A beginner's guide to investing
What are the risks involved with investing?
Investing is not a one-way ticket to riches. Asset prices can fall as well as rise, and there are no guarantees you will make money on your investment.
That’s why saving cash is considered the safe option. You earn interest with your bank or building society, your savings pot grows slowly and there’s very little risk of you actually losing any money.
However, with low risk generally comes lower returns. And if the interest you’re earning is below the prevailing rate of inflation, then the real value of your cash savings is actually diminishing. For example, say you deposit $1000 in a savings account that grows by 1% annually. In one year, you’d have $1010. But if inflation grows by 2%, you’d need $1020 to have the same buying power you started with.
Equities have historically delivered higher returns than cash over the long term, but share prices regularly fall as well as rise, and some companies fail completely. While you’ll invest with expectations of generating positive returns, you must also accept that you could end up with less money than you originally put in.
Did you know?
While it’s common for people to invest in individual companies, a balanced investment portfolio includes multiple other assets. As you’ve come to learn, you can also capitalise on the potential growth of ETFs, investment trusts, mutual funds and many other assets. You can build your own portfolio or employ a specialist individual or company to do this on your behalf.
Understanding your own appetite and tolerance for this risk is a key part of investing. Ask yourself how much you’re willing to commit to the markets, but also how much you can afford to lose if they happen to move against you.
Diversification
One of the most effective ways of managing your risk is by diversifying your portfolio. This involves distributing your funds across different asset classes such as shares, bonds, gold or property.
For instance, government bonds are a much lower-risk investment than shares and should produce fairly consistent returns. This will help to reduce the negative impact on your portfolio if the stocks you hold fall in value.
Below is an example of a balanced investments portfolio that includes various assets spread across many regions.
Building a diverse portfolio of assets can help you manage your exposure to market fluctuations. If you invest in the stock market, for example, you may consider holding shares in different companies, from various economic sectors, in order to diversify your investments. This will help to spread the risk within your portfolio, making it less reliant on the performance of one company or sector.
For example, when there’s an economic downturn, consumer-facing companies like retailers may see their shares fall in value as customers tighten their belts and revenues and profits fall as a result. However, pharmaceutical and utility companies should fare much better during periods like this because the products they sell are considered essentials and aren’t as prone to economic fluctuations.
Buying individual shares is therefore a high-risk strategy, and one that can leave you overly exposed should they underperform. Assembling a decent-sized, well-diversified portfolio is generally a much safer bet.
Lesson summary
- The value of shares can fall as well as rise, so there’s a risk you may sell them for less than what you paid
- One way to mitigate this risk is to build a diverse investment portfolio that includes a broad range of sectors and assets
- When you build your portfolio, consider how much risk you’re willing to take on – including how much of your investment you’re prepared to lose if the markets turn against you
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