The world of finance and investing is vast and complex. This article will take you through some basics on why it may be a good idea to invest and some things to consider before creating your portfolio.
Why Do I Need to Invest?
The simple answer is because of inflation, which is the rate at which prices of goods and services increase.
Inflation therefore helps encourage people to buy now instead of waiting for the future. Inflation may be hidden when observed from year to year.
However when we compare food prices from May 1989 and May 2019, the difference is clear. In 1989 a white sliced loaf of bread was 49% compared to 2019 where the average price was £1.09.
The issue with inflation for your personal wealth is that over time, cash deposits can lose value as inflation will gradually reduce your spending power.
This can have negative effects in the long term when saving for financial goals such as a house deposit or retirement.
To counter this invisible erosion and protect your future purchasing power, you can invest cash into assets for the longer term.
Always Have a Back-Up Pot
It is important to make sure you have enough cash to cover emergency scenarios, debt repayments and everyday spending before you start investing.
Martin Lewis, founder of MoneySavingExpert.com, recommends setting up an emergency fund to the value of “at least six months’ worth of bills”.
The importance of this has been highlighted by the coronavirus pandemic, the consequences of which have caused a 120% increase on people claiming benefits since March.
The “Only Free Lunch in Finance”
Before we start to invest all our money into a few companies, we need to make sure we don’t put all our eggs in one basket.
Harry Markowitz is a Nobel Prize winning economist who devised the modern portfolio theory in 1952. He proved that by investing in different asset classes you can reduce risk without necessarily reducing returns, something he described as “the only free lunch in finance”.
This is known as diversification, which is the process of dividing your wealth between different investments to avoid being too reliant on any single one doing well. Diversification is done to reduce risk while maintaining a decent level of return.
How Long Do You Have?
One of the largest components to consider when creating your portfolio is your age and what you are investing for.
If your investment horizon is 10 years because you want to invest for your house deposit, then you will typically have less invested in stocks compared to bonds than a portfolio designed for retirement. Why is this?
Pu Shen, an economist at the Federal Reserve found that between 1926 and 2002, a US investor had a 30% chance of losing money after inflation if they only bought their stocks for one year and then sold them.
However, if they held on for 15 years then their chance of losing money to inflation fell to around 5%.
Every year the Barclays investment team publish a study titled the Barclays Equity Gilt Survey.
The report looks at the return of investments in UK stocks, Gilts (UK Government Bonds) and Treasury Bills (to represent cash) using data from 1899 to the present day.
The 2019 study found that UK equities outperform cash for 2 consecutive years in the 81 out of the 118 periods studied.
The probability of equities beating cash over 2 years in a row is 69% and if that investment period is extended to 10 years, the chances of beating cash rose to 91%.
This compares to the Gilts (bonds) performance which was 68% and 77% respectively.
According to the study, £100 invested in cash in 1899 would be worth just over £20,000 today. If the investor had invested the same £100 into Gilts, the same money would be now worth £42,000.
However, £100 invested in equities in 1899 would now be worth around £2.7m, although most of us have a much shorter investment horizon.
What To Remember?
This study shows that despite shares being a riskier asset class than bonds, in the longer term in a well-diversified portfolio they have the potential to outperform.
The compounding effect of inflation is subtle but can be a challenge when looking to achieve our long-term financial goals.
By using diversification and asset allocation we can spread risk without necessarily affecting our returns.
Each investment portfolio is unique and can be personalised to cater for your unique needs as an investor.
Photo: CNN Money