Investing is the third step to financial freedom, it’s a way of putting your money to work for you. It’s the one that most people find daunting, especially as films like The Wolf of Wal Street make it seem like a dark art.
The reality is, investing doesn’t need to be complicated and it can make a huge difference to your financial position.
Why is Investing Important?
Investing is an important part of achieving financial freedom. Once you have saved some money, it’s vital that you make it work as hard as you do. Without it, you’ll be working your entire life without any prospect of reprieve.
Here in the UK, most people invest through a private or workplace pension. If you don’t you’ll likely need to rely on the State Pension, which, as of 2021, equates to less than £10,000.
With most banks offering interest rates of 0.5% or less, the only way to earn above-inflation returns is through investing.
What is Inflation and Why Do You Need to Beat It?
All modern currencies suffer from inflation, which can erode the value of your cash. Most governments around the world aim to keep inflation at around 2-3% each year, which, in simple terms, means that an item that costs £100 today will cost around £102 next year.
Therefore, it’s important that you get your cash to grow faster than the rate of inflation. Otherwise, you’ll actually have less money in real terms.
While £2 may not seem like a big difference, inflation compounds over time. The £102 next year will become £104.04 the year after and £121.90 after 10 years.
So if inflation is 2%, inflation-beating returns are those that are higher than 2% per year.
Understanding Risk vs Reward
However, with most banks offering less than 0.5% interest, you are unlikely to earn inflation-beating returns in a simple savings account.
This means you are going to have to look for investment opportunities that offer the potential for higher returns.
Typically, higher returns require you to take bigger risks. This doesn’t necessarily mean doing anything radical or reckless with your cash, but it does typically mean investing in stocks, shares, bonds, and/or other assets.
The amount of risk you take will depend on your own preferences, your age, your position in life and when you plan to access the funds you invest.
Trading vs Investing
If you watch videos about finance or business on YouTube, you will almost certainly have seen ads for companies that run trading platforms or offer guidance on how to trade. However, you should view any ad like this with a large amount of scepticism, especially the ones that hint at how you could “make big returns” or show you fancy cars, property, and clothing to suggest that’s what you could own if you trade with them.
It’s important to understand that these businesses are offering something very different from investing.
What is Trading?
Trading is a fulltime job and requires you to spend hours researching companies, markets, and other factors. You make money by selling stocks or shares in companies (or other financial instruments) for more than you sold them for.
Most trading is very short-termist, holding on shares, options, CFDs, and other instruments for days or weeks.
Despite what their ads might say, trading is not much different to betting on horses or playing poker. Some people are more skilled at it than others, but it’s still gambling.
That’s not to say you should or shouldn’t try trading. That’s entirely up to you. You should just make sure you understand what you’re doing before putting your money on the line.
What is Investing?
Investing is a very different kettle of fish. It takes a much longer-term view, with most investors holding on to shares for years or even decades. When you buy shares in a company, you can profit from increases in its share price, just like a trader. But you can also earn a dividend, which is a share of the company’s profits.
Over the long term, if you reinvest these dividends, they can compound to make significant returns.
For example, investing £1,000 in a company (or a group of companies) that generates an average of 8% returns over 20 years would leave you with £4,660.96 by the end.
What Can You Expect to Make Through Investing?
There is almost never a 100% guarantee of returns through investment, so you should be sceptical of anyone who makes such promises. However, investing sensibly over the long term provides a real opportunity to make decent inflation-beating returns.
A group of people known as the ISA millionaires are British investors who have taken advantage of compound interest by investing in shares and funds to build up £1 million or more. According to Yahoo Finance, there are around 1,000 of these ISA millionaires in the UK as of 2020.
Investing £300 per month for 40 years would be enough to make you an ISA millionaire if you averaged 8% annual returns.
What Should I Invest In?
We don’t give financial advice. This article just lays out the concepts of investing and gives information that can point you in the right direction.
We can’t tell you what to invest in or whether a particular opportunity is right for you. But we can tell you what some other people have said.
Warren Buffett, the famous American investor and owner of Berkshire Hathaway, is a big believer of index funds. In a 2019 article, CNBC reported that he had instructed the trustees in charge of his estate to invest 90% of his assets into the S&P 500 for his wife.
He and many other advocates for index funds like them because they’re easy to invest in, have low fees, and offer a good level of diversification.
A mix of index funds that offer you exposure to the UK, US and global companies could be the easiest, cheapest, and most effective way to invest.
Others say that you should also add in some gold, bonds, and even cryptocurrencies to create even more diversification, though how you mix everything is down to your own needs.
Are There Any Good Investment Books to Read?
Yes, there are plenty of great books about investing that you can read. Some are aimed at absolute beginners and others at experts.
The best three we have found are these:
For beginners: How to Invest When You Don’t Have Any Money
It’s a small and easy to read book aimed at people who have no experience of investing. It was written back in 2000 so some of the references to ISAs and pension rules are out of date, but the basic concepts are timeless. The first half of the book discusses how to get out of debt, but if you don’t have any you can just skip this part.
It talks about using index funds as the main part of your investments and offers ideas for what you can do to supplement it.
For those who want more detail: The Financial Times Guide to Investing: The Definitive Companion to Investment and the Financial Markets
In contrast to the previous book, The Financial Times Guide to Investing contains definitions for every type of investment option you could want. It’s well researched and from a global brand that you can trust.
It’s a bit heavy to read in one go (or even a couple of settings), but it’s a great resource to reference whenever you want to look something up.
For those looking for broader concepts: Rich Dad Poor Dad
Rich Dad Poor Dad is a great book for helping you think differently about money and investing. The author, Robert T. Kiyosaki, is in a unique position to compare the money lessons that rich people teach their kids vs the ones poor people pass down. It’s an easy and enjoyable read and one that you can pick up and refer to in the future.