The basics

Saving v. investing

Savings accounts, whether with a commercial bank, mutual institution or even the post office, have always been a reliable way for investors to enjoy a return on their money without losing sleep at night. Savings accounts stood for stability and security, not volatility and uncertainty. But today's low interest rates mean that savings accounts provide only a meagre return, especially when compared with rates available in the past. Today, many savers are looking for other kinds of investment that can deliver a steady income and/or growth in their capital, while not taking on more risk than they are comfortable with.

Whether your goal is capital growth, capital preservation, income or a combination of these objectives, there are many ways of gaining access to the investment market. The type of investment you choose to meet your investment goals will usually be determined by factors such as your general financial circumstances, age and attitude to risk.

Risk might seem to be something to be avoided when investing, but without exposing your capital to some degree of risk you won't be able to benefit from potential capital growth or an attractive income. The key to finding a suitable investment that will provide the desired level of returns is to understand the relationship between risk and return.

Whether planning for a more comfortable retirement, investing to pay for holidays, a new car or school fees, or simply putting money aside for emergencies, we all want our money to work as hard as possible. Your individual investment profile will define what path you should take to achieve these goals.

Collective investment v. direct investments

A collective investment vehicle is one that pools the money of a number of investors to achieve a particular objective. Investment funds are the most popular type of collective investments. Because investment funds generally hold a large number of different investments, their overall performance depends upon changes in the value of all the assets owned by the fund. Investment funds are constructed to meet a specific investment objective and most measure their performance against a benchmark such as a stock market index.

By investing in an investment fund you can access a variety of asset types and investment in a range of sectors, markets, countries and currencies. This spread or diversification reduces risk and can help smooth out over time the ups and downs in the value of individual shares, bonds or other assets.

Investment funds are managed and monitored by teams of investment professionals. They offer a cost-effective way to benefit from an increase in value and enjoy income distributed by shares or other types of asset while spreading the risk between many different investment securities, and to share the cost of investing among many different investors.

Direct investment

Investing directly in the equity or bond markets allows you, or your advisors, to hand-pick individual shares or bonds you think will perform well. However, with direct investment you will probably find it harder to achieve the same level of diversification found by investing in an investment fund.

Achieving diversification within a directly invested portfolio can be both expensive and time-consuming. Not so with an investment fund, as costs in a fund are shared or spread among all its investors. Experienced investors may have the in-depth knowledge of companies, markets and sectors to make their own investment choices but most people are happy to rely on the expertise and focus of a fund manager.

Understanding underlying assets

An investment fund contains a mix of assets from defined parts of the investment spectrum. These underlying assets will probably be shares or bonds, but could also be money-market instruments (short-term debt). Some investment funds available to ordinary investors may invest in specialist instruments such as derivatives as part of their asset allocation. Other types of fund (but not undertakings for collective investment in transferable securities - UCITS for short - the main type of fund explained in this web site) may invest directly in real estate.

The choice of asset types held by a particular fund will help determine its performance goal. Funds investing in shares generally offer potentially higher rewards, but also sometimes higher risks, than those investing in bonds. Mixed or 'balanced' funds invest in a mix of shares and bonds (and sometimes property) weighted according to the fund manager's view of the economic and market outlook. Traditionally assets are divided into three categories: 

Money-market instruments

Money markets instruments are a type of short-term debt used by governments, banks and commercial companies to provide working capital. Investors often use money-market funds as an alternative to bank deposits because it is easy to invest or withdraw money and returns tend to be higher than bank interest rates. Like bonds, money-market instruments, they provide a fixed rate of interest and repay the original investment at the end of the term. Money-market funds invest in debt from a wide range of issuers in order to minimise the impact of any default.

Bonds

Bonds, often known as 'fixed income' assets, are issued by companies, banks or government authorities as a form of debt or borrowing. They are repayable at the end of a certain period, usually several years, and generally pay a fixed rate of interest. However, in some cases the annual interest (known as the 'coupon') varies during the lifetime of the bond. Another type, known as zero-coupon bonds, does not pay annual interest; instead the final payment received by the investor is higher than the initial price they paid for the bond. Floating-rate notes have a variable coupon, consisting of a fixed spread above a benchmark interest rate (for example LIBOR, the rate at which banks borrow from each other in the London market), which may move up and down depending on market conditions.

Bonds are usually assessed by an independent rating agency according to the risk of default by the issuer. Bonds are an ideal investment option for cautious investors as they provide a steady level of return. And, unless the company or organisation that issued the bond runs into trouble, it will return the original investment in full at the end of the term.

Most established government bonds carry virtually no risk, and while corporate bonds from established companies are also highly safe, they pay higher returns because there is a greater risk that the bond issuer may default on interest payments or the return of the original investment. Generally bonds offer greater price stability than shares, although their price can rise or fall according to changes in interest rates.

Shares

When a private company decides to become a listed company its ownership is converted to shares that can be bought and sold on stock exchanges. A share is a portion of the ownership of a public listed company, and collectively a company's shares are known as its equity capital. The individual or institution that owns the share is known as the shareholder, which receives any income from the shares. Share income is known as the dividend and is fixed by the company according to its level of profits and its other financial needs.

A share's price is determined by a number of factors including supply and demand, consumer confidence, corporate profitability and long-term expectations. Prices will often fluctuate, sometimes for no particularly apparent reason, and knowing the right time to buy and sell shares can be critical to the success of your investment.

Shares can be traded on wide range of markets for financial assets, including regulated markets such as stock exchanges and unregulated markets, especially for smaller companies. Shares can also be traded between institutions such as banks in private deals known as over-the-counter (OTC) trades.

Updated on  
Share |