Investing for beginners

Should I invest?

Whether or not investing is right for you will depend on a number of factors - for example: your goal, your timeframe and your attitude to risk. As a general rule, if you think you will need the money in the next three years and you're not comfortable with the thought your pot can go down as well as up, investing probably isn't right for you.

However, if you have some money saved in a cash account for unexpected bills - typically, we would recommend enough to cover three to four months of essential spending; - have three or more years to invest and you're comfortable taking some risk, you could benefit from investing.

How does investing work?

Investing means buying something - an asset - that you believe will increase in value over time, whether that is a share of a company, a property, gold or something more unusual, such as wine or antiques.

How investing helps put your money to work

At a time of historically low interest rates (the Bank of England base rate is currently 0.1%) cash savings are earning consumers very little interest. At the same time, inflation is eroding the future spending power of their money. Investing, where there is the potential to generate greater returns than the very low interest rates, means there is the potential for your money to work harder for you over the long-term.

1. Future Money

One reason we invest is to have the potential for a larger pot in the future.

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. As a general rule, the higher the risk, you’ll often find there’s also a the greater potential for higher return on your investment – however, it’s important to remember this may come with more chance of short-term volatility.

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

To see the sorts of returns associated with different levels of risk 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 more likely you are to generate greater returns.

Probability of Loss decreases the longer you hold investments

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 in real terms, in other words, they won’t buy you as much as they once would have done.

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:

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

This is what inflation does — it lowers the value of our money over time. 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.

3. Compounding

What are compound returns?

Compound returns are sometimes 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.

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.

Understanding investment risk

If you look it up in the dictionary and you’ll see that risk is described as a situation involving 'exposure to danger'.

1. What is risk

Not the most inviting of propositions. But when looking at risk in terms of investing, fear needn’t be a factor.

Truly understanding risk as a concept is simply a cornerstone of successful long-term investment management.

Risk describes the uncertainty of the returns on an investment. It is an indicator of the potential for losing money and making money. Although we often do not think of it this way, it can mean returns and losses can be unexpectedly high.

Different investments will be more or less risky. Shares are considered more risky than bonds, although this is not true for individual shares and bonds. Investments that are more likely to give higher returns in the long run may have a bumpier ride along the way, whereas investments with a lower return potential are often more likely to remain steady and stable for the duration.

Put simply, investments that have higher risk usually have higher rates of return. So, individuals who are looking to increase the value of their investments significantly, and who are prepared to accept that the value of their investments might fall, are more likely to choose to invest in assets that have high risk.

No single asset class can be relied upon to produce safe, reliable and consistent returns. At Nutmeg, we believe that a diversified investment portfolio — with an appropriate proportion of cash, equities, bonds, property, commodities and alternative asset classes for your goals and risk tolerance — is a better way to maintain and build wealth over the long term.

Some examples:

2. How you feel about risk

Nobody really likes risk, but some are more able to tolerate it.

Knowing how you feel about risk is the first step in determining what sort of portfolio of investments is right for you. This is important as you need to know that you can stay the course if your investment falls in value, as it almost certainly will from time to time. Also, if your portfolio is too cautious, you may be disappointed in the returns you get and it may take you longer to reach your goal.

At Nutmeg, we help people establish their attitude to risk by asking them to complete a risk questionnaire. These questions will help you understand how you feel about investment risk and determine what the right investment strategy is for you.

3. How much can you afford

The question is what would it mean for your if your investment fell in value? The above table gives some idea of what has happened in the past.

Give some thought to how it would affect your plans and your standard of living.

If you have flexibility about when you need your money, you can leave the money to recover from a downturn. How long that takes has varied widely from a few months to a few years, and will also depend on how it is invested. This is a very good way of managing risk, but requires the financial and psychological ability to delay withdrawing your investment after a market downturn.

At Nutmeg, we show you what the downside may look like so that you can really think about what that would mean for you.

4. Your investment goals

Even leaving money in the bank involves some risk, that of inflation.

Sometimes people have a general idea of what they want from their investments, for example to keep up with inflation, or to preserve their capital.

People may also have a more specific goal, such as to build a pot of £10,000 in ten years time to fund a dream holiday. It is important to know whether that is realistic given the risk strategy, contributions and time frame. We help you understand this with our projections which you can access any time by editing the risk level on one of your Nutmeg pots.

If you are going to fall short, rather than change the amount of risk, we will suggest changing your contributions or extending the timeframe. You can also reduce the amount you are aiming for.

Alternatively, if you are going to overshoot your objective you can reduce your contributions, dial down the risk or bring forward the timeframe.

Investment basics

One of the most difficult decisions when investing is what you should invest in.

1. Shares:

A good investment tip is to invest in things you understand.

You can invest in almost anything, but the four fundamentals are: shares, bonds, property and cash. In this section we explain a little more about each one.

Shares are quite literally a share in the ownership of a company. If you buy a share in a company, you own a proportion of that company.

Depending on the class of share, that can mean you are able to vote at the annual general meeting on decisions such as the salary of the chief executive officer. It also means you get a share (or proportion) of the profit of the company. This is the dividend.

Shares are a valuable part of a portfolio because alongside the dividend, the price of a share can rise over time as well.

Of course, share prices rise and fall all the time. That is why owning individual shares can be very risky. A portfolio with a number of different shares diversifies your risk. It is possible to buy a ready-made portfolio that represents the whole stock market, or a section of it. These are called trackers.

The price of shares in larger companies are quoted on the stock exchange. In the UK the main stock exchange is called the FTSE, (more fully, the Financial Times Stock Exchange.)

2. Bonds

Bonds are a loan to a company or a government for a set amount of interest for a set amount of time.

For example Tesco might issue a bond for 10 years at 4%. This means that the buyer of £10,000 of these bonds lends Tesco £10,000 for ten years. During the ten years, Tesco will pay the investor 4% per year, or £400, and at the end of the 10 years, the £10,000 will be returned to the investor.

The creditworthiness of the company is important as a company that is seen as more risky (with a lower credit rating) will have to offer a higher interest rate to attract lenders.

During the 10 years, the bond can be bought and sold. The price will depend on how the interest rate compares with interest rates more widely. For example if interest rates are low, the bond will be relatively attractive and the price will be higher than the £10,000 initially paid.

If the credit rating of the issuer changes, the price of the bond might also change. For governments, bonds are the main way they can raise funds without increasing taxes. The UK treasury issues bonds which are known as gilts – (they are called this as in the past the paper bonds were gilt-edged.)

As a class, bonds are usually less risky than shares. This is because interest rates do not change on a day-to-day basis, although a shift in interest rates will affect all bonds. Like shares, individual bonds are generally more risky than a portfolio of bonds, and it is possible to buy a bond fund representing a large collection of individual bonds.

3. Property

There are two types of property for investment: residential, which is accessed by buying-to-let, and commercial property, which is most often accessed by property funds. For both, the income stream is from the rental, and it is hoped that the capital value of the property will increase as well.

While on average property prices have been increasing this has not always been the case, and in some areas of the UK, and wider global markets, property prices are falling.

Property is an illiquid asset. It can take months, or even years, to find a buyer for a property and then several more months to complete on the property sale. Essentially, you have to consider your deposit and any equity you accumulate as locked in until you sell the property. Another big risk is related to interest rates. If you have a mortgage and the interest rate goes up, it might be some time before you are able to increase your rental income to cover the mortgage costs.

You also need to remember the extra costs of buying and maintaining a property, such as stamp duty, solicitors’ fees and insurance.

Read more in our paper: Should you invest in property or stocks and shares? (pdf).

4. Cash

Cash is very secure in that it is not subject to investment risk.

The amount of money in your bank account will not change in response to external events, but its value will be affected by inflation.

The two risks of keeping too much money in cash are inflation and bank failure.

While very unusual, banks have failed in the past. Your cash is usually protected by the Financial Services Compensation Scheme up to a maximum of £85,000 in each bank, although you might have to wait a short time to get hold of your money.

5. How do I know what to invest in?

Just as it is safer to invest in a number of shares rather than individual shares, it is safer to invest in a collection of asset types rather than a single type.

For example, it is riskier to invest everything in the FTSE100, rather than having some gilts and bonds as well.

So which type of assets do you pick and how much of each?

This depends on your appetite for taking on risk. A slow and steady approach will typically have more bonds and gilts, while a more growth focused strategy will tend to have mostly shares from a range of countries, but may have some other assets as well.

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.

Putting it all together

You can get help deciding the right investment strategy and implementing it.

Do it yourself

You can get help deciding the right investment strategy and implementing it.

Costs and service-levels can vary quite widely so it is a good idea to think hard about how much you want to do yourself, and what sort of help would be most useful to you. In essence there are two ways to go, either do it yourself or get some help.

You can decide for yourself what sort of portfolio you want, then choose and buy funds using a platform. There may be both platform fees and fund fees to pay, and there may be transaction costs.

You will need to keep an eye on your funds to check that they are doing well and that the balance of asset types remains right for you. This is more suitable for more confident and experienced investors.

Some platforms offer ready-made portfolios. You select the risk level and they will choose the funds. These may have an extra layer of fees as a management charge. You pay for their professional oversight of the portfolio.

Some investment companies allow you to buy their funds directly although you will still need to choose the funds yourself. The advantage of this approach is that you do not have to pay a platform fee.

The disadvantage is that you will have to monitor each fund separately, and you’ll receive paperwork for each fund. As with a platform you will need to keep an eye on your funds to check that they are doing well and that the balance of asset types remains right for you.

Get some help

A financial adviser will recommend a fund or set of funds for you, based on your circumstances.

They should spend some time with you, discussing and agreeing the right risk strategy for your portfolio. You will perhaps pay for their time on an hourly basis for their time or they may take their fee as a percentage of the total amount you invest, and there may be an initial charge for setting up the funds as well.

The traditional way to build a portfolio was through a stockbroker. This works best when you have sufficient money to buy a selection of shares and bonds. The stockbroker will recommend good buys and, with your agreement, will place the trades for you. There will be a small tax to pay on each share purchase and your stock broker will charge you a commission as well with varying charges per transaction.

Another more traditional long term investment management approach is through a portfolio manager, who makes decisions on your behalf. Known as ‘discretionary management’, the practice involves the manager making investment decisions at their own discretion. The decision-making process requires a lot of experience in the industry alongside relevant qualifications. As a result it can be expensive, often only available to very wealthy clients.

Nutmeg

Nutmeg is an online discretionary wealth manager. You will need to sign up and answer a few questions to enable us to suggest an investment portfolio for you.

The specific investment will depend on the amount of investment risk that you are willing to take and the investment style you choose.

You will pay us a percentage from 0.25% to 0.75% incl. VAT where applicable, depending on amount invested. Additionally, you will incur the underlying fund costs and the effect of market spread. For further information about the cost of investing, see our fee page.