Let’s begin with the assumption that you have zero prior knowledge about the world of investing, the ultimate goal of this article is to simplify the major investment concepts in a clear and concise manner in order to assist you in building a solid foundation on this topic.
RISK & REWARD
It all comes down to two things: risk and reward. The bigger the risk, the bigger the reward. Of course, the most important concern for any investor is how much money they are likely to make back on their investment. Everyone would prefer to make a huge return without taking any risks, but that is an unrealistic scenario.
As an example, let’s assume that you have 2 investment opportunities: Investment A (3%), Investment B (12%)
Investment A – Offers a guaranteed return of 3%
An example of this is a savings account or a bond. You are agreeing to put your money away for a fixed period of time, in return, you will receive a guaranteed return on your investment. As mentioned above, low risk comes with low rewards.
Bond: If a government or corporation wishes to begin a project without having the money to do so, a method of raising money would be to sell bonds to the public. If you therefore decide to buy £10,000 worth of bonds at 3% interest rate, you would receive £10,300 next year.
[Original Amount x Interest Rate = Return]
£10,000 x 1.03 = £10,300
Investment B – Offers a 12% return with some risk
If you are not happy with the rate of return generated from bonds, you could decide to take a greater risk by buying shares since they offer higher potential returns. However, there is no guaranteed positive return when buying shares, the rate of return is based on how well the company performs.
Shares: (also known as equities), represent a share of ownership in a company, these shares are listed on the stock exchange for people to view and purchase when they wish to. When you buy a share, you are buying a small stake in the company, and you have therefore become a joint-owner of the company along with other shareholders.
£10,000 x 1.12 = £11,200
Investment B offered a greater return in comparison to Investment A, however the company invested in could have performed poorly. A decrease in the value of the company by 5% for example would have resulted in a £500 loss. (£10,000 x 0.95 = £9,500)
TIME & COMPOUND INTEREST
“Compound interest is the eighth wonder of the world” – Albert Einstein
Compound interest can be thought of as ‘interest on interest’, and this is one of the greatest tools that can help you grow your money without you really needing to do anything. The best way to explain compound interest is with the use of examples.
Suppose person A decide to deposit £10,000 in a savings account at 10% interest rate for 10 years. The interest he will earn annually is £1,000, making £10,000 after 10 years, for a total amount of £20,000 at the end of year 10.
Instead of withdrawing the annual interest of £1,000 at the end of year 1, person B decides to add the £1,000 back onto the original £10,000 sum, making £11,000. At the end of year 2, person B will earn £11,000 x 1.10 = £12,100. In year 3 this will be £12,100 x 1.10 = £13,310.
Person B will have £25,937 by the end of year 10, which is 5,937 more than Person A made. This is the result of compound interest
Therefore the longer your original sum is invested, the higher the amount of interest you receive will be as you will be earning interest based on the original sum plus all the interest you have already earned on that amount. This means that the more years you keep your original amount invested, the larger the amount of compound interest.
The concept of risk and reward explained above is the foundation of investing, the concept of compounding is the greatest way of growing your returns.We can now focus on the best method of managing risk: the use of diversification.
Let’s assume that you have decided to invest in shares as opposed to bonds due to your need for a greater return, it would be quite risky to invest your entire sum of money in a single company, you could therefore reduce your risk substantially by buying £1,000 worth of shares in 10 different companies.
The simplest example of diversification is provided by the proverb “Don’t put all your eggs in one basket”. Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them.
Experts have suggested that you should invest in around 30 different companies, however it has been suggested that if the companies are carefully chosen, 10 choices could be adequate to ensure a profit. (Investing in companies in different industries is vital for avoiding industry-wide fluctuations)
The topics explained in this article are the basics you need to know to give you a basic understanding about the world of investing. Below is a list of the books we highly recommend for anyone who wishes to do some further reading on investing.
The Four Pillars of Investing – The four pillars that the book covers are: theory (risk and return, theory of interest, efficient markets, etc.) history (past bubbles and crashes) psychology (herd mentality, mistakes that investors make, etc.) business (why index funds are awesome, and how to avoid getting ripped off by stock brokers or expensive mutual funds) – Buy on Amazon
The Intelligent Investor – This is a must read for anyone who has never picked up a book on investing. With more than a million copies sold, this classic book stresses the importance of looking at the market as one would a business partner who offers to buy you out, or sell you his interest daily – Buy on Amazon
The Richest Man In Babylon – Travel back in time as George S. Clason takes you back to Babylon in his enlightening, insightful book on financial investment and financial success. The original version now restored and revised, this series of delightful short stories teaches economic tips and tools for financial success that have withstood the test of time and are applicable still today. – Buy on Amazon
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