Cut from Process

What is the difference between Saving and Investing?

The distinction is difficult to describe, not precise, but important to recognise. In general:

·         Both are to do with the deferment of spending and the storage of money

·         Saving is short-term and investment is long-term, but…….

·         Techniques of saving can be useful in Investment and techniques of investment can be useful in Saving.

·         Banks and finance houses have a precise meaning for ‘savings’, which is any deposit of money that pays interest.

On this site we will reserve the term ‘saving’ for anything to do with short term secure money (and therefore available to be part of the emergency cash cushion that every household needs). Everything else is investing.

Cut from ‘More Uncertainty’ in Simple Money

Uncertainty = Risk

You won't see the word 'uncertainty' much in investment literature. What you'll see is the word 'risk'. But we prefer the former word here for two reasons. First, it is plain English and describes precisely what we are trying to describe. Second, the word 'risk' has been annexed  to describe and measure a very specific phenomenon - the extent to which the capital value of an investment oscillates. A financial adviser attempting to sell you a product may say that it 'reduces risk' when what he actually means is that its value is less volatile.

'Risk' is perhaps a word that is better reserved for things like loans to Dodgy Bank PLC (DBPLC). You would not lend money to DBPLC at 3% when you could get the same rate from the government. This seems different from the Chancellor's coin-tossing example somehow - more obviously 'risky'.

Well it is. But that's because in lending to DBPLC you are risking default - losing your capital and not just the interest on your capital. The stakes are higher. There's even a special name for it: 'counterparty risk'

But the principle is the same. You might judge there is a 1% chance of DBPLC defaulting within a year. So you need 4% (=3% + 1%) to break even. And you need more than that to compensate for the uncertainty. 5%? 6%? That's for you to decide. Either way this is just like the earlier example except that God (or maybe the managers of DBPLC) is tossing the coin.

Cut from More Assets (I think)

What assets do I chose from?

There is no commandment that says assets must be grouped in a particular way. But it has become conventional to focus on four asset classes: cash, property, bonds and shares. Most savers will restrict their investments to these four.

Commodities and collectables are two other groups worth mentioning. Though we don't recommend them.

Can't we divide groups of assets with finer cuts?

Well, yes. We don't really want to do it, because we think you should keep it simple. But we will mention some common subdivisions:

• In property: your own house(s), retail ('buy-to-let') and commercial.

• In bonds: UK government ('gilts') and 'other' (foreign government, investment grade corporates through to junk bonds). Perhaps the most important: index-linked bonds (a subset of gilts)

• In shares - too many to mention.

• In commodities: gold, other metals, energy (oil & gas), agriculture (e,g, coffee, wheat, sugar)

Cut from diversification

It gets better. It seems to be a characteristic of efficient portfolios that they include a small dash of 'unconsidered' asset classes- that is, classes that do not seem to be particularly attractive investments in isolation.

It is hard to see, intuitively, why this might be so. The best explanation we can give is that the 'unconsidered' asset has low correlations with cash and shares which allows the computer to substitute mostly low-return cash without increasing the risk of the portfolio. But generally, we must admit that if you can't do the maths (and very few can) you'll have to take this on trust.

Cut from More Diversification draft

A mathematical diversion

Given two variables (the share prices of two different companies, for example) a mathematician can define something called a correlation coefficient (CC) which measures the extent to which these two values move up and down together. A CC of 1 means the two prices move in lockstep; a CC of 0 means the prices move completely independently. Any two share prices have CCs between 0 and 1. Given forecasts of the future correlations of a number of shares (10, say) it is possible to compute that share mix that minimises volatility, and some wealth managers have advertised this facility to clients. Unfortunately 10 shares have 81 CCs and the chances of getting 81 forecasts sufficiently right would be slim.

Cut from ‘Equities again’

How much?

You must first settle your asset allocation policy with your adviser. That means deciding how much of your free cash flow you are going to invest in equities and how much in other assets - particularly cash. If you have arrived at this page through the Advanced Investing module you will have already done this.

The maths

The only fixed cost of buying a share is the brokerage fee - say £10 per share. (The other costs are variable - i.e it costs as much to buy , say, £10,000 of shares in one company as £500 in each of 20 companies). So buying 20 shares costs £200, and £200 again when you sell. If you put the same £10,000 into a good investment trust the costs will be 0.5% or £50 per year. So the investment trust is cheaper for small investments, but not by much.

What you should do

If you accept these principles, you should :-

Either

• Buy a diversified spread of individual shares, according to any decision rule that you care to devise. Random picking from a FTSE350 share list sorted into sectors (one share from each sector) is acceptable. But, for discipline, stay with your chosen rule. For discipline.
  
  If you want to try stock-picking it's harmless and, for many, fun. But don't lose the benefits of diversification, which is very easy to do because you will be swayed towards businesses you know.
  
  Don't ever allow yourself to believe you have skill.
  
  Only sell shares for tax purposes or because you need the money. Why incur the costs of buying and selling just to replace one random share with another? Portfolio Turnover

  We can’t bear to let the last go entirely unmodified. Sell if your company makes a major takeover or capital reconstruction. The historical evidence is that the odds are against success.

Or

• Buy a small (up to 5 or 6) selection of widely diversified funds with the lowest possible Ongoing Charges Figure (OCF - total costs as a percentage of funds under management). You may chose Investment Trusts, Open Ended Investment Companies (OEICS) or Exchange Traded Funds (ETFs).
  
  Sell for tax reasons or because you need the money. Also sell if the fund does anything to suggest it is changing its character (for example, it is taken over or changes its investment objectives).

Or

• Do a mix of the two strategies, making sure that no single stock is more than 5% of your total portfolio.

Or

• If your portfolio is too small to make individual shares economic, and you really want to gain experience of direct share investment, put more of your assets into cash (to reduce your risk) and buy a few single stocks (which will put your risk back up again). Be ready to lose all your money in one stock, and feel comfortable with that.

Pros and cons

A pooled investment is more convenient. Buying a fund at least saves you from having to make a choice in an area where you believe you are incompetent. On the other hand, if you buy a few shares, particularly when you are young. you learn the process. And, particularly, you learn something about yourself and your reaction to occasional large losses and gains.