As part of our Investing 101 series, we have previously sought to define some key financial concepts, such as mergers and acquisitions, and equity. However, in hindsight, it probably would have been wise to start with the absolute basics of investing. Therefore, in the next couple of our Investing 101 articles, this is exactly what we're going to do! Whether you're a seasoned investor or a complete novice, hopefully you'll learn a thing or two about the financial world that you didn't previously know!
First and foremost, we need to clarify the difference between saving and investing, because they are two terms that are often used interchangeably, but shouldn't be.
Saving: Putting your cash in a bank account, and hoping that it will grow. This is a defensive move, and while safe, will not make you big bucks overnight. This is because the interest rate in the UK is currently at 0.1%. So, for every £100 you put into your bank account, you will receive 10p back in interest payments. With the government mulling over the prospect of negative interest rates, the value of people's savings will be eroded. Likewise, inflation will also reduce the value of savings. This is why they may turn to investing instead.
Investing: Using cash to buy assets. These assets can be shares in a company, property, or government bonds. There are other asset classes, but these are some of the most common. Investing is about trying to grow your pot of money, rather than letting it sit in a bank account idly.
What other reasons are there for why people invest? Well, apart from stopping their savings being eroded by inflation, people like to take calculated risks in order to earn sizeable rewards. One of the most fundamental rules of investing is the idea of finding a balance between risk and reward. Investing in the shares of a high-growth start-up company may offer a good rate of return, but it will almost always mean that it is a higher-risk investment. Will the company be able to continuing growing? Does it have enough capital (funds) to re-invest in its business? Will it be made insignificant due to there being much larger and popular businesses in the same industry? Before people invest, they must determine their risk appetite - i.e. how willing they are to accept a certain level of risk to generate returns. As an investor, are you looking to earn a quick buck on a volatile (high-risk) stock, or are you looking for a steady long-term increase in your income, that will generally offer less risk exposure?
Liquidity is another concept that is often associated with risk. Effectively, investing requires you to lock away your money somewhere (whether in a company, with the government, or elsewhere). However, what happens if you decide that you want to withdraw your investment, because you need this money to pay for something else, such as a new car, a washing machine, or your child's education? Well, a liquid investment means that it is easy to withdraw your investment fairly easily. For example, hundreds of thousands of shares of Facebook are traded each day on the stock market, so people are always willing to buy and sell them. This makes them liquid. However, if you invest in a house or apartment, it may be harder to sell instantly, meaning that your money is stuck in an illiquid investment. Depending on how urgently you require cash, liquidity of investments may also be factored into your risk appetite.
The final concept to be covered in this piece is compound interest. Sure, you learnt about compound growth in GCSE maths classes, but who really remembers that stuff?
Here's an example of compound interest at work:
You decide to invest £100 in Tesco shares, which pay a 10% return (they don't, but just play along with it). After a year, you would have £110. After two years, you'd get a 10% return on £110, which comes to £121, because you'd get interest on the initial £100, as well as on the £10 interest from the first year. 10 years later, that £100 would equate to £259. Now, imagine that on a bigger scale!
Compound interest shows that your money will grow over time (if invested correctly), as each year, the returns build on each other.
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