Are you an investor? When someone mentions the ‘i’ word certain images spring to mind. A well-heeled individual in a sharp suit clutching a copy of the FT. Or a worldly Alan Sugar-type on the lookout for an off-the-radar opportunity that only he can recognise.
The truth, of course, is very different. Investors look like you, or me, or just about anyone else you can think of who has a pension, or a stocks and shares ISA for instance.
This is because the money you put into pensions and collective investments is invested, even though it may be a fund manager, rather than yourself, who is making active decisions about the individual investments your money is buying.
So, you may well be an investor. Which is why it makes sense to build a little knowledge about the terminology and processes involved in the way your money is put to work.
Of course, we don’t all feel qualified to make investment decisions, and wouldn’t want to get too closely involved with making the kinds of decisions which fund managers and others are paid to do on our behalf. But it’s your money, regardless of who is making the day-to-day investment decisions, so it can’t do any harm to find out more about what happens to your money when it goes into a collective investment or a pension plan.
And to do this, it helps if you ‘speak the language’. So here’s our ‘Investment-speak Phrasebook’...
The four asset classes
This might sound like going back to school or the latest form of exercise at the gym, but it simply means the way that your money is used to generate a return. There are four main asset classes:
- Fixed Interest
Let’s start with the one that people understand best. That would be cash...
You can hold cash inside your pension or investment account, either as a cash deposit account, or invested in a cash fund.
A pension cash deposit account is just like a deposit account outside of a pension. You deposit money into a bank account and earn interest on that money. Interest on a pension deposit account is received gross.
Cash funds are funds managed by investment managers who invest either in cash deposits, or fixed term deposits with a wide range of UK and international banks. They also hold other investments such as Treasury Bills, which are very short-term loans made to the government for a fixed period of one month, three months or six months. The value of some cash funds can go down as well as up and even if they produce a positive return, fund management or administration charges can reduce the return to zero or less, particularly when interest rates are low.
Cash funds can either be pension funds managed by insurance companies, open-ended investment companies (OEICs) or unit trusts.
The benefit of cash is that it does not usually fall in value, however the value can fall if management and administration charges are higher than the rate of interest earned. The big disadvantage of cash is that the historic interest rates generated by cash deposits or cash funds have struggled to keep pace with inflation. This means that the real value of savings held in cash may fall over the longer-term, which is why cash is often seen as a short-term home for savings.
2. Fixed Interest
The idea of an individual lending money to a government or a major company might seem a bit bizarre at first (“All right, Microsoft, I’ll sub you a fiver until pay day”) but that is essentially what fixed interest entails.
Fixed interest involves making a loan, either to the government or a company. In the UK, loans to the government are known as gilts (also ‘stocks’ or ‘bonds’) and loans to companies are known as corporate bonds. The government or company you have lent money to agree to pay interest until the end of the loan term, at which point they aim to pay back the money you lent them.
The benefit of fixed interest investments are that you will get a known rate of income if you hold the investment until the loan is paid back (called ‘redemption’). However, there is a risk that the government or company which has borrowed the money will stop paying interest, or could even default altogether. This would mean losing some or all of the capital lent to them, as well as the promised interest.
Whether to lend to a single borrower, or a wider range
You can invest in individual fixed income ‘stocks’, however, the disadvantage of doing so is that your investment is exposed to the fortunes of one, or a handful, of companies or governments.
Fund managers offering fixed income fundsusually invest in a wide range of fixed income stocks. They are available as pension funds, OEICs , unit trusts and investment trusts. These funds tend to invest across a wide range of government and company bonds which means that the impact of a small number of companies or governments defaulting on their loans doesn’t spell disaster for the fund overall.
Fixed interest investments can go down as well as up in value in response to general economic conditions. This means you might get back less than you invested, even if the fixed interest fund invests in loans from strong companies and governments that don’t default.
Equities is another name for shares issued by limited companies. They give the shareholder a stake in the ownership of a company, which may pay a dividend if the company makes profits.
Shares are issued by companies around the world and traded on exchanges such as the London Stock Exchange. The total value of all the shares issued by a company is known as its market capitalisation – in other words, how much it is worth.
Like fixed interest, it’s possible to invest pension money in individual shares, but again, this could involve a greater degree of risk as the investment return will depend upon how that individual company performs.
The most common way to invest in equities is through a collective fund, which usually invests in hundreds or even thousands of different companies. This spreads the risk of one or a handful of companies falling in value, failing to pay dividends or going bust. These funds can be pension funds, OEICs (a type of company or fund set up to invest in other companies), unit trusts or investment trusts.
The benefit of equities is that they tend to deliver good returns over the longer term and have the capacity not only to keep pace with inflation, but could also deliver a return on top. Some shares also pay high dividends, which if sustainable, are a good match for known income needs.
The big disadvantage of shares is that their price is volatile. Their value can, of course, go down as well as up. And whilst dividends can rise, they can also be cut if the company’s profits are falling.
Many people who invest in property do so through collective funds which invest in a large number of different types of commercial property, reducing risk through diversification. Like shares, property tends to deliver above inflation returns over the long-term based on historic performance, but the future may be different.
One word of caution when considering property funds is that you may not be able to withdraw your savings as cash immediately if market conditions become difficult. Like individual property investments, investment managers may be unable to sell properties to meet demand from investors who want to turn their investment into cash.
Choosing your investments... a final word of warning
Unless you’re an experienced investor, the best idea is probably to leave investment decisions to someone else. If you have a financial adviser, they will help you select funds that meet your financial objectives within your personal tolerance for risk.
If you’re investing for your retirement without professional help, pension providers offer ready-made investment portfolios, for do-it-yourself investors to choose from, which are matched to individual needs.
Please remember that this ‘phrasebook’ only covers some of the basics of investing – it’s certainly not intended to provide a comprehensive education in the subject! You can read more about investment-related topics in our Thinking Ahead newsletter – back issues are available on our website.
Whatever kind of investments you’re making, you need to bear in mind that their value can go down as well as up, and you may lose what you or originally invested. Of course, different investment funds are available to match the level of risk that different people are prepared to take on. But if you decide that you don’t have any appetite for the risk involved in investment, you could simply consider saving a regular amount or a lump sum to add to the provision you’re making for your retirement.
You can find information to help you decide what options might be right for you by going to 'Savings or investment?' on Aviva’s website.