Understanding investing:

How investing helps put your money to work

1. Future Money



The reason we invest is so that we can spend more in the future. This can be for a specific goal, such as a comfortable retirement, or a more general desire to have a safety net should things go wrong.

People invest with the expectation that their money will increase in value. Investment returns depend on the type of asset you invest in. Different types of investments tend to have different levels of risk associated with them. The higher the risk, you’ll often find there’s also a greater potential for higher return on your investment.

For example shares in individual companies may give you large gains, but also large losses. Government bonds will be more steady, with a lower chance of loss, and emerging market shares can be more high risk than developed market shares.

You see the effect of investment returns on future spending on our pension calculator.

To see the sorts of returns associated with each type of investment, you can see a sample portfolio on our try it out page. By changing the level of risk, you can see how the range of possible returns will change.

The other important choice you make is investment term. This means how long you leave your money invested. The longer you invest, the less likely you are to lose money.

Looking at UK stock market data since 1969, you’d have had a 55.2% chance of making gains if you’d invested for 1 day – similar odds to the toss of a coin. But long-term investing dramatically increases your chances of making positive returns. Investing for one month ups your probability to 63.9%, investing for one year boosts your chances to 82.1% and investing for 10 years or more pushes it to 99.4%.

The longer you invest, the less likely you are to lose money.

Probability of Loss decreases the longer you hold investments

probability of loss graph
MSCI Developed Equity Markets with after-tax dividends reinvested, priced in GBP. Source: MSCI (GBP Net returns), December 1969–June 2016, Bloomberg.

2. All about inflation



Inflation right now is quite low, but historically it has been much higher. This is bad news for your cash savings as interest rates are very low.

When you think back a few years, you might remember things being a lot cheaper — the average loaf of bread for example, or a first class stamp. This is because of inflation and, with interest rates being so low, there is the risk that your hard earned savings will slowly lose their value.


Let’s look at an example:

You’ve just discovered that your distant relative has left you some money in their will, but you might be disappointed when you realise it’s just £100. When your relative first bequeathed you that money, back in 1975, it would have been the equivalent of about a month’s wages. Nowadays, most people make more than that in a day.

Let’s look at the effect of inflation on £100:

effect of inflation graph
Source: ONS Internal Purchasing Power of the pound (based on RPI)

This is what inflation does — it lowers the value of our money. So, while the actual number remains the same, it will be worth far less in years to come. In order to beat inflation, your money has to generate a return better than the prevailing inflation rate - and that’s where investing comes in.

quotation marks
Albert Einstein, when asked what he considered to be the most powerful force in the universe is said to have answered:
Compound interest.

3. Compounding



What are compound returns?

Compound returns are often referred to as the eighth wonder of the world. They are also an investor’s best friend.

The basic concept is simple. In the first year of investing you generate returns on your initial investment. In the second year you invest the capital plus the returns, and you generate further returns on the total. And so it goes on, and your money snowballs into a pot that you can eventually retire on.

Of course, investing is always subject to the ups and downs of the stock market, so returns aren’t guaranteed every year. However, by investing over a long timeframe, you give your investment time to make up for any losses.


Underestimating the power of compounding

There have been many studies into compound returns and why we fail to mentally account for them properly. One such study (pdf) was conducted by Craig McKenzie and Michael Liersch at the University of California.

They asked groups of undergraduate students to consider how much their savings would grow if they deposited $400 per month into an investment which grew at 10% per year.

One group were given calculators and asked for a calculated answer, the other group were given no aid at all and asked for a best guess. The results? 90% of respondents got it wrong. Both groups grossly underestimated the final value of the portfolio, as they failed to take compounding into account. The average guess for the portfolio size after 40 years was $500,000. The correct figure is around $2.5 million.


Little things mean a lot

Seeing the full benefit of compound returns is all about time and patience. That means that you don’t have to stash half your income away immediately. If you commit to saving as much as you can every month and make regular contributions to your investments or savings account, small amounts can soon add up.

Correspondingly, what seems like a small disparity in rate of return can soon start making a big difference. Interest rates are persistently low at the moment, and it pays to shop around for the best rate. Many ISA providers have generous introductory offers, and then reduce your interest rate after the account has been open for one year. Be vigilant, keep on top of what rate you’re getting and switch providers if you can get a better deal elsewhere.


Start thinking about your pension now

Thanks to the miracle of compound returns, the earlier you invest or save any amount of money the more it will be worth when you retire. The research group CLSA came to a dramatic conclusion about saving for retirement. They found that if you deposit into a pension from the age of 21 to 30, your pension pot will be worth more than if you saved the same amount each month from the age of 30 to 70. This assumes that you stop contributing at 30 but the fund continues to provide returns at the same rate.


Risk warning. As with all investing your capital is at risk. Past performance is not an indicator of future results and future returns are not guaranteed.