Whilst some of what follows may seem obvious to many, the essential principles of investing are often forgotten or poorly understood, but it is vital that they are considered and comprehended, because they are fundamental to the questions all investors should not only ask, but more importantly, have answered before making an investment of any kind.
Particularly important questions and issues are:
- 'Should I be investing at all?'
- 'What are my investment objectives?'
- 'Is it financially worthwhile for me to invest?'
Our view is that it is impossible to answer the first two of these questions if you do not have a roadmap charting your financial journey through life to your desired destination - or in other words, a proper financial plan.
This is because only by going through the rigours of the full financial planning process will you or your advisers be in a position to make considered, informed decisions about such important matters as whether an investment portfolio is appropriate for you and what level of return you require in order to help you to achieve your financial and life goals.
In considering the answer to the third question, however, it would be worthwhile revisiting a few of the basic features of the capitalist society in which we live:
When you deposit your money with a Bank, Building Society or Government, you are essentially providing them with capital that they can use to finance or expand their wider business or Governmental activities. In exchange for this deposit of capital, you will be offered a relatively low return in the form of interest payments, but with a comforting guarantee that the nominal value of your money will not fall.
However, even though the nominal value of your money will be protected if you choose to only hold cash deposits, you must keep in mind that the real value of your money may well be eroded over time by the pernicious effects of inflation, if you choose to pursue a cash-only investment strategy. Indeed, as we always remind our clients, it is all too easy to underestimate the negative power of inflation or assume that because you can't 'see or feel' it happening, it doesn't exist. Inflation has real consequences and must be taken seriously.
When you invest your money in the shares of companies (equities), you are also providing those companies with capital that they can use to finance or expand their business activities. In exchange for this input of capital, they will try to provide you with a relatively high return in the form of a growth in the value of your capital and usually dividend income as well.
However, the companies in question cannot guarantee that you will receive any dividend income payments, nor can they guarantee that the nominal value of your money will not fall and this uncertainty means that there is an inherent and sometimes discomforting risk involved in offering your capital to companies.
Despite this, there is an observed and accepted phenomenon, supported by a mass of research and data, that over the longer term the returns from equities are considerably greater than those from all other asset classes and importantly, the returns are also significantly greater than the long-term rate of inflation.
This increased long-term return from equities is known as the 'equity premium' - i.e the greater reward delivered to an investor in exchange for their willingness to take a greater level of risk with their capital, by providing it to companies through the purchase of their shares.
The difficulty with the equity premium, as all investors know, is that whilst it appears regularly and consistently over a long period of time, it does not materialise in each and every year and of course, equities can and sometimes do fall in value. This makes for a slightly bumpy ride for investors at times but it does not detract from the fact that in the end, equities will deliver a greater return than any other asset class and inflation.
As such, the simple fact is that risk and return are related and if a greater return than is available from cash deposits is what you require to help you to meet your financial planning objectives, the only way to achieve this is by either revising your financial plan or accepting a greater degree of risk.
To summarise, with investing as in all other aspects of life, it is essential that investors accept there is no such thing as a 'free lunch', whereby the high returns and inflation-beating capabilities of equities can be accessed by taking the low risk associated with cash deposits.