Why Is Investing So Complicated?
We are not taught anything about finance in school. There are no lessons on Saving, Investing, Protecting Wealth. Most adults are financially illiterate through no fault of their own. As adults we are taught that investing in the stock market is risky, it’s a gamble where you could lose everything - cash is safe. Every media outlet and every source of information reinforces this message. It’s wrong, but it’s massively counter-cultural to push back against that. The real risk for the majority of people is not being in equities.
HEADLINE: ‘Stock Market Crashes!!’
Fear sells. All financial news is garbage and should be avoided. The news gives us a massively false sense that investing is risky and “not for you!” Probably the easiest behaviour hack any of us can employ is to stop reading financial ‘news’.
Investing does seem complicated, but it doesn’t necessarily need to be! Part of the problem is the sheer volume of information and jargon that comes at us, some of which seems designed to make us feel that it is complicated and dangerous. How often have you read or heard ‘Investing comes with risk as the value of your investments can go down as well as up’, it’s enough to put anyone off investing!
I was afraid to tackle investing on my own. My first thought was that I would need a financial adviser, but trying to pick one was very complicated. I carried on researching and reading everything I could find about investing and it soon became very clear that over the last decade the investment world has changed significantly. Now everybody has access to wealth creation tools that only the wealthy had access to in the past, it is considerably easier to ‘Do It Yourself’ without the need for a financial adviser.
Investing terminology
So what do we do? One way to approach investing is to start with a basic understanding of the terminology used.
Saving usually means putting your money into cash products such as a savings account in a bank or building society. Saving typically allows you to earn a low return but with virtually no risk.
Investing is taking some of your money and trying to make it grow. Buying assets you think will increase in value over the long term and provide an income. Investing allows you to earn a higher return than saving but you take on a risk of loss in order to do so; as we will see later, investing over a long period of time reduces the risk of loss. Investing is for the long term ‘buy and hold’- ‘stay the course’. You only lose if you sell when the market is down.
Speculating is different from investing. Speculating is short-term trading, high risk, high return. Gambling on a quick result or a belief that you can beat the market.
Assets is the overall term used to describe different things such as Equities, Bonds, cash, property, oil, gold, etc. We focus on Equities and Bonds as they are easily investible and more accessible than other assets. Despite what we are led to believe, investing for wealth is very simple and can involve just two assets: Equities and Bonds.
Equities aka Stocks aka Shares (all the same thing) are traded on the stock market and are shares in a company e.g. Google, Apple. The value of Equities, or the purchase price, reflects the value of the business and will increase as the business becomes bigger and more profitable. This is how we make money.
Bonds are loans to Government & Companies with a set term e.g. £100 for 10 years at 2% pa return. The value of Bonds, or the purchase price, will increase and decrease depending on changes in worldwide interest rates and economic changes.
The value of Equities & Bonds (i.e. the purchase price) can go up as well as down due to political or economic changes (e.g. Covid): Equities more so than Bonds as they are more volatile. A stock market ‘crash’ is when the purchase prices of all Equities fall.
As well as the value/purchase price growth, Equities pay annual dividends to their holders depending on how successful the business year has been. Bonds pay a guaranteed interest payment every year which is set at the start of the term of the Bond. These dividends and interest payments are paid to you annually, increasing the value of your pot of assets and giving compound interest an opportunity to grow year on year. This is how we make money.
An investment fund is a collective purchase of assets allowing investors like you to buy into a basket of assets more easily than you could purchase them individually.
A managed investment fund or mutual fund is where assets are chosen by a fund manager using their ‘skills and knowledge’ to outperform the market, usually with a higher investment fee to you.
An Index investment fund is passive, it does not have a manager choosing assets. It simply invests in every equity or bond in an index, providing diversification at a lower cost than managed funds. An index example is the FTSE 100 which is the 100 biggest companies in the UK stock market, or The S&P 500 which is the 500 biggest companies in the US stock market. A global index can contain Equities or Bonds from markets all over the world.
Investment Fees: When you invest in a fund the provider makes a charge which could be anywhere up to 2% for a managed fund; index funds tend to charge less than 0.5%. Imagine if your fund is returning 5% and then you lose 2% of this in fees!
Rather than relying on a fund manager to pick shares or bonds they think are going to do well, index funds ‘track’ the overall performance of an entire market index and because they typically have lower fees, you keep more of your returns - which can really add up in the long run.
Risk and Volatility
This is the big one. If you understand this, you’re ready to go!
Risk and volatility are often used interchangeably in the financial press. Volatility is the measure of how far the price of an asset moves up or down and risk is the likelihood of an asset losing value.
Equities provide higher returns than Bonds but they are more volatile i.e. regular big ups and big downs in the value/purchase price and therefore more risk of loss. Bonds provide lower returns but with reduced volatility i.e. lower ups and downs and therefore less risk of loss. This is why we buy both Equities and Bonds. Equities and Bonds have a low correlation i.e. when Equities go down in value; Bonds tend to go up, and vice versa. By investing in a mixture of Equities and Bonds you can smooth the volatility and therefore the risk of loss.
The graph below illustrated this showing the growth in value of $10,000 over 30 years from 1992 to 2022 using 3 different investment portfolios, 100% Equities, 100% Bonds, and 50/50:
Portfolio 1 (100% Equity in blue) has grown to $192,000 with lots of zigging and zagging or volatility, but the overall trend over 30 years is upwards! This is why Equity investing is for the long term…you only lose money if you sell in a downturn! Buy and hold; avoid selling in fear when the stock market drops.
Portfolio 2 (100% Bonds in red) has grown to $42,000, significantly lower but with a lot less zigging and zagging volatility and a lower risk of losing money if you need to sell.
Portfolio 3 (50% Equity and 50% Bonds as an example in yellow) has grown in value to $101,000 and as you can see there have been fewer highs and lows i.e. a smoother journey than pure Equities and more growth than pure Bonds. This smoothing may help prevent you from selling in fear when the market drops. This is illustrated by the table below; standard deviation is the measure of volatility and is demonstrated by the size of the best and worst years:
Asset allocation refers to the mix of assets (Equities and Bonds) you hold. The asset allocation depends on how much risk you can tolerate and how long you have to invest. With a long time horizon for investing you can afford to have a higher proportion of Equities and ride the ups and downs. As the time horizon gets shorter, it is best to move to more Bonds as you don’t want your portfolio to suddenly lose value just as you are about to spend it. A sound asset allocation strategy ensures your investment portfolio is one you can hold without fear for the long term through market downturns.
Buying and holding a portfolio of low cost, passive (i.e. not managed), global index funds of Equities and Bonds will reduce market risk by spreading your money over thousands of businesses and Bonds across the globe. Greater diversification, less cost, and greater returns over time thanks to price growth, dividends/interest, and the magic of compound interest.