Throughout
our lives we're likely to be thinking
about the need to save. In our early years
it may be saving for a bike, or a holiday
or a car. Later it'll be about buying
a house or building up a pension. If we
do save then we'll want to invest the
money wisely, somewhere where it'll grow
safely and where it'll be available for
us when we need it. This primer takes
us through some of the things we should
be thinking about when investing our money.
A
windfall
Suppose
that you have just won on the football
pools or the national lottery and so you
now have a large sum of money to invest.
Below
are various options suggested to you.
Your task is to decide how you might allocate
your money across some or all of these
options by analysing the strengths and
weaknesses of each in terms of the rewards
on offer and the risks involved.
•
A Bank Deposit account
•
Tesco shares
•
Gold bars
•
Index-linked National Savings certificates
•
"Lucky Lad" in the 3.30
at Doncaster
•
A home of your own
•
A loan to a friend who would like
to start a business
•
Your own business
Your
choice is likely to be based on the following
kind of analysis:
Bank
Deposit Account
Rewards
Reasonable
return but income and capital may be
eroded by inflation.
Predictable
and regular cash income
No
capital growth.
Not
necessarily very tax efficient.
Risks
Low
risk
The
investment is easy to turn back into
cash.
Tesco
Shares
Rewards
Good
return offering potential for both cash
income in the form of dividends and
capital growth (which may provide tax
benefits).
Major
company and long-term income is fairly
secure.
Risks
All
shares are risky but Tesco is a major
company and should be less risky than
many.
The
amount invested is easy to turn back
into cash as there is a ready market
in Tesco shares. However, the share
price may fall and a capital loss sustained
Gold
bars
Rewards
Unknown.
Highly speculative and dependent on
global markets.
No
regular income. All reward comes through
the potential increase in the value
of gold.
Risks
High
in the short-term, better in the long-term.
Often
seen as way of protecting yourself against
currency fluctuations, inflation and
political instability. Note: Gold has
little intrinsic value; its value depends
on there being a market but it is prized
throughout the world and has a long
history.
Index-linked
National Savings Certificates
Rewards
Reasonable
return in the long-term.
Part
of the return is there to protect the
capital from inflation; therefore the
real return is quite low reflecting
the safety of a Government backed investment
Tax
efficient.
The
return is higher the longer the money
is invested.
Income
is not received without cashing in certificates.
Risks
Few
risks.
The
capital is easy to withdraw.
Lucky
Lad
Rewards
Potentially
high, depending on your expertise and
the odds!
Risks
There
is a great risk of having no income
and losing all your capital.
A
Home of your own
Rewards
Reasonable
return.
No
income as such but it avoids payment
of rent. The investment needs to be
looked after and maintained.
Traditionally
a good protection against inflation
with high capital growth but subject
to short-term fluctuation.
Tax
efficient.
Large
sums tied up without any cash being
generated.
Risks
Low
risk in the longer term but possibly
costly if moving often.
A
loan to a friend
Rewards
As
a loan, the reward comes through the
interest not specifically the success
of the business. A high risk loan may
provide a high interest rate but the
return is still likely to be fixed.
Yet, the ability to pay the interest
is dependent on the success of the business.
No
capital growth.
Risks
Capital
may possibly be protected by security
on the assets but this may not prove
to be very valuable.
May
not be easy to obtain back the capital
invested if needed in the short-term.
Your
own business
Rewards
Potentially
high dependent on success and your own
expertise.
Potential
for both income and capital growth.
Risks
High,
but as management you have control of
the affairs of the business.
So
what are investors looking for?
Having
considered the above investment possibilities,
we are now able to draw a few outline
conclusions. The kinds of issues to consider
will be along the following lines.
Any
investor is looking for some form of reward
whether it is profit, dividends, interest,
capital appreciation or a mixture of all
of them. The precise choice for any investor
will depend on a number of considerations
and they are likely to vary from one investor
to another.
These
considerations would include a person's
willingness to take risks, their need
to have a stream of income appearing in
the form of cash, and also the time horizon
over which they see the investment bearing
fruit. For example, the needs of a young
person who is planning to provide for
a pension in forty years' time and can
afford to take a long term view will be
markedly different from a pensioner who
needs a cash income to live on and whose
time horizon is going to be much shorter.
Within
that framework everybody obviously wishes
to have as high a return as possible in
relation to the amount invested and so
investments will be compared with one
another for their ability to provide a
suitable return.
But
it also seems reasonable that the higher
the risk involved in an investment then
the greater should be the reward. And
so a straightforward comparison of investment
returns will have to be tempered by consideration
of the risk inherent in any investment
and the attitude of the individual investor
towards taking risks. This will depend
on personal needs and personal preferences
and everybody is different.
Some
people will be very concerned about the
security of their income, particularly
those who need to generate a regular income
from their investments. Others will look
to ensure that their capital, that is
their basic investment, remains intact
as far as possible even if the return
might vary. Yet others will be concerned
about the ease with which they can withdraw
or release the money they have invested
especially if the investment has been
used as a means of saving for a particular
purpose, say paying school fees or putting
a down deposit on a house.
In
the latter circumstances it is unlikely
that someone will want to lock up their
money in investments where they cannot
gain access to it easily or where the
investment might fall in value significantly
in the short term, even if in the longer
term it is likely to show a good return.
Inflation
Thinking
about the best place to put our money
should also encompass the ability of an
investment and the rewards it offers to
preserve its value in the face of changing
purchasing power, in other words inflation.
In such a case, possible high cash returns
on, say, bank deposit investments compared
with investing in shares would have to
be put in the context of the gradual fall
in purchasing power of the money tucked
away in a bank.
This
would have to be compared with the potential
for companies to recover their cost increases
through price increases and so maintain
the real value of profits and, hence,
dividends. As long as investors remain
aware that part of their interest income
is compensating them for the fall in value
of their capital then all the options
can be properly compared.
Investing
is about the future
Throughout
our analysis we must have at the forefront
of our minds that, much as we might like
to, we cannot make decisions about the
past, only about the future.
And
so, however much we may look to past information
to help us assess an investment, in particular
accounting information, dividend payments,
share price movements etc, what we are,
in fact, trying to do is to use this information
to help us make a judgement about the
future. If the past Information does not
give us a guide to the future then it
is not useful. In consequence, we should
never be afraid to use any information
whatsoever that we have, both financial
and non-financial, both objective and
subjective, to build up our knowledge
and our confidence about an investment.
"Any
information is good information if it
gives us the right answer!"
Investing
requires confidence
If
we do not have confidence that we will
obtain an appropriate reward for the risk
we are taking, why on earth should we
part with our money? Confidence lies at
the heart of all investing. A person must
be willing to entrust an amount that they
have or can borrow for the prospects of
a greater but uncertain amount to be received
in the future.
So,
what kind of confidence should we be seeking?
This confidence is required at various
levels.
We
must have confidence in the honest and
fair operation of the investment market.
This means that when we are considering
investing we know that we are not at an
automatic disadvantage because others
have more information than we have. In
addition, we must have confidence in the
integrity of the management we are using
to manage our affairs. This involves being
confident that they are motivated to work
on our behalf. It also involves having
confidence in the financial information
which comes out of the organisation.
Once
we are happy with these, then what we
would also wish to do is to understand
and reassure ourselves on the prospects
for the particular business we are investing
in and the ability of the management concerned
to make sound judgements relating to the
opportunities and problems which present
themselves within that business.
Taxation
Finally,
every investor should be considering the
taxation aspects of their investments.
Each investor's circumstances will be
different and each will need to look at
the effectiveness of his or her investments
after all costs have been taken into account,
including those of taxation.
Spreading
the risk
It
is unlikely, even if we're able, that
we would invest in one type of investment
only. Firstly, we've got to balance our
short and long term needs with the types
of investment and, secondly, we should
spread our risk. Even if we like investing
in shares it would not be very prudent
to invest all our money in one company
only. Better would be to build up a portfolio
of many shares, to protect us against
the poor performance of any one company.
"Not putting all our eggs in one basket"
is a fundamental tenet of investing. There
is more to come on this.
