So, for example, if you invest in the shares of a technology company or the work of budding young artist, you might be backing the next Microsoft or Damien Hurst, but you could end up losing your stake. The secret of a good investment is to consider what you want from your money, your timescale and your attitude to risk. Diversification is another key factor.
How to choose the best investments
Choosing the best investment is not easy. Most people would like to get the highest returns with the least amount of risk. But there is normally a trade-off. The highest returns normally come from the riskiest of investments.
If you need to use your money in less than five years, say for a house deposit, or for a new car, then cash savings are your best option because they provide capital security. If you are thinking long term, you have more time to sit out the ups and downs in the investment markets so you can afford to put money into risky assets.
In fact, if you are investing for the long term it is very important to consider investing at least some of your money in something riskier than a savings account because it is more likely to be protected against inflation. This also applies if you are investing for income. Risk can be minimised through spreading your money around different types of investments – diversification. However, if you are the type of person who would lie awake at night if the stock market were to fall for a period, it is best to stick to savings accounts.
You can’t avoid risk. Most people recognise that share prices can go up and down, often due to political events rather than the health of the individual companies themselves. But even cash deposits are exposed to the risk of inflation which means the purchasing power of your money will be eroded over time.
However, you can reduce your risk by not putting all your eggs in one basket. Investing in several companies’ shares, for example, means you will not lose all your money if one goes bust.
The reason that spreading your money across several different types of investment also helps to reduce your risk is as they tend to react differently to events so that when one falls in value another may rise and these movements balance each other out over time.
How to achieve diversification
The best way to achieve diversification will depend partly on the amount of money you have and partly on how much time and inclination you have to monitor your investments regularly.
Cash savings: The foundation of your investments should be your cash deposits. Keep enough in the bank or building society savings account to cover your immediate spending needs and any other major outlays you expect to make in the next five years.
If you are keeping significant sums in savings accounts, remember that the deposit protection limit is £75,000 from 1 January 2016, so keep your maximum deposits with any one bank or building society within this limit.
Other investments: The second stage is to spread your remaining money among different investments such as shares and bonds. Unless you have a large amount of capital and the time and inclination to monitor your investments regularly, it often a good idea to invest in these assets through collective funds, either open-ended mutual funds or investment trusts.
The advantage of collective funds is that for a relatively modest minimum investment of £500 or £1,000 your money will be spread across a large number of shares or bonds. This means you are not putting too much faith in any one particular company so if the business goes bust, very little of your investment will be affected.
Hopefully this won’t happen anyway as most funds are run by professional investment managers who will only choose the shares of those companies they believe are doing well.
Some of these funds are designed to produce a regular income while others are set up to generate capital growth so you can buy the appropriate funds to meet your needs.
Getting the right mix: Try to have a foot in as many camps as possible. More cautious investors will probably want to have more in bonds or bond funds as they tend to be less volatile. Longer-term investors are generally better off having more in shares.
Nowadays there are many funds that invest in a mixture of assets and can act as a one-stop-shop for investors who want to balance their risk. These funds are normally categorised by what proportion they have invested in shares in order to signify their likely volatility.
Nowadays, many people regard residential property as the ideal investment because of its physical nature and the strength of capital gains seen in recent years. However, if you purchase a buy-to-let property in addition to your own home, it does mean that most of your investment is concentrated in one type of asset. Although there appears very little risk in this strategy at present, it would make you very vulnerable if house prices collapsed, say, as a result of a sharp rise in interest rates or greater regulation.
A change in taxation could also affect the market. Recently, the government dropped two bombshells on the buy-to-let market. Tax relief on buy-to-let mortgage interest payments is to be slashed (phased in from April 2017) and buy-to-let properties (and other second homes) now incur an extra 3% stamp duty.
Until now, people buying to let were able to claim tax relief on their mortgage interest payments at their marginal rate of tax. This means that a basic-rate taxpayer would get 20% tax relief, but those at a higher rate would receive 40% relief, and top-rate taxpayers 45%. When the changes come in, tax relief will be a flat rate of 20%.
As with most clouds, there is a silver lining. If you’re a landlord with a lower income, you’re no longer at such a disadvantage to those in the big league. This level playing field may, in fact, help the new wave of ‘silver landlords’ hoping to use their pension pots to buy rental property. Also, if you’re a homebuyer, you may find prices becoming more affordable as the competition from buy-to-let decreases.