Women are excellent at saving our money when we get around to it. In the investment community women are seen to be the savers and men the investors and this is clearly reflected in the statistics. Although Men and women hold roughly the same number of ISA’s, men are more likely to invest theirs in a stocks and shares ISA.
While saving and having easy access to a cash fund is a sensible way to prepare for emergencies, this is not the way to grow your money. That is what investing is for. Both concepts are extremely important to your financial plan but for very different reasons. Let’s take a look at what saving and investing are and where they are appropriate.
What is saving?
Saving is regularly depositing money into an easily accessible bank or building society account. Easily accessible means you have instant access and can draw it out when needed. This brings into focus the element of discipline. In order to be able to build up a reasonable savings balance we have to be disciplined enough not to spend it when those shiny sparkly things are being flashed in front of us.
Money in a bank account is relatively safe as you are unlikely to lose actual capital value. That means you will get back what you have saved with a small amount of interest. Deposits into authorised banks, building societies and credit unions are guaranteed by the Financial Services Compensation Scheme up to £85,000 per person and £170,000 in total for joint accounts.
The disadvantage of cash deposits is that the interest you are likely to be earning on the account is a lot less than inflation. The result is your money loses purchasing power over time. £100 in a year is unlikely to be able to buy the same amount of goods as £100 today.
What is Investing?
Investing is using your money to buy an asset that you hope will either provide a steady income or will grow in value or in most cases will do both.
Investing exposes your money to volatility. Volatility means the value of the assets you have bought will go up and down. If you have bought riskier assets the value may go down permanently and you could make a loss.
Volatility does not in itself cause actual losses, but it does cause paper losses. Let me explain that a little bit further. You buy a house for a certain price. After buying your house the economy suffers a rough patch and the value of your house decreases below the price you paid. You have made a paper loss equal to the drop in value. However this loss will only become a real loss if you sell your house at the depressed value.
If your house burnt down and you were not insured you would suffer an actual loss. You are however able to mitigate this risk by taking out insurance. The management of risk applies to all the assets you invest in with simple risk mitigating techniques which we will discuss below.
The most common asset classes are:
- Shares, sometimes referred to as stock or equities, represent an ownership in a company. The company may be listed on a stock exchange where its shares are available for the general public to purchase. This means it is easier to buy and sell them. Shares in a private company are not available to the general public and tend to be harder to buy and sell.
As an owner you face the risk of company failure but also get to benefit in the profits by way of dividends and increase in the value of the shares because of the increased profitability.
- Bonds, are a debt security, similar to an IOU. A bond is however an IOU that can be traded either on a stock exchange if it is listed or privately.
By investing in a bond you have lent money to the issuer who may be the Government or a company. You receive your capital and an interest return back from the borrower after a given period of time.
Bonds are an obligation on the company to pay the lenders. The company is not obligated to pay the ordinary shareholders. Bonds are therefore considered less risky than shares. This obligation means that if the company goes bankrupt, the bondholders rank higher up in the payment priority than shareholders.
- Property,can be owned directly or through an investment in the shares of a Property Company or Real Estate Investment Trust (REIT). Property that you own and live in is not typically considered an asset unless it can generate an income for you. (For example by renting rooms out or ultimately selling it).
- Commodities, such as Oil and Gold. The investor can invest in physical gold and while they cannot invest directly in physical oil they can do so through the options and futures market.
More commonly though investors can gain exposure to these commodities through Exchange Traded Funds (ETF’s).
- Cash. This is an important part of a portfolio as it gives the flexibility to have investable cash available if the market crashes. A market crash is like an end of season sale with the investable assets marked down. You want to be in a position to shop the sale.
While investing carries a higher degree of risk in that the returns are not guaranteed and your capital invested may fall in value, it has the higher potential for greater returns.
As mentioned earlier it is possible to reduce the risk of investing to some extent by diversifying your investments. This means not putting all your money into one specific investment, such as one company, or one asset class, for example investing only in shares, and even more specifically, one industry, having all your investment in shares from the technology sector and one geography, the UK with Brexit looming.
Diversification has been simplified for investors in that we can now invest into a pool of assets through Mutual Funds, Unit Trusts, Investment Trusts and Exchange Traded Funds (“ETFs”). These funds offer a ready made portfolio which is an affordable way to invest in different asset classes and geographies. The risk on these ready made portfolio’s is further reduced in that certain of these funds, called passive funds, merely invest in an entire subset of the market with minimal human involvement. Diversification done for you!
Where do saving and investing fit into my financial plan?
Saving serves two functions.
- Firstly before investing you need to have the necessary foundations in place. A critical foundation is a fully funded emergency fund. Things happen in life, emergency repairs, medical issues, redundancy and divorce to name a few.
When life’s challenges come to visit you don’t want to have to sell your investments to access cash, especially if the market has gone down at that particular time.
An emergency fund is the cushion for these events. Your emergency fund should cover your basic monthly living expenses, mortgage, food, utilities and anything else you can define as a need as opposed to a want. And it should be sufficient to carry these expenses for a number of months, three at an absolute minimum.
- Creating a cash pot for large expenditures you have planned or know are an obligation in the next five years. This may range from your vacation budget to a deposit on a house. Outgoings within five years are much better suited to a more stable, liquid investment. You don’t want to have your plans derailed by the market tanking exactly when you need the cash!
Investing is your wealth builder. Once you have your foundations in place which include amongst others knowing your risk tolerance and your time horizon, it’s time to get your money working for you.
Knowing your risk tolerance enables you to build a well diversified portfolio that on average produces a return congruent with the level of risk you have taken.
Investing requires a long term time horizon of at least five years to enable your portfolio to ride out the absolutely certain up’s and down’s of the market and benefit from the long term upwardly moving positive trajectory.
In addition by reinvesting the income your earn on your portfolio back into the market you benefit from the magic of compounding. This is where you earn returns on the reinvested income as well as the regular cash investment you contribute to your portfolio over time. Imagine investing as pushing a small ball of snow up a steep mountain as you push the ball gets bigger and bigger until you reach the top and then the snowball is off on its own gathering momentum and snow as it goes. Growing and growing with no effort on your part! This is your money working for you!
Investing enables you to build a self sustaining asset pot that supports your major life milestones, schooling, college education for the kids, retirement and any other life goals you want to achieve along the way.
Saving and investing, different concepts with a very important common goal. Creating your financial freedom!