Tim Bennett looks at five basic factors that will influence how and where you invest.
Legendary US investor and multibillionaire Warren Buffett once said “Investing isn’t easy…” However, he then added “…but it should be simple”. Successful investing starts with a simple, but important, question.
There are two reasons why most people build wealth via saving and investing. Firstly, to live well. Secondly, to ensure that one day they will leave a good legacy. Investing to build wealth can deliver four big benefits;
- Choice – it opens up opportunities
- Independence – it sets us free you to make up our own minds
- Security – it enables us to stop working and retire one day
- Peace of mind – it provides a safety net and something to pass on
So how can you ensure that you squeeze the biggest benefit from every pound that you save and invest? You should start with some key factors that will influence how and where you invest.
Five key questions
1. WHAT IS YOUR TIME HORIZON?
As a rule of thumb, if you will need your money back within the next five years, you should prioritise safety and the return of your capital when investing it. If, on the other hand, you can lock it away for ten years or more then it makes sense to focus on earning the best returns. In between, you will need to strike a balance between safety and returns. These considerations will affect where you invest.
2. HOW MUCH DO YOU KNOW ABOUT INVESTING?
Investments can be categorised into conventional and more exotic, or “alternative” as follows;
Most investors should focus on the column on the left, unless they are pretty experienced. However, wherever you choose to put your money to work it should be with a single aim: overall aim – to consistently beat inflation (i.e. outrun the ever-rising cost of everything we need to buy to live). Taking the “conventional” investments above, historically shares have done a better job of doing this, and therefore building wealth, than either bonds or cash over most time periods, according to the Barclays Equity Gilt Study. However, over short time-frames they tend to be less good at protecting capital as they are more price-volatile. Knowledge about the characteristics of different investments is therefore critical to the way you allocate your money.
3. HOW WELL DO YOU UNDERSTAND RISK?
“Inflation risk”, or the danger that your wealth doesn’t grow fast enough over the long-term, interplays for investors with another one – the fact that in the short-term shares can go down as well as up – that’s called “price risk” or “volatility”. In order to avoid inflation risk you will need to accept some price risk – how much is key to the investment choices you will make. But these are not the only two risks you face. Some investments can be tough to sell and suffer “liquidity risk”. Others may attract “counterparty risk” if there is a danger that the one party to a deal won’t deliver.
These risks need to be understood and carefully balanced so that we hopefully avoid another one – “behavioural risk”, or our tendency to be our own worst enemies. For example, investors who follow the crowd tend to overpay for investments and panic-sell them with everyone else. Following the Golden Rules at the end of this article will help you to avoid some others.
4. HOW MUCH DO YOU WANT TO BE INVOLVED?
Some investors are comfortable doing everything themselves, without help or advice. They may choose an “execution-only” broker who will simply act on instruction when they want to buy and sell investments. Others prefer to have a helping hand and may choose a slightly more expensive “advised” service. Then there are investors who want everything done for them because they may not have the time, knowledge or inclination needed to go it alone. For them a full “discretionary” broker may be appropriate. There is no “right” answer here – this decision very much depends on individual preference.
5. WHAT ARE THE COSTS?
Costs can eat into long-term returns. So always find out what you will pay to set up and manage investments – it might be a percentage-based fixed fee, a “per trade” cost, a set-up/exit charge, or a mixture of all three.
All successful long-term investors stick to certain principles – here is a summary;
- Invest, don’t gamble
- Commit to a plan
- Be systematic
- Spread your money across different types of investment
- Don’t invest in things you don’t understand
- Avoid distracting media “noise”
- Don’t just follow the crowd
- Never panic
A final word of caution – all of these are easy enough to read but take discipline and experience to implement!