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 have stood for stability and security, rather than volatility and uncertainty. But today’s low interest rates mean that savings accounts only offer a meager return, especially when compared with rates available in years past. Today, many savers are looking for other types of investment that can deliver a steady income and/or growth in their capital, without requiring that they take 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 asset you choose to meet your investment goals will usually be determined by many factors, such as your general financial circumstances, age and attitude towards risk.

At first glance, risk may not seem desirable in a capital investment. However, you cannot benefit from potential capital growth or higher returns if you do not expose your capital to a certain degree of risk. 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 you are planning for a more comfortable retirement, need to pay for holidays, a new car or educational expenses, or are simply setting money aside for a rainy day, you no doubt would like your money to work as hard as possible for you. Your individual investment profile will define the path you should take to achieve these goals.

Collective investment v. direct investments

A collective investment vehicle is one that pools money from 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 held by the fund. Investment funds are constructed to meet a specific investment objective and frequently measure their performance against a benchmark such as a stock market index.

Investing in an investment fund allows you to invest in a variety of asset types and in a range of sectors, markets, countries and currencies. This spreading or diversification of your investment reduces risk and over time can help smooth out 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 value growth and enjoy income in the form of distributions from shares or other types of assets while spreading the risk between many different investment securities and sharing investment costs between many different investors.

Direct investment

Investing directly in the equity or bond market allows you to hand-pick individual shares or bonds, either alone or with the help of your financial advisor. However, with direct investments you will probably not achieve the same level of diversification as you would 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 the costs in a fund are shared or spread among all its investors. While experienced investors may possess the in-depth knowledge of companies, markets and sectors needed to make their own investment choices, many people are happy to rely on the expertise of a fund manager.

Understanding underlying assets

An investment fund can invest in a variety of financial assets. As a rule, these assets include shares, bonds or money market instruments (short-term debt instruments). Some investment funds also invest in specialised instruments such as derivatives as part of their asset allocation. Other types of fund (not including undertakings for collective investment in transferable securities, or "UCITS", the main type of fund explained on this website) may invest directly in real estate.

The performance goal of a fund is reflected in the types of assets it holds. Funds investing in shares generally offer higher potential returns, but sometimes also higher risks, than pure bond funds. Mixed funds (also known as "balanced funds) invest in a combination of shares and fixed-income securities (e.g. bonds, money market instruments). The individual components are weighted according to the fund manager's view of the market situation and the economic outlook. Traditionally, the financial assets in which UCITS may invest are divided into three categories:

Money-market instruments

Money markets instruments are a type of short-term debt instrument used by governments, banks and commercial companies to finance working capital. Investors often use money market funds as an alternative to bank deposits, because units or shares of money market funds can be bought or resold on a short-term basis and they frequently offer higher returns than bank interest rates. Like bonds, money market instruments also provide a fixed rate of interest and the original investment is repaid at the end of the term. Money market funds invest in money market instruments from a variety of issuers in order to achieve a broad diversification of their investments.

Bonds

Bonds, often known as "fixed income securities", are issued by companies, banks or government authorities as a form of debt certificate. They are repayable at the end of a certain period, usually several years, and generally pay a fixed rate of interest. In some cases the annual interest, or "coupon", varies during the lifetime of the bond. Another type, known as "zero-coupon bonds", do not pay annual interest; instead the final redemption amount received by the investor is higher than the initial price they paid for the bond. So-called "floating-rate notes" pay a variable coupon, corresponding to a fixed spread above a benchmark interest rate (for example the 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 often assessed by an independent rating agency according to the level of the issuer's default risk. Bond investments are suited for investors who wish to receive a steady income. Moreover, unless the company or organisation that issued the bond runs into difficulties meeting payments, the principal amount is repaid in full at maturity.

Many government bonds entail virtually no interest rate or redemption risk. Bonds issued by many reputable companies are also considered to be very safe. Most of them pay a higher interest rate than government bonds because they also entail a higher risk that the issuer may become unable to meet interest payments or repay the original principal amount. 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 be listed on a stock exchange, the ownership rights to the company are converted into shares that can be bought and sold on that stock exchange. A share represents 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, and can receive income from its shares. Such income is called a "dividend". Whether or not a dividend is paid out and, if one is, the amount that is paid out depends on the profits earned by the company as well as its financial situation and corporate planning.

The price of a share depends on supply and demand, which in turn are influenced by many factors such as the profitability of the company, its long-term business prospects or the general sentiment of consumers and investors. Share prices will often fluctuate, sometimes for no apparent reason, and finding the right time to buy and sell shares is critical to the success of your investment.

Shares can be traded on wide range of financial markets, including regulated markets such as stock exchanges or, especially in the case of smaller companies, unregulated off-exchange markets. Shares can also be traded between institutional investors such as banks in private deals known as "over-the-counter" (OTC) trades.

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