A prolonged cost-of-living crisis – exacerbated by rising inflation, interest rates and energy costs – means that times are tough for millions of UK households.
In this challenging financial climate, it’s more important than ever before to ensure your cash works as hard as possible.
Where households are in the fortunate position of having money left over once day-to-day living expenses – from household bills to the weekly food shop – are accounted for, saving and investing can achieve longer-term financial goals.
Sounds good – but finding a way through the financial maze can be tricky. So where to start? Here’s a round-up of the key points to bear in mind when saving and investing money. From setting targets, to unearthing the right types of investment to suit individual circumstances.
Remember that investing is speculative, not suitable for everyone and can lead to partial, or even total, loss.
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Saving and investment – what’s the difference?
The terms ‘saving’ and ‘investing’ are sometimes used interchangeably. But each has a different meaning and it’s worth understanding both before drawing up plans to reach a particular financial goal.
Saving generally refers to setting money aside with a provider, such as a bank or a building society, in a cash-based savings account.
In exchange for depositing cash, customers are rewarded by being paid an agreed rate of interest which may or may not fluctuate according to wider economic conditions. Generally, the money – or ‘capital’ – that has been deposited is not at risk.
For example, if a UK-registered savings account provider goes bust, then account holders are protected up to a sum of £85,000 by the Financial Services Compensation Scheme. For joint accounts the limit doubles to £170,000.
More problematic for savers can be the fact that, over the course of time, the purchasing power of their money on deposit is likely to be eaten away by inflation – see below.
In contrast, investing is the process of using money to generate a profitable return. This can be achieved by putting money into a range of investments.
There are four main types of investment, often referred to as ‘asset classes’. These are:
- Cash. Savings built up in a bank or building society account.
- Bonds. Also known as ‘fixed-interest securities’. A bond is an ‘IOU’ that pays its holder interest in exchange for a loan to the bond’s issuer. If the issuer is the UK government, the bond is known as a ‘gilt’. Companies also issue IOUs and these are known as ‘corporate bonds’.
- Property. An investment in bricks and mortar. Either in the hope that the building’s value will rise, or that the owner will benefit from rental income. Or a combination of both.
- Stocks and shares. Interchangeable terms also referred to as ‘equities’. Equity investing is where you buy a stake in a company either directly, or via a fund. Shareholders are essentially part-owners of the business in question and will share in both its financial successes and failures.
Other asset classes exist such as fine wine, art, fashion and classic cars. These are often collectively referred to as ‘alternatives’. But mainstream financial products tend to focus on the quartet of assets above.
In a nutshell, investments differ from savings due to uncertainty over the amount of money an investor receives when selling an asset compared with buying it.
The value of the asset may have risen, leading to a profit. But – crucially – there is also scope for it to fall, leaving the investor to face the risk of making a loss.
Every investment carries a degree of risk, some greater than others. The rule of thumb is that the higher an investment’s potential, the higher the risk of losing money.
Bonds are riskier than cash, because there’s a chance an issuer will not meet its interest payments and ‘default’. But the trade-off comes in the shape of a slightly higher rate of interest compared with cash.
Similarly, shares and property have the potential to generate better returns than bonds and therefore sit even higher up the risk/return ladder.
An accumulation of assets is often referred to as a ‘portfolio’. There’s nothing to stop an investor concentrating on just one asset type. But doing this can be risky – akin to ‘putting all your eggs in one basket’.
Spreading your money around different asset classes is known as ‘diversification’ and, for most people, is a sensible investing policy.
Why do people invest their money rather than save it?
There are a handful of key reasons:
Potential for higher returns. Although there’s the potential for ups and downs along the way, historically, money invested in bonds, property and equities performs better than leaving cash on deposit over time.
Protect against inflation. At the time of writing (November 2022) UK inflation is at a 40-year high of 10.1%, while the average interest rate on instant access savings accounts is closer to 1%. A discrepancy this size means the ‘real’ value of money on deposit currently reduces by more than 9% each year. Investing has the potential to generate higher returns to help counter inflation.
Compound growth. This occurs when any income or interest is reinvested and grows along with the original money or capital. Investing £10,000 for 10 years with an average annual return of 5% produces £15,000 if each year’s ‘gain’ is taken out, compared with nearly £16,300 if the gain is reinvested.
What to consider before investing?
There are three rules worth bearing in mind:
- Set up an emergency savings fund
A useful rule-of-thumb is to build up an emergency fund to cover three (preferably six) months of living expenses. This could cover unexpected costs such as boiler repairs or bridge a gap between jobs. Ideally, this money should be held in an instant access savings account so it can be withdrawn at short notice penalty-free.
- Clear high-interest debts first
Another tip is to remember that there is little point would-be investors paying more in debt interest (on credit cards, personal loans, etc) than they would achieve from returns on their investments.
Before making a beeline for the investing route, first make a point of clearing debts, or at least considering cheaper options – such as a 0% balance transfer credit card, or a lower interest personal loan.
- Understand the risks
Risk varies by type of investment. It’s worth remembering that investing carries the risk of losing some, or all, of the money that’s being invested. There is also a risk that returns might be lower than anticipated. Do not invest money where the accompanying level of risk is uncomfortably high for your personal circumstances to bear.
How to set investment objectives
Before deciding on the type of investments to make, run through the following checklist to help come up with an appropriate plan.
Work out financial goals
These will probably align with different life events. For example, short-term targets (two to three years’ duration) could include buying a car or setting money aside for a deposit on a house.
Medium-term goals might cover building up funds to support children (such as helping with school or college fees) or going on a once-in-a-lifetime holiday.
Meanwhile, longer-term goals could consider tackling retirement objectives by paying into a personal or workplace pension to supplement state entitlements later in life.
Setting financial goals at the outset means it’s possible to match suitable investments in terms of time periods, together with their associated risk and returns.
How much to invest?
Having set money aside for a rainy day, the next decision is how much to invest as well as how frequently.
The amount will be dictated by what’s left over each month once day-to-day expenses and bills have been taken into account.
For good financial discipline, consider investing a regular amount every month to build up an investment portfolio over time. Alternatively, look at the possibility of investing a lump sum such as a bonus, windfall payout, or inheritance.
How much risk?
Generally speaking, there is a correlation between risk and return. Investors who are willing to accept a higher level of risk are potentially rewarded with a higher level of return.
Work out a timeframe
Having established financial goals, work out for how long investments are likely to run. With stock market investments, the consensus is that the absolute minimum timeframe should be five years, but preferably much longer. This helps investors to ride out market ups and downs.
Where a proposed time frame does not stretch to at least five years, then investing might not be a sensible choice. This is because there might not be time for performance to rebound from short-term falls. A sale of investments at the wrong moment can put a dent in performance and be a dispiriting experience.
Whatever the time period, it’s always wise to monitor and review the make-up of an investment portfolio – especially as the time approaches to potentially offload assets. Selling stock market assets and moving the proceeds into savings accounts can protect cash from a short-term fall in the stock market.
Capital or income growth?
There are two types of return on investment. ‘Capital’ growth represents the increase in value of an investment, while ‘income’ is the payment generated from holding a particular asset.
With a savings account, income is received in the form of interest. With investments, it usually comes in the shape of dividends – these are cash payments made by a company to shareholder, usually on a yearly or half-yearly basis.
Although many people invest in the stock market for capital growth, the ability to generate an income stream is useful as well. For investors either approaching or at retirement, generating an income stream from investments is a useful way to boost pension entitlements.
What types of investment are available?
There are several ways to invest and there’s no rule to prevent would-be investors from mixing their options. Choice essentially boils down to personal goals and preferences and how actively an investor intends to be in managing his or her portfolio. The main options are:
- Buying individual shares. This is probably the most time-sensitive option requiring DIY decision-making and research.
- Invest in share-based exchange-traded funds (ETFs). ETFs are a halfway house between buying shares direct and buying funds. ETFs invest in a range of individual shares to track an underlying stock index such as the UK’s FTSE 100. Investing via ETFs is like buying into the companies that are on the same index. ETFs are traded on exchanges in the same way as companies, but offer greater diversification.
- Invest in collective/pooled investment funds. As with ETFs, these are run by professional managers who run portfolios of shares and other assets on behalf of multiple investors. Funds focus on specific countries or regions (such as the UK, the Far East) or sectors (such as technology).
‘Actively’ managed funds are where managers decide which companies to include in their portfolio. Passively managed funds use algorithms to track the performance of a particular stock index, such as the S&P 500.
How can I start investing?
1) Open an investment account
DIY investors require access to a dealing account, such as the ones offered by online investment platforms and trading apps. These provide would-be investors with a range of share dealing services.
Investment platforms are represented by some of the biggest names in stock broking and fund management. Several providers have created a choice of ready-made portfolios featuring a range of investments based on a customer’s tolerance to risk.
Investors who are on the move can also choose from an increasing array of dedicated share trading apps.
Several providers provide users with the chance to practise trading using virtual money before taking the plunge for real.
No single investment platform or app is going to suit all customer types. Personal preference, look and feel, will all play a part when making a choice.
In addition to these considerations, it’s important that a provider offers access to the necessary investments (shares, funds, etc) that an investor is looking for.
It’s also important to pay as little as possible for each trade and to try and minimise any other administration charges as these ultimately eat into the returns that can be achieved. Platform providers structure their charges differently, so it’s worth investors shopping around to find a set of fees that works best for them.
Individuals opting for the DIY investing route should consider opening a stocks and shares individual savings account (ISA). This is a tax-efficient savings product that acts as a wrapper around investments, sheltering profits from three key areas of tax: income tax, dividend tax and capital gains tax.
Most platforms provide investors with a stocks and shares ISA option.
2) Choose a robo-advisor
Investors with sizeable amounts to invest – a five-figure sum, say – but who are daunted by the idea of being responsible for all their own trades, could consider using a robo-advisor.
Robo-advisors are a simple, relatively inexpensive way to invest in stocks and shares – a halfway house between a DIY approach and full-blown face-to-face investment advice. Information is provided to the service provider on earnings, investment goals and attitude to risk and, in return, a ready-made investment portfolio is generated by an automated system.
Once up and running, a robo-advisor provides clients with updates about investment performance. The approach is relatively cheap, typically charging a few hundred pounds to get started, and is also fast. A live portfolio can be up and running within a few hours.
On the downside, robo-advisors don’t make intuitive recommendations and there may be a limited choice in terms of the options on offer.
3) Opt for a financial advisor or wealth manager
Investors with larger amounts to invest, such as a six-figure inheritance or windfall, another option is to pay for the services of a financial advisor.
Investors still need to decide what kind of advice they need and the goals towards which they’re working. For example, whether they are investing with a particular life event in mind.
They also need to establish their personal appetite for risk, how long they might want to tie up their money and whether they want to invest in a particular style. Along ethical lines, for example.
When meeting an advisor, a client can expect to receive information about the following:
- Whether the advice is independent or restricted. Restricted means an advisor is limited to the number of providers s/he can recommend. An independent advisor can access the whole market.
- Level of advice. Depending on whether the client is looking for information to help inform a decision, or requires an advisor to manage investments.
- Charges. This may include an hourly rate, a set fee, a monthly retainer, or a percentage of the money that’s being invested. Fees can vary, so it’s worth shopping around.
- How an advisor is regulated. A firm should appear on a register published by the financial watchdog, the Financial Conduct Authority.
Find out more information about financial advice from Citizens Advice.