Simple Pound

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There are tons of possibilities out there to invest and hopefully grow your money and the current obsession with derivatives certainly doesn’t limit that choice. Personally, I will stay away from derivatives until I can be sure that I understand what’s going on.

But let’s start with the basics and give you an overview of the most common investment choices. There’s on simple rule that applies to all of them: More risk, higher return. Whether you decide to keep your money under your mattress (and thus effectively lose money due to inflation) or invest it in a small start-up company depends entirely on you and your risk attitude.

A rule of thumb that is commonly used to determine the ratio of bonds and stocks in your portfolio is 120 - age. This is the proportion you should invest in equity (i.e. shares, equity-based funds, index funds etc.) and reflects the time you have left until you retire (if you are retiring in 5 years you will mind if your portfolio drops by 20% whereas if you have 40 years left you know you have plenty of time to make up for it). In my case this would be 120 - 20 = 100% in stocks, which is what I intend to do - after I’ve got some money sitting in a savings account with a sign round its neck saying “emergency fund”. At which point I can probably already invest 1% in debt-based securities (bonds…)

I intend to break up this post into smaller chunks which should hopefully assure that (a) you don’t fall asleep, (b) you can look up the things you don’t know and (c) I don’t have too many good reasons to procrastinate from doing my revision.

So here we go with probably the most obvious choice: Shares.

Buying shares in a company effectively means you’re buying a tiny part of that company and thus have a right to have your share of their profits. Now with hundreds of thousands (or even millions, depending on the size of the company) of shares in issue this mostly boils down to a few pence per share. The profit is distributed to the shareholders (that is you) through dividend payments. Having said that, there are some companies who are not making any dividend payments but instead are using the profits to re-invest and grow the company. Depending on whether you want a solid income stream or growth from a share, you will have to make your choice.

The former group of shares is often classified as income shares, because they provide guaranteed income on a (semi-)annual basis. These companies are usually large firms whose demand doesn’t depend on economic conditions (utilities or pharmaceuticals come to mind) and you thus distribute their cash reserves to the shareholders. Likewise, these companies usually have a phenomenal market capitalisation (= share price x number of shares), which means that buy and sell transaction don’t affect the share price as much (Microsoft currently has a market cap of $280 billion). This however also implies that the share won’t grow as fast as a smaller share could. In short: the dividend payments are intended to make up for the lack of growth that can be expected.

Therefore, many of the companies classified as growth shares won’t belong to the category of dividend-paying companies (as with everything this is not a black-and-white decision - dividend policies can change and growth shares can also pay the odd dividend, but I’m talking stereotypes here…). These companies usually belong to more volatile market sectors (media, technology) and use all profits that are left over (after interest payments and tax) to fund further investments and thus grow the company. This will (hopefully) be reflected in future income statements (i.e. future profits) which in turn will help convince further investors to join the group of shareholders. Because these companies are usually smaller than income companies they are subject to greater share price movements - and as long as those are in the “right” direction, investors will make money through the increase in value of their shares.

Both income and growth shares belong to the category of common stock, which means that you invest in the ownership (equity) of a company and are allowed to vote for the board of directors every year - who are supposed to represent and act in the shareholders’ best interests. This, however, also means that in case of bankruptcy your claims towards the liquidated assets of the company are subordinated to preferred stockholders.

Owners of preferred stock are owning a part of the company in the same way that owners of common stock do, but with the major difference that dividends paid to preferred stockholders are usually fixed and paid out before the dividends to common stockholders whose dividends are variable (if paid at all). While this promises greater security, the old trade-off kicks in that determines “where there’s lower risk there must be lower return”: preferred stockholders don’t benefit from any growth in profits in much the same way as they don’t lose when profits plummet (as long as the company remains profitable - if it doesn’t, dividends are usually accumulated over time and paid as soon as profits allow).

This was surely a fairly lengthy introduction to the concepts, but I hope it was nevertheless helpful. If you want to read even more about shares and share categories now, I recommend you start here and here.

Read part 2 of “Investment Choices” on exchange traded funds >>

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I have never written a blog before. In fact, I was always fairly unreliable at keeping journals, but this time I have a purpose… I am going to graduate in less than 3 months time and will be earning my first salary. And I think this is a pretty good reason for starting to think about money. There are many, many things I want in life - including material things that come at a cost. And don’t misunderstand me, I love luxury - I love fast cars, good restaurants, quality clothes and cosmetics. But I think it should be possible to afford all these with a little bit of planning and without going into debt.I’ve be using this blog for two purposes: Firstly, I want to keep track of what I’m learning and reading about elsewhere and bundle all this (for me) useful information in one place. And secondly, I want this blog to be my source of motivation where I can keep track of my (financial) goals and encourage myself not to indulge in impulse spending.

So what are my goals?

• Pay back (some of) the money my parents lent me to finance my studies - unfortunately that also includes paying a rather large outstanding invoice for repairs on my mother’s car.
• Fully fund my cash ISA for the tax year 2007/08 - the interest earned on that money is tax free and I don’t want waive free money (especially not when it comes from the government…). I intend to use this money only for long-term purposes. That ultimately includes retirement, but since I’m only 20 years old there will be a few other major expenses (property etc.) beforehand that I plan to cover as effortlessly as possible.
• Accumulate an emergency fund of 3 months worth of expenses - as I am about to move to London, I don’t have much of an idea what amount of money I will need to put aside, but I will find out.
• Build up a diversified portfolio of investment funds - at first, these will largely be index funds but I shall also look into mutual funds to aim for a little more aggressive growth. Following the saying “don’t lay all your eggs in one basket” I will try to diversify the portfolio not only by taking into account the funds’ objectives but also their location - starting off in the UK, I plan to diverge into European, American and international funds, maybe even test out emerging markets.
• Gain experience with individual shares and other alternative investment possibilities - here I will start off with growth shares, on which I have just recently read a fantastic book called “The Zulu Principle” by Jim Slater. Even though it is more than 10 years old by now, I found it very enlightening and helpful - how helpful it will prove in practice shall be seen.

These goals are loosely ordered by both importance and amount of money involved. I will not jeopardise any money on the stock market until I have put enough aside to deal with potential losses. Once I start actively pursuing these goals I plan to put up a graph to track my progress - just like the guys at We’re in Debt did. I hope this will help remind me that I don’t really need that extra pair of shoes until I’ve secured all free money from the government…

And now I really need to go and do some more revision…

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