Why investing isn’t a gamble
I’m relatively new to the world of finance. But when I try to talk about my new(ish) job with my...
The majority of millennials in the US* prefer to keep their savings in cash and don’t trust the idea of a stock market. I imagine the same is the case in the UK. But what if I told you all the money you put into cash today could actually be worth less when you retire? Chances are you’d be a bit more interested in ‘investing’ for the future rather than just saving for it. So what’s holding you back? I’d wager it has something to do with all the scary investment terms and financial jargon lingering around.
I get it: overuse of jargon can lead to a lack of understanding and confidence. But don’t be scared so easily. You’ve already learned the difference between a stock, a bond and an investment fund and that wasn’t so difficult was it?
‘An investment in knowledge pays the best interest’ – Benjamin Franklin
Investing doesn’t need to be a complicated process, but it all starts with a strong foundation and a few basic terms. These are terms you’ll see over and over again – not only in our millennial money series, but on every investment website you come across. So it’s a good idea to have a firm understanding of what they mean – as well as a handy reference. The first part of feeling empowered is education, and these twenty terms should get you started.
We need to take a quick step back here, and start with a ‘stock market index’. A stock market index is made up of a number of different companies. The FTSE 100, for example, is a list of the UK’s largest 100 listed companies.
If you invest in a ‘passive’ fund it simply copies an index – so in our example, it replicates the FTSE 100. An active fund doesn’t just copy an index. Its fund manager will decide if they like a company, or don’t like a company, and will ‘actively’ invest more or less in each. So an active fund investing in UK companies, could look a lot different to the FTSE 100.
Alpha is a term used to describe a fund’s ability to beat a stock market. For example, if a stock market rises in value by 5% but a fund rises in value by 10%, the ‘Alpha’ is the difference or the excess return. Alpha can be positive or negative and is only attributable to an active fund: after all a passive fund that replicates an index, cannot beat that index. At FundCalibre, we sometimes describe Alpha as ‘the value a fund manager adds’.
In our daily life an asset can be a property we own, our possessions or our ‘valuables’. In investment terms it is similar: an asset is anything that has a value that can be converted into a cash price.
We generally talk about four main asset classes; equities (stocks), bonds, property and commodities, but there are all sorts of assets we can invest in.
A bear market is when a stock market (or a bond market, or a property market, or a commodity market) falls in price over a period of time and investors typically feel very pessimistic. Although markets go up and down on a daily basis, the movement is usually small (some 0.1% to about 5%). A market enters a ‘bear phase’ when it has fallen by 20% from its peak. A fall of this magnitude often takes a few weeks or months to occur.
Every time a fund’s performance is mentioned, it is almost always in relation to a ‘benchmark’ – usually the average of its peer group or a market index. In the example we used earlier, a UK equity fund may be measured against the FTSE 100. The idea is that, by comparing a fund to a benchmark, an investor can see how well it has done. What are benchmarks and do they matter?
We like the greek alphabet in finance, don’t we? Beta is a measurement of an asset’s volatility relative to its market. Let’s try this one in a hypothetical example: a bit like one of your friends may have a quicker temper than others (they are more volatile), if UK company A’s share price moves up and down a lot more than the value of the FTSE 100 moves up and down it is also more volatile. A company with a beta score of 1 is exactly as volatile as the market. If it is greater than 1 it has a higher beta and if it is lower than 1 it has a lower beta. Simplez.
A bull market is the opposite of a bear market. It is when prices are rising and the value of the market is going up, over a long period of time. It is usually also a time when an economy is strong and investors are feeling confident.
A capital gain is another term for profit. It occurs when you sell an investment for more than you paid for it and it is the difference between the two amounts. So say you invested £100 in the FTSE 100 and then sold your investment when it was worth £120. You have made £20 capital gain. The important thing to remember is that a capital gain doesn’t actually exist until you sell the asset. The bad news is that some capital gains can result in tax being payable (capital gains tax). The good news is we each have an annual ‘capital gains allowance’ and some investment wrappers like ISAs and pensions are free from capital gains tax.
A capital loss is the opposite of a capital gain (boo). It’s when you sell an asset for less than you paid for it. The good news is that you only get a capital loss when you sell the asset – so if you don’t sell, it is just a ‘paper loss’ and it could become a capital gain in future if your investments performs better. The other good news is that you can ‘offset’ your capital losses on one asset against capital gains of another on your tax return. But ask HMRC to explain that one!
When a company makes a profit it has a choice as to what it does with that profit. It can reinvest in the business – by buying new PCs or opening another office, for example – or it can pay some of the money to its shareholders, a bit like a bonus or extra reward. When a company pays this money to its shareholders (usually as a cash payment), it is referred to as a dividend. Funds can also pay a dividend. This happens when the companies in which a fund invests pay dividends, and the fund passes on these payments to its investors. Dividends, like capital gains, can also result in an investor having to pay tax. However, we each get an annual dividend allowance, and if we invest via an ISA or a pension wrapper, there is no tax payable.
Think of the saying “don’t put all your eggs in one basket”. It is basically saying that if you do and you drop the basket, all the eggs will break and you’ll be left with nothing (unless you like scrambled eggs with a side if shell). It’s similar when it comes to investing. If you put all your money into the shares of one company, you are reliant on that company doing well. If it goes bankrupt you could lose all your hard-earned savings. If you invest in a lot of different companies – or better still, invest in different assets, your investments are ‘diversified’. If one does badly, it doesn’t matter as much.
An equity is also sometimes called a ‘stock’ or a ‘share’. Companies around the globe issue shares and investors can buy (and sell) those shares. You don’t own part of the company, as such – you can’t just walk in a take a desk or a computer – you own some of its equity and can vote on how the company is run.
Most of us borrow money at some point in our life. Whether it’s money borrowed from the ‘bank of mum and dad’ to put a deposit on a house, or money spent on a credit card to pay for a holiday, we all have experience of it. Companies borrow money too and ‘gearing’ is a measure of a company’s financial debt (or leverage), expressed as a percentage. It shows the extent to which the company’s operations are funded by lenders versus shareholders.
You often hear the word gearing when people talk about investment trusts. For example, take an investment trust with a value of £100 million. In a rising market, the fund manager may see lots of potential opportunities, but to take maximum advantage, he or she might want to invest an extra £20 million. Having borrowed the money he needs, the investment trust is now 20% geared.
As Maria once said in the ‘Sound of Music’ “let’s start at the very beginning, it’s a very good place to start.” So back to the letter A in this list and Active funds. A passive fund is the opposite. It replicates an index like the FTSE 100 and you invest in a company whether it is deemed to be good or bad. Passive funds are sometimes liked because a) they are deemed to be cheaper than an active fund (but this isn’t always the case) and b) because active funds don’t always do an better.
At FundCalibre we are advocates of active funds and spend all our time trying to identify the ones that do (mostly) perform better than passive funds after charges have been taken into consideration.
A portfolio usually refers to one of two things. It is either being used as another word for ‘fund’ or it is a way of describing the collection of assets in which your invest. So if you invest in five funds, you have a ‘portfolio’ (of five funds). Think of it like you would your student portfolio: all of your (best) pieces of work together in one place.
‘Return’ is another word for the profit on an investment, or the performance of an investment. For example, Fund A ‘returned’ 10% over the past 12 months means Fund A increased in value by 10% over the past 12 months.
The literal definition of risk is to expose someone or something to danger, harm, or loss. In investment terms there are many types of risk and, just as in our everyday lives, it is also very subjective. A risk to one person is not a risk to another. But for many investors, the biggest risk is that they could lose all of their money.
In very simple terms, volatility is a statistical measure of how much the value of an asset goes up and down. Commonly, the higher the volatility, the riskier the security. Beta is one way of measuring it but there are many more ways.
The first step to getting a handle on investments is understanding the lingo – even if it’s a little dull and boring. The more you expand your financial vocabulary, the more confident you’ll be in talking about not only your finances, but financial news, events and what-have-yous. Once you feel you can ‘talk money’, your whole perception of investing will start to change too.
Don’t believe me just yet? Next week we’re explaining why investing isn’t gambling – a common investment myth. So send all your burning investment “facts” and questions to email@example.com and you might just see them featured.
*Source: BlackRock Global Investor Pulse Survey 2017. A survey of 4,000 Americans between the ages of 25 and 74. On average, Americans hold 58% of their assets in cash. That number is 65% for millennials, a slight drop compared to 69% recorded in 2016, but decidedly higher than the cash allocation recorded for other age groups.