Preparing to Invest
What should I consider?
Investing your money wisely can feel both daunting and exciting. In a previous post you can find here, we highlighted some of the main options and mechanisms for investing. Here are some of the things you should think about in deciding where to put your hard-earned cash:
There are normally 2 ways of thinking about risk:
a) Your inherent risk tolerance - this is really part of your personality – are you a bit of a gambler, willing to take a chance that you will lose some of your money in order to have a chance of growing it more, or do you want to be absolutely sure that you’ll get everything back?
b) Your risk capacity - this is a more objective measure of how much risk you should be taking in your investments, based on what you’re saving for, and your personal situation.
The different options we described in the earlier post have very different risk levels and expected returns. According to every financial theory there is, taking more risk should mean higher long-term returns.
Buying an individual company’s shares (especially a small one) is very risky – you may double or triple your investment, but you may lose everything if the company goes bankrupt.
In a bank savings account, you might only earn 5%-6% per year (less than inflation) but you’re guaranteed to get your money back.
Unit Trusts and ETF’s are somewhere in between depending on their strategy. The level of risk of the investment option you choose should then depend on both your risk tolerance, and your risk capacity, which together make up your risk profile. One other thing to remember, you can’t have the best of both worlds – low risk and high return investments don’t exist. If any promise you this, stay away – you can be sure the risk is much higher than you’re being told.
What are you saving for, and how far away is it? If you’re saving towards paying for your children’s school fees in 3 months’ time, you probably don’t want to take any risk that a fall in stock markets means you can’t pay. On the other hand, if you’re saving for your retirement in 25 years’ time, it wouldn’t be wise to put your money into a bank account and at best track inflation for all that time. You’ll be losing out on the opportunity to make your money work for you. So, time horizon is key to determining your risk capacity – the longer it is until you plan to actually need the money you’re investing, the more risk you should be willing to take. If you are saving for your retirement 30 years away, should you really care if the value of your investment has fallen by 20% this year. It won’t feel good for sure, but what you should stay focused on is what your capital will be worth when you retire way into the future. Also, how big is this investment relative to other savings you might have. If you’ve got a number of different investments, you should consider your overall risk levels, if you’ve been conservative somewhere else, maybe you can afford to take more risk with this investment.
Level of Sophistication
Each of us has a different level of understanding of investment. Some people may feel confident that they understand stock markets, and are able to pick the right share(s) to invest in. Others may have only very limited experience of investing, and would simply be guessing about which companies’ shares to buy. For less sophisticated investors, be very careful with taking a lot of risk without taking advice from a trusted expert.
Several of the options described previously, like tax free savings accounts and retirement annuities, are designed to save you tax. The value of the benefit depends on your own tax situation. If you’re a high earner and/or you have a lot of other investments, then choosing a tax effective structure is really important, but if not, then maybe other factors like cost and the ability to access your money in an emergency are more significant.
As an extreme example, if you don’t pay income tax anyway, then there’s not much value of locking your money away in a pension fund until you’re 55 (unless keeping it safe from yourself can be considered a benefit). For most people, tax-free savings accounts are a good first stop for saving money regardless of your current tax situation, as they are generally cost effective and tax efficient, and you can access your money in an emergency. They do differ by provider though so do your research.
That’s a very high-level overview of some of the key factors that influence how you should invest your money. But everyone is different, and making generalized recommendations is not a good idea. There is a lot of information on the internet that you can access, read up on what’s out there, and talk to your friends and family, especially those with some experience. There are also financial advisers out there who can help you – find someone you trust who you are confident will recommend the solution that is best for you, rather than for their own pocket.