Beginners Guide to Investing

By PURSUIT of FIRE on in Invest Money - Level 6

A lot of people are afraid of investing money. For some people it is just the fear of the unknown. They don’t understand how the stock market works and are too afraid of losing money.

There have been some pretty big loses in the past too which doesn’t help matters. In December 2018 the stock market dropped nearly 20% seemingly wiping out an entire year and half’s growth with it.

However, within a month and a half it was back up to where it was before the drop.

That is the thing with the stock market, there will always be occasions when it will drop but for the most part it is an upward trend.

Let’s look at the S&P 500 index for the last 20 years from Yahoo Finance:

As you can see there are quite a few drops over this period, 2000 - 2003 (Dotcom Bubble) and 2007 - 2009 (Great Recession) stand out as particularly bleak times.

However, over the last 10 years (Feb 2009 - Nov 2009) the S&P has increased nearly 300%. If you reinvested the dividends you received during that time you would be looking at a 374% return. That is the equivalent of a 15.6% return every year. Don’t believe me look for yourself.

The real cost of fear

However, even though 15.6% return sounds pretty good you also need to take account of inflation.

Each year the cost of stuff goes up. If you have £1050 in your account now, you could go out and get yourself the new iPhone 11 Pro. Let’s say you get cold feet and decide to wait a year for the iPhone 12 Pro to come out. It comes out but this time it is £1100. That is inflation for you, but it doesn’t just apply to shiny phones. It applies to everything from your house to the cost of a pint of milk.

In the UK the inflation rate for 2019 was 1.8%. That means, if you left your money in your current account earning 0% interest it would have effectively lost 1.8% by the end of the year. You won’t notice a difference in your balance but you won’t be able to buy the same amount of stuff with that money as you could a year ago.

Now if we look at the stock market 15.6% return is actually a 13.8% return taking account of 1.8% inflation.

Until now you probably felt pretty good about your “savings”. Stashing money away into a savings account at the end of each month, building up a nice stash. Except now you realise that your savings account is only paying 0.30% interest, and at the end of the year you have effectively lost 1.5% of your money. Oops!

I bet you wouldn’t put your money there if it was advertised as -1.5%.

The highest savings account I have found at the moment that allows instant access to your money is the Marcus account offering 1.45% AER. This is lower than inflation, so you are still losing money at a rate of 0.35% each year. About as much interest as you are getting on that high street bank savings account of yours.

Let’s take a hypothetical example. You have £1000 to save.

Option 1

You save it with your high street bank with an interest rate of 0.30%. At the end of the year you would have earned a whopping (wait for it, drum roll), £3 interest.

So you now have £1003. But unfortunately due to inflation you can’t buy as much as you could with £1000 this time last year. You now need £1018 to buy the same amount. So you have effectively lost £15.

Option 2

You invest the money in an index fund in a stocks and shares ISA which increases by 15.6% over the year.

At the end of the year you have £1156. You still need £1018 to buy what you would have done a year ago but that is still a £138 profit.

How to Start Investing

Many people start investing in the wrong way. They invest in a single company and then get a nervous twitch every time the stock price moves. That really is putting all your eggs in one basket. Pick the wrong stock and you are very likely to lose money.

Take Ford for example:

The stock had quite a large drop over the space of 5 years and then remained fairly stable but with little growth. Compare this to the previous graph of the S&P 500 and you can see how much you would have missed out on by putting all your money into one stock.

What if you could spread your risk and invest in hundreds of companies at once. Even better yet, what if you invest in only the top 100 companies. This is the purpose of index funds.

The S&P 500 is an index of 500 US companies and there are many funds you can purchase which track this index and buy stocks in all the companies listed. Similarly in the UK we have the FTSE 100 that lists the top 100 companies.

So before you go trying to pick stocks, your best bet is to find a low cost index fund to invest in. A good choice for low cost funds is Vanguard. Take their Vanguard FTSE 100 Index for example with a cost of just 0.06% a year.

The Lower Risk Option

Ok, hopefully by now you realise that putting your money in a 0.30% interest savings account for the long term is a bad idea.

However, maybe you are not sold on the idea of putting all your money in stocks in case we have another one of those 20% stock market crashes.

The alternative is to offset the risk of stocks with bonds. Bonds still return a higher interest than savings accounts but not as high as stocks. Just like stocks you can also buy bond funds.

With bond funds all the money is grouped together to buy a number of short term and long term bonds. These bonds starting paying out at different intervals meaning they get consistent returns similar to stocks. With bond funds you don’t have to have your money locked away for several years either.

You can even get funds that manage the allocation of stocks and bonds for you. Again Vanguard is a great choice for this and their LifeStrategy range of funds is a good option.

Depending on how risk averse you are you can pick between their 100%, 80%, 60%, 40%, 20% and 10% stock options with the rest invested in bonds. The lower the percentage of stocks the lower the drop of a potential stock market crash will be. However, this also comes with a lower gain overall.

Vanguard show a few examples on their website on what the potential gain differences might be for different stock to bond ratios.

If you are in the UK your best option is to start investing in a Stocks and Shares ISA as you won’t have to pay any taxes on all the money you make in the stock market.



AUTHOR BIO

Alex started Pursuit of FIRE in 2019 to try and help people reach financial independence. He has spent nearly a decade working as a software developer in the finance industry and now is looking towards early retirement so he can spend more time with his young family.