Basics of Investing

23/11/2024

It can be hard to know where to start when you look to start saving for the future. The aim of this blog post is to help provide some guidance, and a structure to follow if you want to start putting some of your hard-earned money to work.

First things first

Before you invest a penny you need to be totally sure that you are investing for the long-term and that if something unexpected happens you have protected yourself against financial loss.

If you haven’t already please check out my blogs on The Importance of Insurance and Getting Started With Financial Planning before reading any further about investing. It is so important that you have an emergency fund and the right insurance in place before you look to start investing. Otherwise, if something unexpected happens you may need to withdraw from your investments at the wrong time, upsetting your whole plan.

Where to start?

Now that you have dealt with the basics of Financial Planning and built a solid foundation we now turn our attention to the task of how to build real long-term wealth through investing.

Saving vs Investing

The first thing you need to know is the difference between saving and investing.

Saving – This is money not spent that has been deferred for future spending. It should only be held in cash and is for short-term savings for purchases and emergencies.

Investing – This is the intentional allocation of money in a systematic way to achieve income or growth. Typically the timescales are 5+ years (often much much longer) and the potential return is an inflation-beating return dependent on the level of risk taken.

What accounts should you invest in?

Now that you have chosen to invest you will generally be presented with a choice of 3 products that you can invest in.

General Investment Account (GIA) – This is an investment account in which you can invest as much as you want into. Gains are taxable in line with Capital Gains Tax (CGT) legislation and you will be required to pay income and dividend tax on any interest or dividends you receive within the portfolio.

Individual Savings Account (ISA) – This is an account into that you can pay a maximum of £20,000 per annum. Unlike the GIA however, all of the gains, interest and dividends within the ISA are totally tax-free. You do not pay tax on them at any time and can access the money free of tax at the point of withdrawal.

Pensions – There are a wide array of pensions out there but if you are looking to set one up yourself it will likely be a Personal Pension or a Self Invested Personal Pension (SIPP). Pensions also grow free of capital gains, interest and dividend tax but you do have to pay tax when the money is withdrawn. Typically you can withdraw 25% of the fund tax-free but pay tax at your marginal rate on the remaining 75%. Pension legislation is complex but the general rule is that you can pay up to the lesser of your total annual earnings or £40,000. ie if you earn £35,000 the maximum you can put in is £35,000 but if you earn £60,000 the max is £40,000. You cannot access pensions until the minimum retirement age which is currently age 55 but is increasing to 57 in April 2028. You also receive tax relief on the contributions you put in which makes pensions very attractive to investors.

When it comes to allocating your savings between these accounts it is worth talking about the pros and cons of each. GIAs are generally not used unless you have maximised your ISA allowance, given the favourable tax status of the ISA.

Generally speaking, you will get the most bang for your buck by investing in pensions. For basic rate taxpayers, you get a 25% uplift in your contributions which is a massive benefit. Higher rate taxpayers get even more tax relief than this as they get another 25% uplift by completing a tax return. The obvious downside to pensions is the lack of access and the taxable element of the pension upon withdrawal.

With that in mind, it is often best to be pragmatic with your investing and split your savings across both an ISA and a pension to get the best of both worlds. You have the tax relief benefits of the pension which will help your funds grow quicker and then you have the ease of access and tax-free withdrawals of the ISA in the future. These two run perfectly side by side.

Asset Allocation

When it comes to investing there are, generally, four main asset classes and it is important to understand what each of them is and the role they each play in investing.

Cash – Cash is used to pay for any investment fees and allows for quick withdrawals if ever needed

Bonds – Bonds are used to reduce volatility and minimise the risk of capital loss. They are safer and more comfortable.

Property – Property is a hedge against inflation because property values tend to rise with prices. Can also be used as a diversifier.

Equities (Stocks and Shares) – Equities are used for their growth potential. They are the most responsive to both the ups and downs in the market and are the real driver of returns within investment portfolios.

Diversification

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that should each react differently to changes in market conditions.

Active vs Passive Investing

What is active management?

Active investing is the process of constantly analysing and monitoring the markets and actively buying, holding, and selling at key moments to exploit fluctuating changes in prices. The goal of active management is to beat the performance of the overall market index.

To achieve this, active managers use a mixture of their instinct and experience, research, forecasts, and analysis to invest in what they deem to be the most attractive funds.

The benefits of an active approach include the freedom and flexibility to invest across the market (and avoid any sectors that go against a client’s requirements) and the chance to outperform the market.

As for cons, active investment is generally more expensive due to the higher fees involved. Plus many active managers take a longer-term approach, due to the resources required to carry out the in-depth analysis behind active decisions. As a result, the expenses can exceed potential market gains. There is also the risk that the performance of the fund is dependent on the talents and success of a particular manager and is not repeatable should that fund manager change.

What is passive management?

A passive approach, also known as indexing or tracks, aims to replicate the market performance, rather than beat it. The goal is to equal the returns of a specific index by investing in securities that represent that index, as opposed to actively trying to anticipate and benefit from fluctuating changes in prices – there has been much research into the passive and active debate.

Back in 1991, Nobel Prize-winning economist William F Sharpe found that the average return on an actively managed dollar will be less than the average return on a passively managed dollar in his paper ‘The Arithmetic of Active Management. This is because actively managed funds need to have a greater return to counteract the additional costs of active management.

The benefits of passive management include considerably lower fees and expenses than an active approach and better returns. And more recent studies back this up. In July 2021, the FT Adviser reported that ‘just half of active managers performed better in monetary terms – after fees were taken into account – than their passive counterparts during the aftermath of the coronavirus-induced market crash,’ with just 21% of funds in the IA UK All Companies sector seeing better returns after fees than their passive equivalents. Not to mention, it is a quick and simple way to enter a market.

How do we actually Invest?

So now that we have discussed what accounts to use, the difference between passive vs active and more you are probably wondering where to invest your money now that you have the accounts ready to go.

The vast majority of people who are self-investing would be best served to invest in Passive Multi Asset Funds. These funds pool your money with thousands of other investors and spread the money across different asset classes all across the world to create essentially what is an off-the-shelf investment portfolio. They will probably invest the money better and more cheaply than you could do yourself.

Most of them are named according to their risk profile eg balanced, cautious etc and you should try to find one of the risk-rated funds that align with your risk profile and timescales.

Don’t meddle

Once you have set your account up and chosen your investment fund it can be tempting to move things and second guess yourself.

If you set up a pension or an ISA and set a regular monthly investment and then select a regular off-the-shelf risk-rated passive multi-asset fund you shouldn’t need to do any tinkering.

The biggest difficulty you will find is as you get more interested in your finances and managing your money you will be tempted to meddle with your choices.

Good investors learn not to pay attention to short-term market events. If you are a long-term investor, then what does the short term matter?

Ignore the news, keep investing regularly and watch your wealth grow over time. Don’t meddle.

Review annually

It is a good idea to review your personal finances annually. It is good to take stock once a year to see if your current setup is still suitable. For example, you might now have more surplus income than you had a year ago. (or less).

When to seek advice

If you are thinking about getting started but still don’t know where to start then consider speaking to a financial planner. Ideally, someone who is Certified or Chartered. If you would like to have a confidential no obligation chat about your plans then please get in touch and I would be happy to see if I could help

Matt