How, When And Where To Invest

Many people are scared of investing. They prefer the safety of leaving their cash in a bank or building society. While it's true you won't see the value of your savings lurch up and down on a daily basis, we're going to show why failing to invest can cost you money in the long term. And we're not talking about a few pence, we're talking about thousands and thousands of pounds!

The five main types of asset

First of all, let's look at the five main types of asset you can park your dosh in:

Cash (e.g. a savings account with a bank or building society); Bonds (e.g. a loan to the government or a large company); Property (e.g. residential or commercial property); Equities (e.g. shares in companies such as BP or Vodafone); and Commodities (e.g. copper, oil or coffee) A general rule of thumb is that the riskier an asset is, the greater return you'd expect to earn from it over the long term. We're going to talking a lot about the "long term" in this guide - generally it means five years or more.

Cash is generally considered to be the safest asset, but it also likely to give you the lowest return over a period of several years or more. Bonds are slightly more risky than cash but normally generate roughly the same level of long-term returns. Property tends to do well over long periods and the returns are quite stable. The returns from equities and commodities vary the most from year to year, but tend to be highest of all over long periods.

As an example of the difference in volatility, here in the UK, the real annual return of cash over the last 100 years (i.e. the annual return after taking off inflation) has been primarily between minus 5% and plus 8%. For equities, the majority of annual returns for the last 100 years fall between minus 15% and plus 25% and the chances of losing money in any individual year has been approximately one in four.

Long-term returns

To illustrate what effect this can have, let's look at some numbers. Here is the average annual return for cash, equities and gilts over the last fifty years (note that gilts are the main type of bond in the UK, being a loan to government). The figures are taken from the Equity Gilt Study produced by Barclays Capital.

Asset Average return
Equities 5.7% pa
Gilts 2.4% pa
Cash 2.0% pa

Expressed in percentage terms these figures don't look that interesting. So let's look at them another way. Say you invested £1,000 in each of these three assets fifty years ago. How much money would you have now?

Asset Value after 50 years
Equities £15,752
Gilts £3,218
Cash £2,692

Now we're talking. Investing in equities would have resulted in five or six times the amount you would have got from gilts or cash! And remember that these figures are after inflation, meaning the buying power of your initial £1,000 would have increased 16-fold over the course of the last fifty years.

No one knows what will happen in the next fifty years of course. However, these figures span numerous wars, recessions, shocks and other crises. We think they provide a reasonable as to what sort of returns to expect in the future as well.

As we've seen in the last decade though, the returns from shares can be weak for a considerable period of time. A key point to recognise here is that if you want to earn a high rate of return, i.e. higher than you'd typically get from a savings account, you need to accept some risk. That means getting comfortable with the fact that your investments will go down in value some of the time.

When To Invest

That's all very well, you might say, but I don't have fifty years to invest. However, you might if you've just started work and you're looking to invest for your retirement. But investing in shares also works well over shorter periods, too.

Turning to figures from Barclays Capital again, we can see that shares have beaten cash the majority of the time over shorter periods as well.

Period Shares have beaten cash
2 years 67% of the time
5 years 75% of the time
10 years 93% of the time
20 years 99% of the time

Even over a period as short as two years, the chances of shares beating cash are two in three. However, most people, ourselves included, advise that you shouldn't invest in shares for any period shorter than five years. The rationale is that the chances of losing money less than five years, while fairly small, are still quite significant.

For example, there have been two occasions in the past 100 years where shares have fallen three years in succession. So you're usually better off sticking to cash if you have definite plans for your money in the next five years (to put down a deposit on a house for example).

So when should you invest? The earlier the better. It's advisable to keep a portion of your money in cash, in case of emergencies. Three to six months' salary is a good guide as this is often the period you'll need cover before any insurance policies you may have start to pay out.

Once you have an emergency fund in place, the longer you give yourself to invest, the greater your returns are likely to be. So invest as soon as you can. There is a risk that you will invest just before stock market takes a tumble. There is very little you can do about this. No one knows where share prices will go in over the next minute, day or month. All we do know is that the long-term direction of the stock market is up - but it's not a straight line!

In practice, you're unlikely to invest all your money at one particular point in time. It's far more likely that you'll invest small amounts of money on a regular basis. So while you might see immediate stock market falls some of the time, most of the time this won't be the case.

What about property and commodities?

The more observant among you may have noticed that we seem to have lost two asset classes in the last few paragraphs, namely property and commodities.

There a few reasons for this. First of all, annual return figures for shares are a lot easier to measure. Property figures are complicated by factors such as rent and how to account for maintenance costs.

It's also a lot easier to buy and sell share-based investments, as we'll see later. You can't just sell one room of a house for example and property transactions can take months to complete.

The indications are that investing in property and commodities is likely to give you a similar long-term return to equities. So all three types of asset are well suited to long-term investment plans.

Property investing, via buy-to-let, is obviously very popular at the moment and benefits from the fact you can 'gear up' your investment by putting down a small deposit and borrowing the balance of the price. This can magnify your returns over the long term although it does add additional risk as you have to continue to find money to pay interest on what you borrow. Property does have another advantage over equities in that returns tend to be less volatile and it has been much rarer for it to fall in value over the course of any given year.

Commodities are somewhat of a curiosity. They tend to have long periods of poor returns followed long periods of good returns. After many years in the wilderness, they have recently undergone a resurgence. The price of oil and gold, for example, is a lot higher than it was ten years ago. Investing in commodities is not as easy as investing in shares however.

How to invest in shares

The main reason the Motley Fool favours shares as a type of investment is ease of use. You can buy and sell quickly and cheaply and in more or less any amount you want.

So how do you get involved? You can invest directly, buying and selling shares in individual companies such as BP and Vodafone. If you have the time, and lots of discipline, this can be best way to go.

Many people feel more comfortable getting a fund manager to do the investing for them. You can get funds that invest in particular markets such as the UK, US or the Far East. You can also get funds that invest in certain types of industries, such as biotech or mining. You can get even funds that just invest in smaller companies (as there some who believe that small companies offer greater potential returns).

As a rule, you pay up to 5% as an initial fee when you invest and around 1.5% each year to the people who manage these funds. There is a cheaper alternative - you can invest in funds where the decisions about where and when to invest are made automatically according to a strict set of guidelines and not by an overpaid fund manager!

Typically, these sorts of funds, called index trackers, will cost you nothing in initial charges and around 0.5% a year. Over the course of, say, twenty years these lower charges mean you end up keeping a lot more of your money.

Lower charges mean index trackers perform better than most other funds (often called managed funds). Indeed, over a period of five years, an index tracker is likely to beat 75% to 80% of other funds. Over longer period, it's likely to do even better.