What even is a stock anyway?
Scrolling through social media you might come across a fairly common news headline like “BREAKING: Stocks fall by over 300 points”. Anyone in their right mind might think, well what does that mean? What’s a stock and why should that matter to me? Is a 300 point another financial crisis or something that’ll be reversed by tomorrow?
Stocks, shares and equities: the exact same thing
If you’ve thought about opening an ISA for your savings, you can either open a Cash ISA or a Stocks & Shares ISA which allows you to invest your money for future returns in things like equities – also called stocks and shares. After all this is the finance industry, why use one word for something when apparently three will do…
Stocks are small pieces of a company you can buy, meaning that when the company does well, so does your investment.
You can invest in these directly and you, or your adviser, decide which individual companies you would like to hold. Alternatively, investing in a fund alongside other peoples’ savings allows you to hold several shares at once, saving you a lot of time and hassle. This can also help lower your risk because one company which might perform poorly is less likely to drag down your whole investment.
How can you make money from stocks?
At the most basic level, your investment in these companies will do well if they are worth more when you want to sell than when you originally invested. You can measure this by looking at a stock’s price performance over time. Let’s take the three largest companies in the world: Microsoft, Apple and Amazon. £100 invested in the stocks of any of these companies 10 years ago would be worth many more times that today – this gain is what’s known as ‘capital growth’.
As always, it’s important to remember that there is a risk in investing – for every Apple and Amazon there are many more unfortunate companies which failed! The value of equities will vary, causing fund prices to fall as well as rise, so you might get back less than the original amount you invested.
The other way stocks can make you money is through income paid to you by the companies in the form of dividends, kind of as a thank you for being a shareholder and to show that the company is performing well and making money. A company’s board of directors make the decision about how much, if any, should be paid out to shareholders. Some funds have a special focus on those companies which consistently pay out dividends to investors, often called ‘equity income’ funds.
Are stocks right for me?
Before investing in anything, you should think about your investment time horizon. Over long time periods, stocks have delivered incredible returns but due to their constant ups and downs they might not be suitable if you need to sell your investment in just a few years. But if you’re investing for a long time, say for your retirement or more than 10 years, investing in stocks even through a financial crisis can be beneficial as you’ll be buying good companies while they’re unfairly cheap.
Compared to other types of investment such as bonds, property or plain old cash, equities have performed better but are typically a more risky place to put your money. There’s a reason why multi-investment funds have more equities if they are looking for higher returns than those which are more cautiously positioned.
Don’t underestimate the power of compound returns
Albert Einstein reputedly called compounding the “eighth wonder of the world”.
We agree. Here’s why it matters for you.
Whether you’re thinking of saving for a house, retirement or just a rainy day, you’ve probably been told that the sooner you start, the better. And it’s true. All else equal, the more time you give yourself to save, the better the chance you’ll have of achieving your goals.
But the reason behind this is not just that you’ll have more paychecks coming in from which to save. It’s also because you’ll give your savings more time to grow.
For instance, if you invest £100 and receive an annual return of 5%, you’ll have £105 waiting for you at the end of the first year. Nothing to sneeze at, but hardly life-changing. However, it’s when you leave your money invested for longer that things can really start to get interesting…
That’s because it’s not just your initial investment that has the potential to generate returns. The potential return on your returns can help you realise your savings aspirations more quickly.
Using the same example, the £105 you have at the end of year one would not grow to £110 after year two as you might think, but £110.25, with the £5 gain from year one generating £0.25 in its own right.
Projecting this further out into the future, and assuming constant annual returns of 5%, the same initial investment of £100 would grow to almost £128 after five years, £163 after 10 years and an exciting £339 after 25 years. Please note that this example is purely illustrative and real world returns may vary significantly from year to year.
Put simply, the potential returns on your returns really matter, and its power only grows over time. So while the best time to get started with your savings may have been a very long time ago, the second best time is today.
A compounding case study – can just £20 a month help your grandchild buy a house?
The arrival of one’s first grandchild is a truly special occasion. But sometimes alongside the joy of welcoming a new family member into the world come parental financial worries over how to meet the day-to-day costs of raising a newborn child. And as if that’s not enough, our Bank of Mum and Dad research shows that many parents will also want to find ways to help their children get on the property ladder
Grandparents, too, are often keen to help out. With my first grandchild just approaching his first birthday, I was left thinking recently about how I could use the amazing long-term power of compounding to help him build the foundations of his future house today.
Taking my grandchild as an example, what would happen if we invested just £20 a month on his behalf for him in a Junior ISA from his 1st birthday until his 30th – the current average age of a first time buyer in the UK?
Assuming an annual rate of return of 5%, this relatively modest investment would yield a considerable tax-free lump sum of over £15’000. A huge help for anyone looking to buy a house and just a whisker away from the average BoMaD contribution in 2018.
Please note this example is purely illustrative. The value of investments and any income from them can fall as well as rise, and may not perform predictably. Please also bear in mind the effects of inflation on your investment.
Why it can pay to keep calm and stay invested
While ‘time in the market’ can help investors to achieve their savings goals, attempting to ‘time the market’ can have the opposite effect.
Stock markets can bounce around in response to everything from changes in the weather to the latest tweet from the White House. For those who have spent some time nurturing their savings and investments, this may be unsettling.
But fluctuations in share prices do not necessarily translate into smaller savings pots. This is because long-term savers are armed with an incredibly powerful weapon: time. Even after dramatic declines, most stock markets have tended to recover in due course.
Following the financial crisis – when the future of capitalism itself seemed to be in doubt – the global stock market* took less than three years to rise above its previous peak in sterling terms.
Of course, history isn’t a guide to the future. Yet these sorts of episodes do point to the potential benefits of staying invested over the long term. By selling out of investments during periods of market jitters, in anticipation of possible losses, investors may miss out on the gains that can often follow declines in share prices.
The following chart helps illustrate this point, by showing what a £100 investment would have generated in returns, simply by staying invested throughout the entire period.
This outcome is partly due to the small matter of ‘compounding’ the income accrued from payouts by companies, known as dividends, which can help enhance returns and reduce losses over the long term. Compounding here is the process where you re-invest your dividends back into shares – enabling you to receive yet more income on your investments.
It is important to remember that past performance is not a reliable indicator of future results, and the value of an investment can go down as well as up. That said, we believe ‘time in the market’, or investing for the long term, can help you to boost your returns and achieve your savings goals, while attempting to ‘time the market’, by nipping in and out over the short term, can have the opposite effect.
* As defined by the MSCI World index, dividends reinvested.
How to make investing easy
When you invest money in a stocks & shares ISA using collective funds (also known as mutual funds), rather than buying a specific share or basket of shares directly, you enjoy the benefits of simpler administration, lower costs and professional fund management.
You don’t have to consider and act upon the various corporate actions of the companies that you’re invested in. Nor do you have to undertake the buying and selling of shares or account for and reinvest any dividends paid out on your shares. This is all taken care of by the administrator of your ISA funds – your investment manager.
Investing in the shares of just one company exposes your money to a risk of total loss if that company goes out of business. Funds can avoid this risk by pooling your money with other investors to buy a broad spread of different companies’ shares, so that if one share within your fund crashes in price – the price of your fund only falls by a small percentage.
Funds that invest in just one or two sectors of the economy can be riskier. For example, funds that invested only in bank shares were badly hit in the financial crisis. Or funds that invested only in technology companies lost about 90% of their value in less than three years in the dot.com bust that occurred between 2000 and 2003. A broad based stockmarket fund, on the other hand, will hold several shares in companies from any given sector of the economy and will hold shares in companies from many industry sectors too.
Investing in a fund can help you avoid being over-exposed to risks in specific companies or specific industry sectors. And you can achieve some risk reduction either by holding all the shares in your chosen market through an index tracking fund, or through an actively managed fund. Or a mixture of the two.
Index tracking funds may have an advantage in cost terms, and can work well as a core holding, particularly when you don’t want or need to generate returns that are higher than the overall stockmarket. However, you need to remember that full index tracking funds have to hold all the shares in all sectors of the market, at all times, even when a sector, like the technology or banking sectors we talked about earlier, have become expensive and are a risk of a market correction.
Mixed investment funds offer a simple and effective way of investing for people who don’t want to get too involved in choosing lots of funds. In a typical mixed investment fund, the cash deposit element will provide capital protection and, in normal times, a small interest return. The bond element will, if managed well, provide slightly higher returns than the cash element with some but not as much risk as your real assets in the stockmarket or property. And it’s these real assets – including the reinvested income - that should contribute the higher returns to your fund over time.
A well-managed mixed investment fund will capture some of the return on the stockmarket without exposing you to all the risk. These days, the investment industry categorises their mixed investment funds to help you set a limit on your stockmarket exposure. You can choose whatever suits your tolerance and capacity for investment risk. Alternatively, you can choose a mixed investment fund from the ‘flexible’ investment category which, as its name implies, gives the fund manager full flexibility – to invest up to 100% of the fund in the stockmarket.
Being a tax smart investor
How you allocate your long-term savings between cash, bonds, shares and commercial property investment funds can have a big impact on how your money can grow.
Investment returns come in the form of interest on cash and bond (also known as fixed income) funds, dividend payments and retained profits arising from owning a part of profitable companies or funds invested in commercial property.
The more you can minimise taxation of the income and gains, the more returns you retain and the more your savings can grow. The majority of people, particularly in the early stages of their wealth accumulation journey, don’t pay tax on the income and gains arising from savings and investments. That’s because basic and higher rate taxpayers are allowed to earn a tax-free amount of income and all taxpayers are allowed to make a certain amount of tax-free capital gains each tax year.
A basic rate taxpayer can currently earn up to £1,000 in interest from savings accounts and bonds (higher rate taxpayers can earn £500), and all taxpayers can earn up to £2,000 in dividends from equities and £11,800 in capital gains from any asset in the 2018/19 tax year.
Based on current yields this means you would need to have more than £67,000 in cash or over £50,000 in fixed income funds and up to £50,000 in equity-based holdings before the income arising would be taxable.
If you hold savings and investments within an Individual Savings Account (ISA) those income and gains arise without further tax, whatever your tax position. While an ISA is most attractive for those with more than £50,000 of investments and where they are also a higher or additional rate tax payer, it can still make sense for basic rate taxpayers and those with modest amounts to hold investments within an ISA. There is no extra charge for investing in an ISA and there is no need to declare the savings and investment returns on your tax return.
You can invest up to £20,000 each tax year into an ISA. This can be into a cash ISA, an investment linked ISA, or a combination of the two. It’s also possible to get a bonus from the government if the cash ISA component is made to a Help to Buy or Lifetime ISA, but there are certain restrictions and penalties for withdrawals.
The ISA allowance is a ‘use it or lose it’ entitlement and can’t be carried forward if you don’t use it within a tax year. With Legal & General you can get started with just £100 a one-off payment, or as little as a £20 regular monthly contribution, so you can start on your investment journey today.
The threat of inflation – and what it means for your money
Bank accounts are often viewed as one of the safest homes for your money. But what happens if we take price rises into account?
Inflation is a term commonly used to describe increases in the cost of goods and services. It is often bandied around in politics and the media with little further explanation than this – and yet depending on the context, it can be either a good thing or a bad thing.
If you own your home, and your region experiences a period of house-price inflation, that could well be a good thing for you (less so for people trying to get on to, or move up, the property ladder).
But if the overall rate of inflation in the economy is growing at a faster pace than your savings, that is almost certainly a bad thing for you. This is because the money you have put in a bank account, or invested, would buy fewer goods and services than it previously could.
This is best understood in terms of cold, hard pounds.
Let’s take an extreme example: if you were to put £100 under your mattress for a rainy day, and inflation runs at 2% annually, you would need to add the equivalent of another £2 in today’s terms to your stash after every year to enable it to keep its purchasing power.
Or – in a more probable eventuality – if that £100 were placed in a bank account, it would need to earn interest of at least 2% to cancel out the impact of price rises.
To demonstrate just how potent the threat of inflation can be, let’s return once more to the mattress scenario. The following chart shows how much your £100 would be worth over the course of 10 years under different inflation rates.
Purchasing power pounded
After 10 years with inflation at 2%, you would only be able to buy £82.03 worth of the things that you could have originally bought with £100; with inflation at 4%, that sum would shrink to £67.56; and with inflation at 6%, its purchasing power would shrivel to £55.84.
As we pointed out earlier, not all types of inflation are terrible. But these stark figures show that if you want your savings to retain their value – and even grow – it is worthwhile looking at ways to generate returns over and above increases in the cost of living.