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Investing is the process of buying assets with the aim of making a profit if they increase in value over time.
Assets in this context are equities (stocks and shares), bonds, property and other commodities or financial instruments that have the potential to provide capital gains or income.
How does investing work?
The purpose of investing is to buy an asset and sell it at a higher price, known as making a ‘capital gain’.
Ways that aim to make capital gains include:
- a company’s share price rising
- an increase in the price of bonds on the back of higher demand
- the price of a commodity, such as gold or silver, rising as demand increases or supply falls.
- an increase in property prices due to a shortage of homes or an area becoming more desirable.
In addition to capital gains, investors may also receive an income, typically in cash, from assets:
- companies may pay out a proportion of profits in dividends to shareholders, usually once or twice a year.
- bonds pay income in the form of interest payments to bond-holders.
- landlords receive rental payments from tenants.
What are the basic types of investments?
There are four main types of assets for investors to choose from:
1. Equities
Investors can buy shares, or equities, in publicly-traded companies, such as those listed on the London Stock Exchange. Shareholders benefit from a rise in the company’s share price if it performs well, and may also receive income in the form of a dividend.
It is possible to buy shares in a particular company direct from a stockbroker. However, this is a higher-risk option than owning shares in companies indirectly via a fund.
Funds offer investors a diversified portfolio of equities across a range of sectors and geographical regions. Funds are either actively or passively managed.
Active funds tend to charge higher management fees as the fund manager actively picks shares to try to outperform the benchmark, whereas passively-managed funds, also known as index funds, charge a lower fee as they aim to track or replicate an index.
2. Bonds
Bonds are a form of loan issued by companies or governments, with interest paid in the form of a ‘coupon’. The bondholder will receive interest for the period of the bond, in addition to repayment of the capital at the end of the term.
Bonds are also known as ‘fixed income’ investments and are generally less risky than equities. Government bonds, called ‘gilts’ in the UK and ‘Treasuries’ in the US, are also lower risk as the UK and US governments have never defaulted on repayments.
Bonds are assigned credit ratings, with riskier ‘junk’ bonds typically paying more interest to compensate for the higher risk of the issuer defaulting on the repayment.
However, bonds are not a risk-free investment. If interest rates rise, demand for bonds will fall as investors are able to receive a higher interest rate elsewhere, pushing down prices.
3. Commodities
Commodities tend to be split into two groups – ‘soft’ commodities that are grown or reared (such as coffee, wheat and livestock) and ‘hard’ commodities that are mined or extracted (such as fossil fuels and precious and industrial metals).
As with other assets, commodity prices are a function of supply and demand. The price of industrial commodities will rise if manufacturing output increases, while supply issues, such as extreme weather events, can push up the price of commodities.
Although it is possible to hold some commodities, such as gold and silver, in physical form, it is more typical to gain exposure through commodity trading in futures and options.
Another option is to invest indirectly through commodity funds, either via exchange-traded funds (ETFs) tracking commodity prices or broader-based mining funds.
4. Property
One option is to invest directly in property by buying a house, either to rent out or live in.
Property prices will depend on a number of factors including interest rates, the state of the economy, investor sentiment, government policies and local amenities.
Alternatively, buying shares in a real estate investment trust (REIT) offers a way of investing in property indirectly. These funds invest in commercial or residential property and provide income in the form of dividends.
How to approach risk and investing
Before investing, it’s important for investors to decide what level of risk they’re willing to take, or put another way, if they’re comfortable with the possibility of making a loss.
Risk and return are typically correlated as investors will demand higher returns in return for the higher risk of losing money. By the same token, lower-risk investments, such as government bonds, generally offer lower returns.
Although certain bonds are seen as a lower-risk asset, they are subject to fluctuations according to what is happening in the broader financial space. In 2022, for example, they lost over 30% of their value, according to Credit Suisse’s Global Investment Returns Yearbook.
But in 2023 some investors began to look for bargains across bond markets as interest rates stabilised, helping a recovery in prices.
James Norton, head of financial planning at Vanguard, comments: “Low risk portfolios will lose less money, but it doesn’t mean that low risk portfolios will never lose money. I think people have slightly forgotten that, just because it’s low risk, doesn’t mean it can’t lose money.”
Investors should also consider the length of time they want to invest for:
- assets such as equities are more appropriate for long-term investing which gives time for stock markets to recover from a downturn
- investors looking to access their funds in the next few years may choose to invest in lower-risk assets with lower price volatility (movements in price over time).
Typically, one of the best ways to manage risk is to own a variety of different assets, for example, cash, bonds, equities and property. A diversified portfolio means that if one asset underperforms or loses money, another asset may outperform to offset this.
How to start investing
It’s relatively straightforward to start investing and many investment platforms allow investors to start with small sums of money.
There are three main options to choose from:
- Self-invested portfolios: investors who are confident in choosing their own investments may choose a trading platform offering a wide range of shares and funds, as well as ready-made portfolios.
To help with this, we’ve produced a guide to our pick of the best trading platforms. Alternatively, investors looking to shield their portfolio from income and capital gains tax might also like to consider investing via an Individual Savings Account or Self Invested Personal Pension.
- Robo-advisors: these offer a middle option between DIY investing and financial advice. Robo-advisors offer a relatively low-cost way of building an investment portfolio which is automatically customised to an investor’s risk tolerance and financial goals.
- Seeking financial advice: investors wanting more personalised investment advice might prefer to consult an independent financial advisor. This is likely to be the most expensive option but may suit less confident investors or those preferring a more hands-off approach.
Consider starting to invest early, and consider investing regularly
Regular investing can help investors take advantage of market fluctuations. If stock markets fall, investors can buy more units of a given investment, meaning they pay the average price over a period of time. This is also known as ‘pound cost averaging’.
Investing early also helps investments grow through the power of compound returns.
Let’s take a look at an example. I invest £10,000 and it grows at 8% a year (the average return for the FTSE 100 over the last 50 years). After 10 years it will be worth over £21,000. But if I leave it for 30 years, it will grow to over £100,000.
Investing over the long term also helps to smooth out the natural cycle of stock markets, which typically experience a significant downturn every eight to 10 years.
Finally, one of the most important skills for investors is to keep their nerve and not panic sell investments when prices dip.
Vanguard’s Norton comments: “It’s really important not to be short term about it. Don’t focus on that one year.”
