescue?
Thankfully there’s an investment for that — funds provide you diversification by design as they’re a basket of investments. There is an entire industry of people dedicated to understanding these investments. Without this knowledge, expertise and time to research it is very hard to outperform the market as an individual investor.
There are two main types of fund, differentiated by how the assets are managed under the hood:
- Active
A fund manager and team of analysts manually pick assets for you. Their goal is to “beat the market”, which means beat a tracker. Your challenge for investing with an active manager is knowing which one to choose. It is common for less than half of managers to actually beat the market. Thankfully this can be diversified as well, and you can invest in multiple funds. Generally these charge much larger management fees than passive tracker funds. On average between 0.75% and 1.25%. - Passive
Assets within a passive fund are automatically managed as they simply track an index. For example, if BP was 4% of the FTSE 100 index then 4% of the funds assets would be BP stock. The fund then periodically sells and buys stocks to match the index composition. This ensures that if the FTSE 100 gains 6% over a year, so will you holding this fund. These funds can change as low as 0.06%, although some can charge as high as 0.8%.
Time horizons — how long to stay invested
Another way to reduce your risk is to invest for the long haul. Do not take your money out for a long time, as in 10 or 30 years kind of long time.
You cannot know when the market will rally or crash.
Who could have guessed COVID19 would happen? It is the nature of markets that once one person knows something everyone does, so they move very fast and it’s impossible to know they are going to turn until they do (legally anyway, as otherwise it’s probably insider trading or market manipulation…).
Because of this, if you will need cash soon, it is best to sell sooner to lock in a good price then wait in the hope it goes up some more. If you are invested for a short amount of time the risk of being caught selling lower is heightened. If you’ve had 30 years of growth in an index, a normal dip is unlikely to remove all of that growth in one go.
This is also why it is paramount to invest when you are younger to get the most out of it — you can afford to take riskier moves as you have a longer time for your money to grow if it doesn’t work out. If your horizon is short you don’t have that luxury, you must be cautious.
What do you do?
To give a window into my own personal finances: I hold passive index tracked funds, across several accounts (SIPP, LISA, ISA) that are also distributed across different geographical regions (US, UK & EU) that I attempt to keep roughly balanced. By this I mean if the value of one region goes up, I will distribute new money into the account to the other regions to keep my spread consistent.
Tracking broad indexes across multiple regions give me a lot of diversification for a low ongoing charge. If I wanted to hedge against stock volatility I would also looking to introducing some other investment types like bonds (as they vary much less both up and down), but as I’m still quite young and have several decades I intend to keep my exposure in equities for the foreseeable future.
Outside of my investments, I also keep a decent chunk of cash handy in high interest savings accounts, so I should never need to dip into my investments for day-to-day expenses or emergencies. It is more important to have an emergency fund than to start investing, so sort that first if you don’t already have one: Introduction to Personal Finance
I also have a small amount of shares in a few technology start ups, but I treat this money as a wild bet that I don’t expect to get back.
In short
The perceived wisdom for those starting out is to invest for as long as you can, in as diverse a portfolio as you can. I personally let the market do the work for me by investing in passive trackers.
Disclaimer: This is information on investing, not financial advice.
I am not financial adviser, seek advice from a professional.
