Investing is a way to increase the value of your money over the longer term, in return for taking an element of risk, typically greater than that associated with depositing your money in a bank account. There are a number of reasons why this makes sense, but the most important one is to stay one step ahead of inflation.
There are various types of investment, some will be right for you and some won't. It all depends on your attitude to risk - that is, how much risk you are prepared to take, and what you are trying to achieve with your investments.
Think about why you want to invest. Perhaps you are looking for an investment to provide money for a specific purpose in the future. Alternatively, you might want an investment to provide you with extra income.
This section will help you understand the key issues to consider when investing.
Things to think about before investing
- How much can you afford to invest?
- How long can you afford to be without the money that you wish to invest? Many types of investment products should be held for at least five years.
- What do you want your investment to provide: capital growth (your original investment to increase in value), income or both?
- How much risk, and what sort of risks, are you prepared to take?
- Are you happy to 'go it alone', or do you want to share costs and risks with other investors (by using a pooled investment, for example)?
- Do you want to be consulted on investment decisions, or are you happy for the investment manager to do this for you?
- Are there any tax benefits - what tax will you pay on your investment and can you reduce this in any way?
If you are going to invest your money, you need to be prepared to take some risk and to potentially see at least some fall in the value of your investment.
When deciding whether to invest, it is very important to ask yourself how comfortable you would be facing a short-term loss in order to have the opportunity to make long-term gains. Risk is a very personal thing - what may be a small amount of risk to one person may be extremely significant to another.
The single most important thing to bear in mind when deciding whether to invest or not is that the value of investments can go down as well as up.
Another important thing to consider with investments is that if the value of your investment goes down, you will only actually make a loss if you cash it in at that point in time. When you see the value of your investment fall, this is known as a paper loss, which is not a real loss until you sell the investment.
Firms that provide investments or give advice on them have to give you clear risk warnings about the products they distribute or advise on and they have to explain these risks to you fully. If they are advising you on an investment, they also have to make sure that the product is suitable for you.
It is very important to remember that some types of investments carry a much higher risk than others. There are some, higher risk, types of investments that carry with them the potential for an investor to lose all of the money they have invested.
Living with risk
Risk can never be entirely eliminated, but it is possible to manage it to a certain extent, by diversification - which simply means spreading your risk. Different investments behave in different ways and are subject to different risks. Putting your money in a range of different investments can help reduce the potential loss, should one or more of them fall in value.
It is also important to remember that risk and reward generally go hand in hand. The more risk you are prepared to take, the higher the potential reward. If you are not prepared to lose any of your money under any circumstances, then you have to accept a much lower level of return and an investment is probably not a product that you should be considering.
If you see an investment that promises a high return in exchange for taking little or no risk with your money, be very wary. The old saying 'if it looks too good to be true, it probably is' almost always applies to the world of investments.
The chart below gives an indication of the relationship between risk and return. Generally, the lower the risk, the lower the potential reward. So, for example, cash and gilts (bonds issued by the government) are the safest types of investments, but offer lower returns. Investing in the shares of UK companies is much more risky, but offers potentially higher returns.
You should also be aware of currency risk. Currencies (such as Sterling, Euros and US Dollars) move in relation to one another. If you are putting your money into investments in another country then their value will move up and down in line with currency movements as well as the normal movements in the value of the investment.
Although people tend to talk mainly about the risk of losing money, there are other risks to think about. One of these is inflation risk. Inflation simply means that you will need more money in the future to buy the same things as you do now. Consequently, when investing, beating inflation is an important aim. Investing in cash may not beat inflation over the long term.