Investing money can be daunting for beginners. This article explores how to invest your money, from basic concepts to professional, expert tips on investing.
Who should read this article?
This article will be useful if you are interested in investing money, but do not know where to start. We focus on the most important principles you should follow when you invest your money, starting from the basics through to the professional approaches we take as investment advisers. Please bear in mind that this content is designed for information only, as investing can be more complex in practice. If you need further guidance, we recommend that you seek professional assistance. You may have read similar warnings in the past, but investments can fall in value as well as rise, so approach this topic with sensible caution!
Key topics covered in this article
A beginner’s guide to investing money
Start here if you are new to investing money. We explain some of the key concepts around investing money, and what you need to know when thinking about how to invest.
What are investments?
Investments are any assets you buy where you attempt to get a profit in return for your money. The general idea of investments is for your initial capital to grow over time. Many investments also generate an income, which you can receive or use to enhance your capital. Most investments are long-term in nature.
Types of investments
Investing money can take many forms, but here are the main types of investments you might come across:
- Shares (equities)
Shares entitle you to a share of a company, usually accessed via a recognised stock market (such as the London stock exchange in the UK). The shares will grow in value over time if the company performs well. You will also receive a share of the company’s profits via dividends. The value of shares fluctuates daily, so this can be a volatile investment type;
Cash investments are typically bank savings accounts, which do not grow the original capital, but pay a low level of income as interest. Cash investments are not volatile, but tend to grow very slowly, and usually behind inflation;
Property investments usually involve buying a physical residential or commercial building, land, or other agricultural assets. You can also buy shares of property investments via collective investments. You might expect a property to grow the capital value over time, and also to pay you an income as rent;
- Fixed interest (bonds, or gilts)
You can lend money to a company or government, which pays the initial capital back after a fixed period. The bond issuer will pay you a fixed income while you hold the investment;
- Foreign currency
You can buy foreign currency with the hope of generating a capital growth if the value of that currency rises compared to your own. This tends to be a volatile investment as values change by the minute;
- Art, antiques and other collectables
Investors buy assets like art, antiques, or any other collectable items (cars, wine etc.), with the hope that these assets will increase their capital value;
You can buy traded commodities that are required for industry to function. Commodities include: precious metals, raw materials, and agricultural produce. Investors hope that the capital value of these assets rise when demand outstrips supply;
You can lend money to individuals or companies directly, generating a profit on the interest rate charged to the borrower.
You can invest in particular specialist areas, which often come with significant risks ad the aims of large returns. This might include investing in start-up companies.
Investment returns tend to come from a variety of sources.
- Capital growth
Capital growth comes when the sale price of your asset is greater than the purchase price. This can be delivered by demand for the asset, depending on a variety of factors. Effectively, if someone is willing to pay a greater price for your investment, then it will generate capital growth. Of course, capital values can fall as well as rise;
Shares pay a dividend, which is a share of the profits of the company after tax. Dividends may rise or fall depending on the success of the company, and the plans for the expansion of the company. Dividends are never guaranteed when investing money, so you cannot always rely on them;
If you have savings in a bank, or fixed interest assets, these pay an income as interest. The interest may be variable, fixed for a period, or for the lifetime of the asset;
Property pays an income in the form of rent for the use of that property. Rental income will change according to demand for that property. Of course, not every tenant will pay their rent on time!
Inevitably, there are costs associated with investing money. We consider investment costs in greater detail below. Investment costs are incurred for a variety of reasons, such as:
All investments carry some level of risk. There is no such thing as a risk-free investment, so you are gambling your capital to some degree. Much of this guide is aimed at managing investment risk, and we consider this area in more detail below. The risk you take when investing money varies from very low through to very high, depending on the assets you buy, and the way you hold your investments. Key investment risks include:
- Capital risk – you might get back less than you put in;
- Inflation risk – the cost of living might grow faster than your investment returns.
- Low risk investments tend to make small gains, but have little prospect of a capital loss. Your main risk is long-term inflation.
- High risk investments tend to be provide more volatile returns, but expect to return a higher level of capital growth over time to compensate for this extra risk. Your main risk is short-term volatility.
Your investment term will affect how to invest your money. Some investments are intended to be short-term, while other investments can be long-term in nature. These will have very different characteristics, and expectations. In general:
- Short-term investments are simpler in nature, have easier access, and lower growth prospects
- Long-term investments might be more complex in nature, could have less flexibility, but higher growth prospects
For most people investing money is not the same as portrayed in the media. Most investors do not sit by banks of data screens shouting ‘buy’ and ‘sell’ orders down the line. Most investments are bought and held for a long period, aiming to generate a return over that time. Time in the markets is an important concept when investing money.
How to buy investments
The most common investments held tend to be:
We all hold at least one bank account, which allows us to receive income and pay our bills. You can extend this to holding savings accounts, which might pay a higher interest return, possibly with lower access to your cash;
Many people take their first long-term investment by a property, often to live in. This can be developed buy buying residential or commercial property to rent (buy-to-let);
Most people invest money in the stock market to buy shares. this might be directly held, or via some sort of investment product such as a pension plan or shares ISA. A stock market is simply a way for you to buy commonly-held, larger companies. The stock markets exist to bring together buyers and sellers. Essentially, a company share will rise in value due to a variety of factors such as the financial performance of the company, the health of the overall economy, and simple demand for that investment.
Usually, the cheapest way to invest money is to buy directly from a recognised exchange, or on the open market. However, you need to be a bit more experienced and knowledgeable to buy directly, as this can be complex.
In the UK, the London stock exchange offers direct purchase of shares in over 3,000 publicly traded companies. You can also invest in less-established companies via the Alternative Investment Market (AIM). You can purchase shares in privately-held companies directly with the owners, but these shares are less accessible given that they do not operate on a recognised exchange.
You can buy cash investment directly from a bank.
You can buy property using an estate agent.
You can also buy collective investments, which pool your money with other investors, typically in similar assets (shares, bonds, cash, or property).
This has the advantage that an expert might make investment decisions on your behalf. Pooled investments tend to be more expensive than directly-held investments, but offer diversifying benefits as you can spread your money around a variety of assets within the fund.
There are a wide variety of different collective investment types, and each can be held within different investment tax wrappers.
You can use pooled investments to buy pretty-much any type of investment imaginable: shares, cash, property, fixed interest, and even more specialist investments.
Types of collective investments
There are many types of pooled investments. These can be active or passive in style.
- Open-ended funds
Examples of open-ended funds are unit trusts or OEICs. Your fund manager will take in money from investors and use this to buy assets in the fund. The investment is open-ended as the fund manager can issue more units if the fund has more investors.You buy a share in this collective investment in the form of units in the fund. If those units perform well, the unit price will increase and your asset value will grow. Open-ended funds allow you to access your money at any stage, based on the underlying asset values of the fund.
- Closed-ended funds
Examples of closed-ended funds are investment trusts. An investment trust is a type of company that raises money in tranches from investors that are used to buy assets in the fund. This means that the investment is closed-ended as the number of shares is limited. You buy a share in the collective investment in the form of a share in the fund. If the share’s assets perform well, your assets will grow in value. Closed-ended funds are different to open-ended funds as they allow the investment manager to borrow against the assets in the fund. This increases the risks of the investment, as it can boost returns in rising markets, and also worsen losses in a falling market (known as gearing). With investment trusts you can only sell your investment if you can find a buyer for the shares.
- Index funds
Some collective investments are specifically designed to track an index, for low-cost investing. Examples include Exchange Traded funds (ETFs). ETFs are traded on stock exchanges like shares. They have become a very popular way of low-cost investing. When you invest into an ETF the fund manager will simply buy more of the same index that is tracked by the fund, keeping costs relatively low.
- With-profits funds
With-profits funds allow you to pay into an investment with other people. The funds add bonuses each year according to the performance of the underlying investments. With-profits funds allow you to smooth the returns of your investments, so that growth is more stable and less volatile than in other investments. The general principle is that these bonuses cannot be taken away once added, so you should only ever see your investment value rising. You can also get a final bonus when you sell out of the fund, provided investments have performed well. However, with-profits funds can also levy a ‘market value reduction’ if you sell from the fund at a time when holdings have fallen in value. This means that in practice investments can fall in value, and it can be difficult to see the underlying value of your holdings.
Investment tax wrappers
You usually buy your investments within a regulated tax wrapper. Here are some of the main investment tax wrappers, although we consider this area in more depth below.
This might be a simple account like a bank account, or direct holdings such as shares;
- General investment account
This is a taxable investment account that allows you to hold a variety of directly held investments such as shares, or pooled investments like funds.
- Individual Savings Account (ISA)
An ISA is a tax-free tax wrapper around another account. The most common ISAs are cash ISAs, which make a bank account tax-free; the alternative is an investment ISA, which makes a general investment account tax-free. Growth, income, and withdrawals from ISAs are tax-free.
- Pension plan
A pension plan is a long-term retirement savings plan, that gives you initial tax relief on your savings. Growth in pension plans is tax-free. You can take out 25% of your fund within limits once you reach age 55, and other withdrawals are subject to income tax.
Who offers investment advice?
You can get investment advice from a variety of sources. Just be careful to understand what advice you are getting, and where this advice applies (or stops).
- Personal contacts
You may get investment advice from a trusted friend or family member. Just remember that this advice does not come with any guarantees or regulation to back it up. You are on your own if something goes wrong.
- Financial institutions
Many banks and financial institutions offer investment advice. Most only offer advice on the company’s own products, or sometimes a limited panel of providers. This advice may be appropriate, but it can mean that the advice given might not be as appropriate than if the adviser had considered other alternatives.
- Stock broker
Stock brokers are investment professionals who exist to execute trades on behalf of clients. You might use a stock broker for expertise and convenience. However, a stock broker will not make specific personal recommendations based on your personal circumstances or tax position.
- Financial adviser
A financial adviser who specialises in investments is likely to make a specific, personal recommendation based on your individual needs, and wide circumstances such as tax. Most financial advisers are independent of product providers, and so can advise on the whole investment market. Some financial advisers are restricted to a small panel of products or investments. This can mean their advice is limited to these investments, which could mean that their recommendations are not as wide as independent advisers. If you choose this option, your investment adviser will make a recommendation based on your personal circumstances, but they will not execute this recommendation without your permission. This gives you more control over investment decisions.
- Discretionary management
If you choose this option you outsource all investment decisions to a professional adviser, who will manage the running of your investments without asking your permission once you have agreed the outline parameters. Discretionary management is convenient, but offers you less control over decisions, and you can get unexpected tax consequences as your investment manager will not consider your individual tax circumstances. Discretionary investment management is usually the most expensive investment option.
All investment professional advisers are authorised and regulated by the Financial Conduct Authority in the UK. This means that they should appear on the Financial Services Register, which lists their permissions to give advice, as well as their status as an adviser. Financial regulation is extensive in the UK, so all investment professionals who offer advice should come with a variety of additional safeguards:
- Professional qualifications
- Ongoing professional development
- Oversight from a regulator
- Membership of a professional body, such as the CISI (our professional body)
- Appropriate ethics
- Investment research tools
- Insurance and capital
- Access to the Financial Services Compensation Scheme
- Access to the Financial Ombudsman Service
Of course, if you take investment advice from a regulated professional adviser you will have to pay initial and ongoing fees for advice and service.
General principles for investing money
There are a number of general principles to follow when investing money. This section explores some of the fundamental principles of how to invest.
Plan before you invest
Of course, it makes sense to have a plan when investing money. Really, you should start with the end in mind. Consider what are your investment goals, such as:
- What is the purpose of the investments?
- What is your investment term – how long are you investing for?
- Will you need access to the money?
- Are you investing for growth or income (or both)?
Ultimately, you should aim to adapt your investments to your practical needs, rather than just the need to grow your assets. Once you know the goals of your investments, you can start to plan how to invest.
Discipline with investments
Sticking to your investment plan
Once you have invested your money, it is important to stick to the investment plan. You should set the investment direction, and only correct your course when something needs your attention. Too much tinkering can lead to under-performance for a variety of reasons.
We only use tried-and-tested, evidence-based investment ideas, and learn from the mistakes of others. We are not interested in the latest investment trends. Most investment success comes from temperament rather than insider knowledge
You should regularly monitor your investments, but not too often! Try to avoid the stress of daily updates on the performance of your investment holdings. Too much investment monitoring can lead to stress when you see the investments rise and fall. The general trend should be upwards over time, and the investment volatility seems less when you examine your investments over a longer period. Of course, you should monitor your investments, so you cannot just set up your plans and then hope for the best. We tend to schedule an annual review of the investments, but monitor progress every 3 months. Of course, if something important changes in your portfolio you may need to monitor the position at other periods. See below for more about investment research.
Understanding your investments
Regular investment reviews
Most amateur investors do not review their investments. We recommend that you schedule regular valuation updates, and annual reviews to ensure that gradual adjustments are made to keep you on track.
Your investment term is the length of time over which you plan to invest.
When investing money, this is generally a period greater than 5 years, simply because this is a reasonable period for you to generally expect to overcome investment charges. A 5-year investment term will reduce the chance that your investments lose value, although of course this cannot be guaranteed.
Investment term and risk
Switching from growth to income
It may be a mistake to reduce the level of risk as you get closer to the date you plan to access your investments, unless you plan to liquidate the holding entirely to spend all the capital at that date.
If you plan to take a gradual income, this will inevitably extend the term of your investments. Imagine accessing your retirement funds at age 60, but living for another 25 years. In this situation, continuing to take investment risks should help your investments to grow more over time, extending the income potential of your holdings for a longer period.
Life expectancy or longevity
You may live a lot longer than you imagine. Take a look at this life expectancy data from the Office for National Statistics in 2019. This should affect your thinking on how to invest for 3 reasons:
Longer life expectancy means that you can afford to take greater risks, since you have more time to make up temporary downturns.
For example, if you are investing money for the rest of your life, your investment term is likely to be to the date you die. This is probably a very long period. Say you are aged 60 now, and the average life expectancy is to age 85. That makes your investment term 25 years, and possibly longer.
Income for longer
If you are likely to live longer, you will need to extend your income for a greater period.
This makes it important to set up the risks you take with your investments correctly.
The longer you live, the greater the impact of inflation on your investments and income. Generally, we want an increasing income from our investments, so you also need the underlying capital to grow too.
Investing money is all about managing risk.
All investments involve some sort of risk, from almost no risk, to a high level of risk. To learn how to invest money, you need to understand the fundamental principle that the greater the risk you take the greater returns you should generate, on average over time; the reverse is also true.
Therefore, over time, you should expect low risk and low returns on assets such as cash or bank accounts (perhaps below inflation), with greater risk and greater returns on riskier assets such as shares.
Different assets are exposed to alternative forms of risk (such as volatility in shares, or inflation in bank accounts). Do not be lured into believing that you can take risk off the table by being cautious. As the section below on cash and inflation shows, all you would do is to swap volatility risk for inflation risk. If you are too cautious for your goals then you risk running out of money, or poverty.
Risk vs reward when investing money
This chart shows the relationship between risks and returns.
The curved line represents the theoretical ideal trade-off between risk taken, and the returns on your money. Typically, over time, if you take greater risks with your capital, you should expect additional returns, although your investments may fluctuate more.
Based on past returns, you can estimate the possible growth and income. Of course, none of this can be guaranteed. If you take lower risks with your capital, you should expect lower returns over time, and you risk inflation eating into your returns.
When investing money you should aim to match the investments to your chosen risk style. Your goal will then to stay within your chosen risk band, as shown in the chart, and as close as possible to the ideal balance between risk and return.
You can amend this as your goals or circumstances change over time. A professional investment management service like we offer aims to oversee your investments and make small changes to keep you on track within the risk parameters you set. When investing money in this way, you can also use past returns to guide your assumptions (with careful consideration) to estimate how your decisions now might impact on your future goals.
How much risk are you prepared to take?
- Your investment experience and expertise
- Your investment goals and term
- What would happen to your lifestyle of something goes wrong
Once you know your risk profile, you are in a better position to choose investments which balance the risks you are prepared to take. In general, you should consider building your investment portfolio to match this risk profile, provided the expected results match your goals.
Would (temporary) falls in value affect your lifestyle?
Investments are volatile – almost all go up and down in value. In general, when assets have fallen in value in the past, this has tended to have been a temporary drop as part of a larger general rise in value.
It is important to consider whether you can ride out these short-term fluctuations. If any drop in value to your investments would have an impact on your standard of living, you should consider taking action to minimise this effect. If not, you can afford to take greater risks. Do not underestimate this issue.
Think about your own situation, and how your lifestyle would change if your investments were to (temporarily) drop by a large amount, say 40%.
Your answers to this question will guide your decisions on how to invest your money. If you need access to this money sooner rather than later, you may need to change something when investing money.
This issue goes back to the other general points already made:
- How do you fund your current lifestyle?
If you use your investments to fund your lifestyle then a fall in value could affect your income as well. What would need to change to resolve this issue? If you use other sources of income to pay for your lifestyle costs then a temporary fall in value might not be a major issue for you.
- When will you need access to the invested money?
If you are investing money for the long term, then it is likely that you do not need access for many years. In this case, you can probably wait out any short-term fall in value to your invested money. If you are working towards a goal that is quite soon (fewer than 5 years), then you should consider whether that goal might be affected if the invested money was to fall in value. For example, if your investments are intended to repay your mortgage in 3 years, then a temporary fall in value could have serious consequences. This might mean you are less able to bear losses than someone who is saving for retirement in 20 years.
How much investment risk do you need to take?
Notice that we asked how much investment risk you need to take, rather than how much investment risk you are prepared to take. This is an important distinction:
- How much investment risk you are prepared to take highlights the ideal maximum risk when investing money
- How much investment risk you need to take assesses the impact of the potential returns on your overall investment goals when investing money
When investing money this can affect your investment approach in 2 ways
Risk tolerance greater than your goals
You may be prepared to take greater investment risks than your lifestyle requirements when investing money. In this case, you might want to spend more money, or take less investment risk. For example, if you describe your risk profile as moderate, but an analysis of past investment returns shows that you only need to take cautious risks to achieve your goals, then why take the extra risk? If you do not need to take risk, then why do it? You may be prepared to continue to take greater investment risks than strictly necessary when investing money. This could be because you hope to achieve your goals sooner than planned, or because you will use the potentially greater returns towards loftier ambitions with your lifestyle.
Your goals are greater than your risk tolerance
You may have more ambition for your lifestyle than your investment risks will allow. In this case, you might want to readdress your expectations, or take more investment risk. If you do not do so, you are likely to underachieve when investing money, and might not get to your overly-ambitious goals. You might have to spend less later on, or put back your goal dates. Some cautious investors should consider taking extra risks to achieve their goals.
Investments and inflation
Inflation is the rising cost of living that typically takes place.
When you consider how to invest your money you must take inflation into account, because the value of money now will feel like less in the future. The longer the period, then the greater the effect of inflation on your investments.
Inflation has generally been lower in the last few years than it has been in the past. But this does not mean that the effects will not be strong when investing money.
How does inflation affect the value of money?
The Bank of England has a helpful inflation calculator, which allows you to work out how past inflation rates have affected prices for goods, on average. This uses the Consumer Prices Index (CPI), which is the UK Government’s preferred measure of inflation.
The table shows how much money £100 in the year shown would cost today.
|Year||£100 then costs what in 2019?||Average inflation rate|
Using this data gives us a way to estimate the expected inflation rate in the future, but of course we need to keep this under review. We tend to use an expectation of inflation at 3% when preparing our financial plans as this is the average rate of inflation over the past 20 years.
When investing money for our clients, we use inflation as an effective cost on the returns of your investments. This effectively means that when you consider how to invest, you have to save more money to reach your goals, as those investment goals are likely to cost more money in the future due to the effect of inflation.
Your own inflation rate might not be the average inflation rate
The Government uses the Consumer Prices Index (CPI) for most of its measurement of inflation, but not for all areas. This uses a ‘basket of goods’, which is deemed to represent general spending in the economy. However, this measure does not include lending costs or Council Tax. It does include some curious items, which you may consider that you might not choose to buy, and these are weighted to attempt to balance their effects. As a result, CPI is useful to measure the whole economy, but might be less so for you personally. There is some evidence that lower-paid, or more elderly people pay a higher portion of their income for some services (such as heating, or food). When these costs are rising, their inflation rate could be much higher.
Your investment schemes may use alternative inflation rates
Another issue to consider is that your future income might use different inflation rates to your overall assumptions.
You might take 3% as a general assumption for the inflationary impact on your investments. However:
- The State pension uses the ‘triple lock’ – it rises by the greater of CPI, average earnings, or 2.5%
- Final salary pension schemes use different rates to revalue future pensions, depending on the period when the income rights were accumulated
Too much cash - inflation eats investment growth
- The blue line shows the actual growth of the sample bank account – you would have made a measly £906 after 10 years
- The red line shows what that account would have felt like after 10 years – your bank account would feel like it lost you £1,830
While inflation is currently lower than historical averages, cash savings are currently losing money in real terms. If you hold too much cash you are simply exchanging volatility risk for inflation risk. The longer you put off taking risk with your investments, the greater the risk that inflation will eat into your savings.
Shares preserve purchasing power
Shares have a greater chance of beating the risk of inflation over time, but come with increased volatility as part of their nature.
As a result, if we manage your investments, we will give your investment portfolios as much shares as we think is suitable to achieve your financial planning goals, within the limits of risk that you are prepared to take.
Generally, the more shares you hold, the better your chance of long-term growth. When investing money in shares you have to factor in an expectation of occasional sharp, but temporary falls in value.
The above chart shows how an investment of £10,000 made in 2010 into UK shares has outperformed inflation. It shows the return of the UK stock market, after allowing for the cost of living (in 2010 prices). After adjusting for the cost of living, shares have tended to grow in real terms.
- The blue line shows the actual return over 10 years – £11,828
- The red line shows how this growth would have felt after the effects of inflation. It would still have been impressive at £6,352, and certainly better than a bank account.
The price of this growth is short-term (temporary) fluctuations in the value of your holdings
Compound interest is the effect of producing interest on already accumulated returns, not just the original investment (in effect, interest on accumulated interest).
This effect is important when considering how to invest. Compound interest will help you to grow your assets faster, the longer they grow. With compound interest, generally the largest growth will come in the final years of your investments.
The data below compares simple interest to compound interest, assuming £10,000 is invested each year, with a growth rate of 10% per year. Bear in mind that these growth rates are just used to illustrate the effect of compound interest when investing money, and may not be actually achievable over 20 years!
You can see from this table that after 20 years, using simple interest you would gain £20,000. Using compound interest the total interest would be £430,025.
Here is the same data in a chart:
You can clearly see that the compound interest produces the most gains the longer you invest your money. When considering how to invest, this concept of time becomes very important.
Reinvesting income boosts returns when investing money
Most invested assets generate some income (such as dividends or interest).
If you do not tell them otherwise, your investment provider will pay the income on a regular basis into your bank account. If you spend this income you are not using compound interest to the fullest. If you instead reinvest this income, to buy more of the same asset, your returns can be boosted dramatically.
This applies to investment portfolios built for capital growth; income portfolios should therefore expect lower capital growth over time as the income is spent and the money cannot be used to boost the overall capital growth of your investments.
How reinvesting income can boost your investments
This table shows the average returns for our moderate income model portfolio for the 5 years to the end of 2019. With income reinvested, the returns were boosted by 2.41% per year over 5 years.
This table shows the additional growth produced by the same portfolio, assuming an investment of £100,000. After 5 years, the reinvestment of income produced £17,056 in additional growth.
Time in the markets reduces the chance of capital losses
The length of time invested is an important factor in your portfolio.
Essentially, the longer the investments are held, the more likely you are to grow your money. There are natural cycles of investment growth when investing money, although it is almost impossible to predict these in advance. Therefore, the general principle should be that you should not invest money unless you are prepared to commit your funds for a considerable period (say 5 years).
Time in the market - UK stock market data
Take a look at this data on the UK stock market over 20+ years. The data on the UK stock market over 20+ years shows that the longer you are prepared to invest, the less likely you are to experience loss of your original capital, although there of course have been periods when this happened.
UK stock market – 1 year returns for 2000 to 1999
Measuring individual years, between 2000 and 2019 the UK stock market rose 70% of those years, and fell 30% of those years. This is why the general trend tends to be upward over time for the UK stock market. If the stock market rises 7 years out of 10, and falls 3 years out of 10, then the overall trend should be towards growth.
UK stock market – 5 year rolling periods ending 2000 to 2019
The same data as above has now been expanded to show 5 years of investment into the UK stock market, finishing at the end of the years shown on the chart. This shows that over this period, investing for 5 years would have generated a positive return in 85% of the periods, and a loss in 15% of the periods. The general message is that a 5-year investment period has proved to reduce the chance of loss to capital when investing money – for investments into the UK stock market only.
UK stock market – 10 year rolling periods ending 2000 to 2019
The same data has now been expanded to show 10 years of investment into the UK stock market, finishing at the end of the years shown on the chart. This shows that over this period, investing for 10 years would have generated a positive return in 100% of the periods, and a loss in 0% of the periods. This appears to show that a longer investment period reduces the chance of losses to capital for investments in the UK stock market. Of course, none of this is guaranteed to be repeated when investing money.
Time in the market - different risk-rated investment portfolios
The same general conclusions can be expanded to other investment strategies when investing money.
After all, few people would consider investing money wholly in the stock market alone. The data below examines how managing risk with our investment portfolios changes the data on gains versus losses over time. This data shows the annual rolling periods over the last 20 periods to the end of 2019, using the average returns for the investment sectors we recommend, and adjusted for the percentage mix of the investment sectors used in our Model investment portfolios. If you click on the link, you can see the latest published returns on these investment portfolios. Bear in mind that this is not guaranteed to be repeated, but this data bears out the general point that the longer you are able to invest, the less likely you are to lose some of your original capital
Our model portfolios – 1 year returns for 2000 to 2019
This data shows that by taking a risk-rated approach to our professionally-managed portfolios, our asset allocation seems to reduce the periods of loss and increased the periods of growth when compared to the UK stock market. This demonstrates that proper asset allocation, and diversification in your investments is important to manage the risks of loss.
Our model portfolios – 5 year rolling returns for periods ending 2000 to 2019
This data shows that our asset allocation further reduces the risk of loss (based on past data), for lower risk investments when compares to the UK stock market.
Our model portfolios – 10 year rolling returns for periods ending 2000 to 2019
This data again backs up that the risk of loss has tended to be minimised the longer the investment period.
One of the best ways to manage risks is to diversify your portfolio.
Investment diversification is important because before you buy an investment you cannot be sure how each asset will perform. The aim of investment diversification is to limit the downside for cautious investors, while accepting that the upside will not be as great.
More adventurous investors will be prepared to accept greater short-term losses in their investments, in the expectation that greater returns can be achieved over time. In our experience lack of investment diversification is one of the most common mistakes that amateur investors make.
Advantages of investment diversification
- Limit downsides
The main benefit of investment diversification is that you hope that your assets will react differently to various events – by spreading your investments around different asset types you hope to limit the downside in negative periods. Research has shown that investment diversification limits the downside of your portfolio without too much impact on the upside.
- Reduced volatility
Most diversification tries to limit volatility in the portfolio by controlling how much assets rise and fall. Diversification is unlikely to mean that you can avoid falls in the value of your investments. However, the aim is to slow falls when markets shift dramatically.
- Longer-term results
Some studies indicate that a properly diversified investment portfolio can add to longer-term results.
Disadvantages of investment diversification
- Short-term gains can be limited
Investment diversification can mean that you lose out on short-term gains of more volatile investments.
- Time and administration
Investment diversification adds to the complexity of a portfolio, meaning greater administration, and time spent managing the strategy. This is one reason why many amateur investors do not diversify their investments; it takes time and effort.
- Higher costs
Inevitably, if you diversify investments you are more likely to hold a wider range of assets. This can mean greater costs as some assets are just more expensive. Wider trading can also increase transaction costs.
Why diversify? Predicting investment winners
Take a look at the data below. This shows the returns of the various investment sectors that we use in our model portfolios. This has been presented to show the percentage return before charges from top to the bottom for the last 10 years. It is very difficult to predict a winner from this data, which is why instead we spread your money between these assets.
This data shows exactly why investment diversification is so important when investing money. It is almost impossible to predict how assets will perform ahead of time, so we do not try to do this. Predictions are nearly always wrong. If you look at the data presented, you will see in white the results of our model moderate risk investment portfolio over those years. Clearly, this investment portfolio was never the top performer, but you can see the effect of diversification in action. The moderate risk portfolio was generally in the mid-range of returns, with much of the upside, but less of the worst-case scenarios.
Types of investment diversification
Types of investment diversification
This section explains more about the complex arrangements to allow you to invest money in a properly diversified portfolio.
Type of investment
There are a wide variety of ways to hold a diversified investment, even within a tax wrapper like an ISA.
- Holding direct investments
You can buy your investments directly, which is typically how a stock broker would arrange investments for you. They might diversify when investing money by buying a portfolio of individual shares. You could hold dozens of companies, and that would spread your risk (see Number of Holdings, below).
- Collective investments
We recommend collective investment funds, also known as pooled investments when investing money on behalf of clients. These come in a variety of forms, such as unit trusts, OEICs, ETFs, or investment trusts. Taking aside the technical differences, the main feature that unites these investments is that they pool your money with other investors, and effectively hold a basket of direct investments according to the goals of the fund. For example, if you buy a large UK companies investment fund, this will hold a wide variety of UK large company shares in various proportions according to the judgement of the fund manager. This means that you can outsource the direct investment decisions to experts in that investment area. We might further diversify when investing money to hold a variety of collective investments.
Number of holdings
You can diversify your investment and spread your risk by increasing the number of holdings.
For example, if you hold a single company’s shares there is no diversification of your investments. If this company stops trading, then you lose your entire investment. If instead you hold 100 companies equally, and a single company fails, you only lose 1% of your overall investment. A professionally managed investment portfolio is likely to use collective investments, which hold a variety of underlying investments. You might buy a single fund that could hold 50-200 actual investments.
Types of asset
You can increase investment diversification by using a variety of types of asset.
Our model portfolios use the asset types in different proportions according to the risk profile, and the outlook of the investment approach:
- Cash or Money Market
This might be actual cash held within your investment portfolio; alternatively you could use investments that work like cash, such as Money Market funds, which use a combination of cash, and other complex instruments. Cash does not return a capital growth, but does pay interest, typically at a relatively low rate of return. This asset tends to be the lowest volatility of the investment types we use, but also has the lowest returns. We use these investments to dampen down volatility when investing money.
- Fixed interest
Fixed interest means corporate debt or Government debt, either in the UK (known as gilts) or overseas. These investments can fluctuate according to demand, and pay a fixed interest for the length of the investment, which is often determined at outset. Fixed interest tends to be lower volatility than other investment types (not always). We use fixed interest broadly to provide lower volatility to a portfolio, but also to hedge against inflation over time. What tends to happen is that much of your fixed interest investments return capital growth equivalent to the cost of living over a longer period. Of course, this is not always true, and there can be periods of higher volatility even with typically “safer” investments. Fixed interest can be sub-divided into further categories. For our model portfolios we use UK gilts, and index-linked gilts, plus corporate bonds (split into investment grade, high yield, and overseas corporate bonds).
Most investment funds buy into commercial property rather than residential property. These investments tend to provide capital growth over time, but also pay an income from rent. You can buy funds that own property directly (i.e. they own the actual buildings and then lease them to a company). Many household names you might know do not own the company premises, or retail units. Instead, they lease these buildings from a property investment fund. These property funds benefit from a stable income source, and capital growth over time. However, at times of economic stress the funds may not be as liquid to sell as investments that trade on a recognised exchange. These investments can temporarily close to new investors, or halt sales, while the fund is allowed to sell property to generate the cash demanded by investors. The alternative is to buy property investments that trade in shares of companies that hold property. These tend to be more volatile, but can be traded at any time. Of course, there are many other ways to hold property in an investment, including direct purchase of a property.
- Shares or Equities
Shares are where you are investing money directly into a company. Effectively, you own a proportion of the company according to the number of shares held, out of the total issued shares. Shares tend to provide long-term capital growth (provided the company performs well). The equities also provide an income as a dividend. Shares are the highest volatility investment that we recommend, but tend to provide the greatest growth over time. We include shares when investing money to give you growth or income above inflation over time. You can sub-divide shares into a wide range of asset types, including within the UK, larger or smaller companies, as well as other locations worldwide.
If you use different types of asset you can spread your investment risk because they each perform well at different part of the economic cycle. Ideally, your investments should have an element of negative correlation as this means that when one asset type does poorly, another might be doing well. This can be difficult to achieve as many asset types have inter-linked fortunes when markets fall. For example, if the economy performs poorly you might expect shares to fall in value; if this happens, property prices might also be affected – there might be a correlation between these types of assets. In general, we use the same types of asset in all of our model portfolios, but we use greater proportions of more volatile assets (like shares) in the more adventurous portfolios, and less of these asset types in more cautious investments. The reverse also applies: we use greater amounts of less volatile investments (like fixed interest or cash) in cautious portfolios, and lower amounts in adventurous investments. Our typical investment portfolio holds 15 investment funds, each in a different sector. Each fund has between 50-200 holdings. This means your investment might average 1,875 individual holdings.
You can improve investment diversification by holding assets in multiple jurisdictions.
Many investment portfolios naturally focus on the home country, but you can spread risk by investing money outside of your own country. We tend to use a variety of methods to diversify your portfolio into overseas assets. We buy shares in North America, Europe, Asia, Japan, and other Emerging Markets. We also spread your fixed interest investments into UK fixed interest, and global fixed interest.
If you diversify investments you are likely to spread your holdings into a variety of geographical regions.
This can increase the risk of currency fluctuations. Spreading your investments across different currencies can have a diversifying effect, but it can also amplify the risks when your home currency changes dramatically. As an example, imagine that you live in the UK, but hold an investment held in US Dollars. If the US investment rises, you will see the benefits in the return; if UK Sterling also falls a the same time then your US holdings will rise at a faster rate. This effect can work in reverse as well: if your US holdings fall in value while UK Sterling rises, then your losses will be greater.
One way to manage this can be to hedge your investments against currency fluctuations, and some investments offer this as an option (probably for additional cost). The investments use complex financial instruments to attempt to head off wide fluctuations in currencies.
One problem with investment diversification is that we live in a connected world. It can be difficult to find asset types that always perform in opposite ways. In an ideal world your diversified portfolio would have some investments that increase, while others decrease. Unfortunately, many typical investments show positive correlation – they tend to rise or fall in value at similar times. Different investment types can temper this, but you may benefit from holding assets that perform quite differently. Our model investment portfolio typically holds commodities for this purpose. Commodities is a wide term that tends to include items such as precious metals or agricultural products. These investments often have a different investment cycle to shares or fixed interest. However, commodities tend to be highly volatile.
Diversification of non-invested assets
When investing money do not forget that other assets should be taken into account for your diversification. For example, your main home is property and your bank savings is cash. Having too much of one asset type can skew your investment diversification; you may need to reduce your invested holdings in these areas to compensate.
Simple diversification options
Some investments are designed to make the process of investment diversification easier for you. For example, you can buy widely diversified investment funds such as a managed fund, which aim to provide a broad range of asset types within one investment. This can be a good approach for a limited goal, but many not be appropriate for longer-term specific goals where tailoring and timing are important.
Rebalancing your investment portfolio
Naturally, each of the assets in your portfolio will perform in a different manner at various stages of the economic cycle.
Typically, over time, riskier assets will tend to grow faster to form a larger proportion of your portfolio. This in turn alters the risk of your portfolio. If you leave your assets with the original investments and make no changes, in general you will gradually see the riskier assets out-performing the safer assets. If you make no changes, your investment portfolio is likely to take more risk after longer periods.
To minimise the risks of this happening, when investing money we will recommend that you switch holdings back towards the ideal asset allocation. We would typically arrange this annually, but some advisers rebalance portfolios more often. The downside of rebalancing investments is that this generates additional costs and complexity. The positive side keeps your investments on track in terms of risk.
How does investment rebalancing work?
Imagine that you are investing money with a portfolio split half with cash, and half with shares (the “Ideal” stage). This is not an optimised diversification strategy, but is useful for our example!
If that was you ideal asset split for your chosen risk level, then you should aim to retain this balance of assets over time. Imagine that some time has passed and you move to the “Future” stage. In our example, the shares have grown in value (the reverse could be true), and the cash has also grown, but by a lesser amount. In this example, the shares are now worth 60% of the total, and the cash 40% of the total. In this case, the faster growth of the shares means that the future investment portfolio takes greater risks than the ideal portfolio. The solution is to move to the “Rebalanced” stage. You should sell some of the higher growth items and but some of the lower growth items. This will reset your investment risks.
Academic research has estimated that rebalancing investments can add up to 0.5% to annual returns over the longer term.
How do we rebalance investment portfolios?
Of course, our professionally managed model investment portfolios use more than 2 asset types, so the rebalancing we perform is more complex than shown in this example.
However, the principle is the same – to bring your investments back in to line with the ideal risks you are prepared to take, and need to take. If you use an adviser like us, then portfolio rebalancing should be part of the service.
When considering how to invest bear in mind that all investments rise and fall in value.
This is true of property and shares in particular. It could be said that investment volatility is the price that investors pay for above-inflation investment growth over time. In turbulent stock market periods it can be tempting to reduce the risk of your portfolio by biasing the portfolio more towards safer assets.
If you are investing money try to avoid the news – it only focusses on short-term negativity, rather than longer-term positive trends. The truth is that investment markets are not always rational, and there are always apparent risks on the horizon. Part of our role is to help you to stay invested when markets change. Selling holdings when markets change can hamper future performance in the longer term, or even to lock in losses.
It is best to trust in the process of the portfolio and markets, so that you can benefit from any recovery in the market. A big stock market fall in one period is often followed by a big gain swiftly afterwards. These periods of turbulence become less important over time.
It can be tempting to try and make short term gains on portfolios by moving in and out of the different markets. This is how many amateur investors see how to invest.
This behaviour almost always leads to losses, or at least lower returns over time. Even with very strong market and economic data, this approach is almost impossible to get right every time. For this reason, when investing money portfolios should be put together to deliver longer-term performance rather than taking active short term bets. We try not to guess the market because we know we will never get the timing right. Instead, we focus on delivering stable returns over the medium to long-term. In general, this means buying investments, and holding them for the long term, even when markets rise and fall. The aim is to get rich slowly, over time.
An impossible view of market timing
Many amateur investors think investing money is about buying when the market is low, and selling when the market is high (demonstrated by the example chart above). Of course, if you do get this right you will make spectacular gains (if only it were this easy!). The reality is that it is usually impossible to know where you are in the cycle, so you may delay decisions until the market has peaked, or possibly when it has started to rise. Changes tend to be swift, and bigger when the market shifts direction. You are better off holding your nerve and letting the market produce for you over time.
Market timing in practice
This chart shows the returns for the UK stock market for the past 20 years. The blue bars represent the percentage return for the stock market in the UK for each of the last 20 calendar years. The green shows the highest position during that year, and the red, the lowest position. Looking at this, in 2016, at various points during the year the UK stock market had
- Fallen by over 10% (red)
- Risen by over 30% (green)
- Ended up returning over 15% for the year (blue)
The purple ovals highlight that during many years the stock market shows a loss part-way through the year, which eventually converts into a gain by the end. You should not aim to time your entry or exit from the market as you run the risk of getting this dramatically wrong. Imagine if you sold out at the worst position in 2009 (-18%), only to then see the stock market recover to +30% by the end of the year. We see this in action regularly with people who do not consider how to invest properly. They either wait too long to invest (out of fear of losses), or chase gains at a time when the market has already peaked. Data shows that more people sell shares when the market falls, and more people buy shares when the market rises. Neither is logical, and neither will generate ideal returns over time.
Holding enough cash
One way to balance investment volatility is by holding an appropriate amount of cash.
We have already highlighted above how cash tends to lose value compared to inflation over time, so it is important to get this balance right depending on your situation. It can be tempting to hold too much money in your investments, which may not be easily accessible, or could fall in value at the wrong time. We believe you should balance your long-term investments against your short-term need to access capital for emergencies, projects, or income.
You should hold enough cash to pay fees within your portfolio. Otherwise, your investments may need to be sold to pay these fees.
Holding a cash buffer for income
If you take an income from your investments, this could be affected in the event that your investments temporarily fall in value. Investment downturns are inevitable, and unavoidable, so it makes sense to prepare when investing money. If you invest into a long-term portfolio, but take a fixed income this may eat into your capital faster when your investments fall in value.
In extreme situations, you might run out of money much sooner if the timing goes against you (especially if the fall in value happens at the start of the fixed withdrawal period). One solution is to reduce your income when the capital value falls.
An alternative is set out below:
This diagram shows how an income cashflow reserve can work in practice. The idea is to hold around 2 years variable income in a cash account. This is a compromise between having your money invested for longer-term growth, and having enough cash available to continue with your planned lifestyle costs in the event of a short-term market fall.
If your investment happen to fall in value, you can use your cash buffer to wait out the downturn, and only go back to taking withdrawals once markets have recovered. Of course, even this approach is not guaranteed, but it does mean that you can pay less attention to the stock markets when they are falling. You should let your long-term investments to grow over time, but keep a sensible cash reserve to cope with short-term investment fluctuations.
Investment costs and tax
It is important to understand the charges of your product, the investments funds, and any transaction costs.
While necessary, the investment charges are a drag on the performance of your investment. Low cost is good, but not always the best. If you can buy the same investment at a cheaper cost, you will get a larger net return. However, a wider investment choice can lead to larger returns, even if the costs are greater.
Type of investment charges
Why are investment charges important?
Investment charges are important because they act as a drag on your investment returns.
Suppose your investment returns 8% in one year, but you are charged 2%, the net return will be something like 6%; if the same investment only charged you 1%, the net return might be 7%. This means that you should pay close attention to the charges of your investment since they can seriously reduce your investment growth over time.
Of course, having a lower-cost investment does not necessarily mean you will achieve higher net returns. If the higher-cost investment achieved 10% return before charges, but charged you 2%, you would end up with 8% net return.
If the lower-cost investment achieved 8% return before charges, but charged you 1%, you would end up with a net return of 7%. As you can see it is not a straightforward issue, but is one to which you should pay close attention.
Types of investment charges
Typically, if you invest money you could be subject to any of the following types of investment charges:
- Investment management charges
These charges cover the cost of research and managing investments on your behalf. Investment management charges are typically deducted from the investments you buy.
- Product fees
These charges cover the cost of managing your investments within a given tax wrapper, possibly on a single investment platform. Investment product fees are typically deducted from the investments you buy.
- Adviser fees
These charges cover the cost of providing financial and tax advice on the suitability of your investments. You can pay these fees via deduction from the investments you hold, or separately.
Your investments may also incur tax on purchases, capital gains, or income. We consider investment tax in a separate section below.
How do investment charges work?
This section gives you an idea of the type of charges you would pay for buying retail investments such as OEICs and unit trusts. The charges set out below assume you buy your investment directly with the investment provider. We have compared this retail approach to one assuming you use a financial adviser in the next section.
Many retail investment funds charge up to 5% of the initial capital. These charges vary, and are gradually reducing due to competition. Many investment funds have no initial charges.
To put this into context, if you invested £100,000 the initial charge could be as high as £5,000. in this scenario, £95,000 would be invested. The initial charge could also apply to regular savings. For every £100 you save, £5 could go in charges, leaving £95 to be invested. This initial fee is calculated differently for unit trusts, but it effectively works out as a charge of up to 5% of your initial investment.
- Annual Management charge (AMC)
Investment funds typically charge an Annual Management Charge (AMC). This pays for the management of your investments as well as other annual costs. For a share-based investment fund the typical retail Annual Management Charge is 1.5% of the total investments per year. Some types of investment funds, such as corporate bonds, have typically lower Annual Management Charges. Some, more complex investments have even greater Annual Management Charges.
- Transactional charges
Unfortunately, the Annual Management Charge is not the end of the story for annual investment charges. You also need to look out for additional charges. These can include transactional charges such as dealing costs, trustee fees and taxes paid by the investment managers. These tend to be quoted separately to the Annual Management Charge of the fund, and might add an additional 0.25% per year (sometime much greater) to the Annual Management Charge. In general, the more the fund manager buys and sells investments, the greater these transaction costs can be. A study by the financial regulator estimated that trades made by fund managers account for additional fees which are very difficult to track.
- Performance fees
Some investments have an additional performance fee which is payable if the investment beats a certain level of returns, perhaps beating an index. These can be as high as 20% of the excess returns above a certain level. The argument is that the fund manager has done so well in that year that they can justify this additional charge.
- Ongoing charges figure (OCF)
Most investment funds display the ongoing charges figure on factsheets, and the Key Investor Information. The OCF takes into account ongoing charges, and includes the Annual Management Charge (AMC), as well as dealing costs, but not necessarily all transactional charges. The Ongoing Charges Figure does not include performance fees (where appropriate).
- Total Expense Ratio (TER)
Some investment funds are still permitted to display the Total Expense Ratio (TEF). This is like the Ongoing Charges Figure (OCF), but also includes performance fees (where appropriate).
As you can see, it is not always easy to compare the charges of investment funds on a like-for-like basis. You should compare investment charges carefully.
Some investments have a charge for exiting the fund, perhaps before a certain date.
These are typically applied to older investments and are rare with most collective investments such as OEICs and unit trusts. Just be careful to check these do not apply to you before you sell an investment.
How do investment product fees work?
Investment product fees can vary widely between products, depending on whether they are marketed directly to investors (usually more expensive), or via investment advisers or brokers (usually cheaper due to economies of scale).
As financial advisers we typically recommend that clients invest via an investment wrapper. These are administration platforms which allow us to buy and sell investments for you, and to make trades easily. They have a number of benefits:
- Simpler administration
The idea of these platforms is that they allow you to keep all of your investments in one place, thus making your administration burden much lower. This convenience helps you to keep track of your investments much more easily.
- Transparent charges
Most investment wrappers allow you to clearly see the charges that you pay. This transparency is generally having a downward pressure on costs as platforms complete to win and retain business.
- Access to a vast array of investments
Investment platforms allow you to buy from a massive array of investments. Instead of choosing from 50 funds offered by one investment provider, you can instead choose from thousands. in some cases, the range of investments is unlimited. You can also access institutional investments, not typically open to retail investments. These can have lower charges and better fund performance.
- Access to different tax wrappers under one platform
You can bring together different types of tax wrappers such as investment accounts, ISAs and pensions. This means you can move money between your wrappers when it makes sense to do this. You can also follow a similar investment strategy across all of your investment wrappers.
- Buying power
These investment platforms have billions invested on them, which allows the platforms to reach deals with the investment companies to offer their investment funds at a discount. This can greatly reduce your costs. The buying power of the investment platforms typically reduces the Annual Management Charge cost of an investment by half – from 1.5% to 0.75% per year.
Investment wrapper charges
- Platform charge
Think of the investment wrapper as an administration platform. Charges vary, but would typically range between 0.25% and 0.5% of the investments held per year.
- Tax wrapper charges
Some investment wrappers have level annual costs for holding certain tax wrappers. These vary, but might be £20 to £100 per year depending on the company and wrapper used.
- Dealing costs
Some platforms charge dealing costs, ranging from a flat fee of say £5 per trade, to a small percentage of the value traded, say 0.2%.
It is rare for investments to have an initial charge when you buy them through an investment wrapper. This immediately saves you the 5% charge you might pay for buying the same investment directly with the provider.
Annual fund charges
The buying power of investment platforms means they can do deals with the investment fund managers for selling greater amounts of investments through their distribution channels. This typically reduces the Annual Management Charge by half, so from 1.5% per year to 0.75%. If you work this out, the total charge might look like this:
|Charge||Retail||Wrapper||Saving using a wrapper|
|Annual wrapper charge||0%||0.35%||+0.35%|
|Annual fund charges||1.5%||0.75%||-0.75%|
|Other annual charges||0.25%||0.25%||0%|
In the example above, you would save the 5% initial charge, plus 0.4% per year in Annual Management costs. Let’s put this into monetary terms, assuming an investment of £100,000:
|Charge||Retail||Wrapper||Saving using a wrapper|
|Annual wrapper charge||£0||£350||+£350|
|Annual fund charges||£1,500||£750||-£750|
|Other annual charges||£250||£250||£0|
In this example, which is only a guide, we can see that by using a financial adviser you would have saved £5,000 in year one, plus £400 per year for every year you hold the investment. This is money which goes directly to greater growth in your investments.
How do investment adviser charges work?
Investment advice fees also reduce the growth of your investments. Of course, you should get a payoff in return for this fee:
- Comprehensive research Your financial adviser should be able to help you to choose from among the best investments available using a variety of research tools to analyse the market.
- Experience and expertise Your financial adviser should use a combination of experience and expertise to help you to avoid costly investment mistakes.
- Process Investing money is all about following a certain process to ensure that you do not miss obvious areas. Your financial adviser should help you to ensure that you have all the areas covered that you might not think of.
- Risk management A vital area in investing money is managing the risks you take. Your financial adviser should be able to help you to diversify assets, and to ensure that you take the levels of risk appropriate for your needs. They will also ensure that your investments are regularly brought back into line over time to avoid you taking a different level of risk to the one you signed up for.
- Ongoing service Your financial adviser will be on call to regularly review your portfolio, and to answer questions you may have. This is probably the most important area.
Ways to reduce investment charges
Obviously, we would recommend that you take financial advice before making any investment decisions. However, if you have the knowledge to do it yourself, you can certainly save money.
Doing it yourself
One method could be to buy investments directly. This could mean purchasing individual shares or bonds directly from the source. This way you will save on the platform charges and adviser charges mentioned above. Just be careful that you know what you are buying, and ensure that you properly diversify your assets.
You can use one of the many discount brokers out there. They will usually provide you with a low-cost, advice-free option to buy pretty much any investment you could want. Check that the charges are genuinely cheaper, and again, ensure that you know what you are buying.
Investments with typically lower charges
- Index funds (passive investments) Index funds, also known as passive or tracker funds, allow you to invest in an index such as the FTSE 100 of UK shares. There are various methods used to build these funds, but their main benefit is that they are typically much cheaper than ‘active’ investments. You might buy a share-based index fund or ETF for 0.25% Annual Management Charge rather than 0.75% Annual Management Charge with an actively managed fund. The additional charges might also be lower due to a lower turnover of assets (although this varies). The main downside to these funds is that you will always get just below the average returns of an index. It could be argued that the best actively managed funds give you a better chance to beat the index. Of course, it is very difficult to do this consistently over time.
- Investment trusts Investment trusts tend to have much lower Annual Management Charges than OEICs and unit trusts. This can be a useful way of reducing your charges. The downside is that investment trusts often come with higher volatility and therefore risk than other investments.
- Special offers There is now more pressure on investment providers to reduce their charges. Often they will tempt investors with reduced charges on some sort of special offer. This can often come in some sort of initial discount.
Where to find information on investment charges
Key Investor Information Documents (KIIDs)
The easiest place to look to find out the initial and regular charges under an investment fund is to look up the Key Investor Information Document. This is information which must be provided to investors, and so comes in a standard format. Details of the charges will be given as Entry charge, Exit charge, Ongoing charge (includes Annual Management Charge plus other annual expenses) and Performance fee.
All investment managers produce their own investment fund literature. This includes investment brochures, fund manager commentary, fund factsheets, and other marketing material. This information usually contains information on investment charges.
Active or passive investments
There are positive reasons for investing in actively managed investments as well as passive index-trackers (which tend to be cheaper). We have included information on active vs passive investments in the section on investment costs. To a certain degree this is a little unfair, as the differences are not limited to costs. However, the cost is the main difference between active and passive investments.
We do not have a particular bias, and prefer a statistical analysis of particular investment sectors to guide our decisions. We like to take a risk-based approach and can see the merits of both sides to this argument. We like passive investments because we believe that buying and holding investments at a low cost should work for long-term investing; however, we also use actively managed investments in our portfolios as it is not possible to source suitable passive investments for every sector we recommend.
Active investing is the more established method of investment. This investment method gives more control and influence to a fund manager.
- The goal of an active investment manager is to try to beat the market average returns.
- Active investors believe that markets are irrational, and that their approach can exploit these issues.
- Active investment managers use a variety of in-house analysis tools, plus judgement and experience, to pick investments based on how they believe a particular investment sector will perform.
- They may have a particular investment style, which will also guide their approach.
Active investment is more expensive than passive investment, as the fund manager has greater costs associated with all that analysis. Therefore, over time, to be successful, active managers have to be able to generate additional returns to overcome that additional investment cost. In general, actively managed investments tend to work well in less-established markets, which it can be more difficult to replicate an index of the sector. Investors tend to choose actively managed funds when they believe that insight can add value to investment decisions.
Advantages of active investments
- Flexibility to beat the market
Active investment managers argue that they have more flexibility to adapt their strategy according to the market conditions. In theory, this means that active investments could out-perform in all circumstances (rising, and falling markets). Of course, the reality does not always match up to this theory.
- Hedging & risk management
Active investment managers can use complex instruments to replicate certain investments or indexes at a fraction of the cost. This is intended to limit downside investment.
You can use active investment to offset high gains against losses, which could reduce your individual tax burden in certain circumstances.
Disadvantages of active investments
This is the main downside of active investment management. The costs of active management are much, much greater than passive investing. You need to pay for all that research, and the high salaries of the active investment managers. This in turn reduces the net return to actively managed investments. Passive investors believe that the longer you hold an investment, the bigger the effect the additional costs have on the returns. The UK financial regulator recently concluded that there is weak price competition between actively managed investment funds.
- Judgement & skill
Active investment managers can use their judgement, and this can have large effects – for positive and negative. Research has shown that it is rare for active managers to consistently get judgement calls right over the longer term. In addition, ‘star’ fund managers leave, or retire. Their skills can be difficult to replace.
There are many academic studies that have analysed the relative merits of active versus passive investing. Many studies have shown that passive investing provides greater returns in a buy-and-hold scenario. There is also some evidence that some actively managed investments simply replicate an index, while charging higher fees for active management.
Passive investments (index investments)
Passive investment is growing at a faster rate than active investment. Passive investing takes the view that it is impossible to beat the market, especially over the longer-term.
- Passive investments aim to replicate an index and only buy and sell holdings to reflect changes to that index. For example, a passive investment might replicate the FTSE 100 index of leading UK shares.
- Passive fund managers believe that by the time investment information can be accessed, that it is too late to act on this data.
- The passive fund would buy and hold investments according to the components of that index, changing the size of holdings regularly according to market movements, and if an individual company is added to, or removed from that index.
This means that trading costs are much lower. Investors tend to choose passively managed funds when they believe that it is impossible to outperform the market over time; they want to minimise investment costs to maximise investment returns. Passive funds are much cheaper than active funds, but typically deliver a return slightly lower than the market average. This approach works well in larger, stable investment markets; in contrast passive funds have less chance of working well in less developed markets, or in falling markets. As a result, passive investors tend to adopt a buy-and-hold strategy.
Advantages of passive investing
- Very low fees There is very little human management of these investments, which keeps costs extremely low
- Transparency Because passive investments holdings are based on an index, the components of the fund should be similar.
- Tax Most passive investing is designed as a long-term strategy, few buy and sale transactions can mean lower capital gains tax.
Disadvantages of passive investing
- Not for every market Not all investment markets have a suitable index that can be easily replicated. This could be the case is the market is widely distributed, such as corporate or government bonds. Alternatively, the market may not have uniform characteristics; this is the case with smaller markets such as emerging markets. Passive investment do exist in these areas, but tend to take a proxy approach aiming to replicate the market without having to own every element. In any case, the asset allocation choices of a passive fund are never uniform.
- Returns always lower than the average Passive investments aim to return the average of an index, less costs. Active investors tend to view this with suspicion, claiming that this means that passive investments always return less than the average.
- Falling markets Passive investments will not have any judgement in falling markets. This means, at least in the short term, that you should see passive investments drop in value in all falling markets.
Tax on investments
Most investments attract tax in some way. This section considers the main taxation that your investments will have to pay. The tax paid by your investments is effectively a cost, so you should aim to minimise tax where you can.
Understanding the difference between your capital and income
Tax on investments is levied according to whether the original capital has grown in value, or on the income generated (even if not withdrawn).
- Capital growth Any profit on the original investment amount. For example, Sarah buys shares for £1,000. She later sells these shares for £3,000. Sarah has made a capital gain of £2,000.
- Income Any income paid that does not affect the capital value. For example, Sarah’s shares pay a dividend of £500 per year. This money is treated as income.
Capital gains tax on investments
In general, capital growth is taxed under capital gains tax. This does not apply to every investment type. You pay capital gains tax on any profits you make on your investments. This is paid when you sell or dispose of that asset. If you are UK resident you generally pay capital gains tax on worldwide assets. If you are resident abroad you generally only pay capital gains tax on UK property. Investments that attract capital gains tax
- Property that is not your main home (second homes, rental property, commercial property)
- General investment accounts
- Unit trusts
- Exchange traded funds (ETFs)
- Fixed interest securities (gilts, corporate bonds)
- Business assets
- Collectables such as paintings and antiques
Investments that do not attract capital gains tax
- Venture capital trusts
- Personal possessions worth less than £6,000
- Gilts that are not held within investment funds
- Premium bonds
- Bank accounts
Capital gains tax allowance
Each tax year you have a capital gains tax annual allowance. Capital gains realised on investments during that tax year can deduct this annual allowance. If your total capital gains are less than the annual allowance then you have no tax to pay. Your capital gains tax allowance is:
- £12,300 for each person
- £6,150 for a trust
The above capital gains tax allowances have been frozen to 2026, which means you are likely to pay more tax as investments grow in value.
Capital losses can be offset against capital gains for the tax year. For example, Martin bought shares 10 years ago for £10,000. He sold these for £45,000, realising a capital gain of £35,000. He also bought an antique necklace for £10,000, but sold this for £5,000. Martin can offset the capital loss against the capital gains in the same tax year. Therefore, Martin’s taxable gain is reduced to £30,000. If you make a capital loss for a tax year you can carry this loss forward indefinitely, provided you register the loss with HMRC within 4 years of the end of the tax year.
Capital gains tax exemptions
- You are exempt from capital gains tax on transfers to your spouse, unless you separate and do not live together in that tax year. Your spouse will take on your accrued tax liability if they later sell the investments.
- You do not pay capital gains tax on investments you give to charity.
Reporting on investment capital gains
If you sell investment property you must report and pay capital gains tax within 30 days of the sale of the property. For other investments you report and pay capital gains as part of your tax return to HMRC. You must report by 31st December after the tax year in which you had the capital gains on investments.
- Work out the sale price
- Deduct the purchase price
- Deduct any allowable expenses, allowances or losses
Do you need to inform HMRC of capital gains or losses?
You do not pay tax if your capital gains are below your Annual Allowance.
- You must report capital gains in your tax return if these gains are greater than the Annual Allowance.
- You must report capital gains even if they are below the Annual Allowance, when the total sale value was greater than the Annual Allowance.
Read more on declaring capital gains to HMRC.
If you realise a capital loss in a tax year you should register this with HMRC even though tax will not be due. You have 4 years from the end of the tax year to do this, and once registered you can offset any future capital gains against this loss.
Investment capital gains tax rates
Gains on investments after allowances are added to your other income for the tax year.
- Gains falling within the 20% income tax band are taxed at 18% for property, or 10% for other investments
- Gains falling within the 40% or 45% income tax band are taxed at 28% for property, or 20% for other investments
- Trusts pay capital gains tax at 28% for property or 20% for other investments
- Sales of a business may attract Business Asset Disposal Relief, which reduces capital gains tax to 10% on qualifying business assets
Capital gains tax is a complex tax, and you should seek professional tax advice for help in this area. Click here for more information on Capital Gains Tax.
Income tax on investments
In general, you pay income tax on a variety of income paid by investments. This is a very complex area, and you should seek professional advice. The income tax allowances shown below have now been frozen to 2026. In practice, this may mean you pay more income tax as your income grows.
Reporting income tax on investments
You are responsible for reporting the income paid on most investments to HMRC for each tax year. Most investments pay income before tax, so you will need to make arrangements to pay the income tax you owe. You need to report your income as part of your tax return, or separately to HMRC by 31st January following the relevant tax year in which the investment income was received.
Investments where you need to report income tax
- Bank accounts
- Corporate bonds
- Investment funds
Investments where you do not need to report income tax
- Pensions (income tax is deducted at source)
- ISAs (exempt from income tax)
- VCTs (exempt from income tax)
Investment income tax allowances You benefit from a variety of income tax allowances for investment income:
- Up to £5,000 if your non-savings income is less than £17,570 This allowance is reduced if your non-savings income is between £12,570 and £17,570. For example, if your total non-savings income was £16,000, you could have up to £1,570 savings income tax-free.
- £1,000 additional savings allowance if you pay income tax at 20%
- £500 additional savings allowance, if you pay income tax at 40%
- £2,000 allowance for dividends
Do you need to inform HMRC of taxable investment income?
Most bank accounts and investment accounts now pay income without deduction of tax. We will provide our clients with a full breakdown of their taxable investment income in May after the end of each tax year.
You do not need to declare income received, which is below your allowances:
- Interest – £1,000/£500
- Dividends – £2,000
If your total income from interest or dividends from all sources exceeds either allowance, then the taxable income should be declared to HMRC. Further tax will be due.
If your total income from interest and dividends is less than £10,000 you can notify HMRC by phone. If your total income from interest and dividends is greater than £10,000 you will need to complete a self-assessment form.
Income tax rates for investments
You generally add taxable investment income to your other taxable income. The first £12,570 of income is tax-free. You pay standard income tax rates (0%, 20%, 40%, 45%) for savings and rent. For dividends you pay income tax at:
- 8.75% for income that otherwise pays tax at 20%
- 33.75% for income that otherwise pays tax at 40%
- 39.35% for income that otherwise pays tax at 45%
Summary of tax on investment types
Please note that this table is intended as a general guide to tax on investments. The tax status of investment wrapper is complex, and more detailed than set out below. You should seek financial advice or tax advice if you are not experienced in this area. This is not an exhaustive list, but aims to provide context around the main taxes on the most common investment types. We have highlighted:
- Positive effects in green
- Negative effects in red
|Investment type||Tax on initial investment||Tax during investment||Tax on exit/sale/withdrawal|
|Bank account||None||Income tax on interest1||None|
|Property||Stamp duty land tax2||Income tax on rent less expenses||Capital gains tax on sale3|
|Shares||Stamp duty reserve tax4||Income tax on dividends5||Capital gains tax on sale3|
|Corporate bonds||Generally none||Income tax on interest1||Capital gains tax on sale3|
|ISAs||Stamp duty reserve tax4||None||None|
|Personal pensions||Tax relief on personal contributions6||None||25% tax-free cash Income tax on other withdrawals7|
|Venture Capital Trust||Tax relief on contributions8||None||None (provided held for 5 years)|
- Interest allowance on all interest each tax year:
- No tax payable for interest below the allowance
- £1,000 per tax year for anyone who pay income tax at 20% or less
- £500 per tax year for anyone who pays income tax at 40%
- Up to £5,000 additional allowance if your non-savings income is less than £17,570
- Stamp duty is payable on all property purchases, with relief for first-time buyers. Rental property pays greater stamp duty than main residences. See this stamp duty calculator.
- Capital gains tax allowance for all individuals is £12,300 per tax year. Gains below the annual allowance are free of tax.
- Individually-held corporate bonds and gilts are not subject to capital gains tax, but corporate bond and gilt funds are subject to capital gains tax
- Taxable gains are added to other income.
- Gains that fall in the 20% income tax band are taxed at 10% for investments or 18% for directly-held property
- Gains that fall in the 40% or 45% income tax band are taxed at 18% for investments or 28% for directly-held property
- Stamp duty reserve tax is payable on paperless share transactions at 0.5% of the transaction
- When you buy shares directly
- When you sell units in unit trusts and OEICs – passed on in management charges
- Each person has a dividends allowance of £2,000 per tax year. Dividends below this allowance are free of tax
- Taxable dividends are added to other income.
- Dividends that fall in the 20% income tax band are taxed at 8.75%
- Dividends that fall in the 40% income tax band are taxed at 33.75%
- Dividends that fall in the 45% income tax band are taxed at 39.35%
- Contributions to personal pensions attract tax relief
- Pension contributions are boosted by 25% at source within the scheme
- 40% and 45% income tax payers can reclaim additional tax relief via their tax return
- Personal pension withdrawals are taxed as earned income, but up to 25% of the fund can be withdrawn tax-free. More complex limits and rules apply to this tax-free cash.
- Venture capital trusts attract tax relief of 30% against income tax for investments between £5,000 and £200,000 per tax year. Investments must be held for 5 years, or tax relief must be repaid.
Tax planning with investments
If you can shelter your money from tax legally, then why not use your tax allowances? The money you shelter from tax (primarily income tax and capital gains tax) will grow at a much faster rate than if you are taxed on your income or gains.
Should tax planning with investments tax place at the start or the end of the tax year?
In most cases you will get the best possible return on your money if you invest in tax planning with your investments at the start of the tax year. Don’t wait until the last minute at the end of the tax year as you risk losing your tax-free allowances in some way. Of course, some tax allowances are not available immediately – for example, you may need to wait until you receive a bonus to shelter that money from tax. If you have the capital put aside in taxable investments or savings, then you should consider moving this money into tax free shelters as soon as you can each tax year.
9 methods for tax planning with investments
Tax planning with investments can be complicated, so you should always seek advice from a financial planner and/or a tax adviser. Investments can go down as well as up, so take care to understand the risks before you commit your funds. Please bear in mind that this is a summary of some ideas, and not a substitute for advice. Clearly, there are many other methods available, which are beyond the scope of this article. These are Government-sponsored allowances for you to use, and we have ranked them from the simplest to most complex.
Income tax personal allowance
- £12,570 per person per tax year
- Via your salary or tax return.
- Each person pays 0% income tax on earnings below this level.
- Consider using this allowance where you can control your income (via a business).
- Most people cannot control their income
Personal savings allowance
- £1000 per person per tax year if you do not pay 20% income tax;
- £500 if you pay 40% tax;
- Additional allowance of up to £5,000 available, provided your non-savings income is below £17,570.
- All savings and bond interest up to the limit is free of tax
- Savings and corporate bond interest is received tax-free.
- Applies to investments held outside of ISAs and pensions.
Downsides None although you pay tax on the additional interest.
- £20,000 per person per tax year
- £4,000 per person into Lifetime ISAs (part of £20,000 ISA allowance)
- £9,000 for each child
- Fund from your savings or from taxable investments (such as your general investment account),
- Tax-free growth – fund grows free from income tax and capital gains tax.
- All income and capital withdrawals free from income tax and capital gains tax.
- Your spouse can take over your accumulated ISA allowances after your death
- £2,000 per person per tax year
- All dividend income up to £2,000 is free of tax
- Dividends from shares or businesses are received tax-free.
- Applies to investments held outside of ISAs and pensions.
- Business owners are likely to pay more tax.
- You pay tax on the remaining dividends at 8.75/33.75/39.35%
Pension Annual Allowance
- Up to £40,000 per person per tax year provided you have earned income
- Up to £3,600 if you have no earned income
- Reduced to £4,000 if you have taken flexible pension income
- If your total income is over £240,000 your allowance reduces gradually to £4,000 p.a. via the tapered annual allowance for high earners.
- From earned income or business contributions – both before tax.
- Without earned income you can save a maximum of £2,880 per tax year.
- Fund grows free from income tax and capital gains tax.
- Tax relief on contributions Personal contributions get immediate uplift in pension: £100 contribution attracts additional £25 tax relief. 40% tax payers get to claim an additional £41.66 per £100 saved via your tax return. 45% tax payers get to claim an additional £56.81 per £100 saved via your tax return.
- Company contributions save corporation tax at 19%.
- 25% tax-free cash at retirement.
- No access until at least age 55 (57 from 2028 onwards).
- Income from pensions is taxed as income between 0% to 45%.
- Personal contributions over £2880 must come from earned income.
Pension Carry Forward
- Carry Forward from previous 3 tax years – potentially £120,000 available
- You must make the maximum allowable pension contribution in the current tax year, and then use the earlier 3 years, starting with the earliest year.
- Fund grows free from income tax and capital gains tax.
- Tax relief on contributions: Personal contributions get immediate uplift in pension: £100 contribution attracts additional £25 tax relief. 40% tax payers get to claim an additional £41.66 per £100 saved via your tax return. 45% tax payers get to claim an additional £56.81 per £100 saved via your tax return.
- Company contributions save corporation tax at 19%.
- 25% tax-free cash at retirement.
- You can’t receive personal tax relief on personal contributions in excess of your earnings in a tax year and you only receive higher rate tax relief to the extent that you have paid it.
- No access until at least age 55 (age 57 from 2028).
- Income from pensions is taxed as income between 0% to 45%.
- Personal contributions must come from earned income.
- You must have been an active member of a pension scheme in the tax year you want to claim unused relief
Enterprise Investment Schemes (EIS)
- Up to £1,000,000
- Income tax relief and capital gains tax deferral
- 30% upfront income tax relief on investments up to a £1 million for the current tax year and/or £1 million carried back to the previous tax year.
- Capital gains tax deferral for the life of your investment – investments offset other capital gains.
- Tax-free growth provided you qualify for income tax relief.
- Very high risk.
- Your shares must still qualify for relief at all stages.
- Offset capital gains will attract tax when you sell your EIS.
- You must hold the EIS for 3 years or you lose the tax relief.
Venture Capital Trusts (VCT)
- Up to £200,000
- Income tax relief
- Up to 30% income tax relief if you invest between £5,000 and £200,000 in any tax year.
- You can reinvest and attract further tax relief after 5 years.
- Tax-free dividends.
- No capital gains tax on gains.
- Very high risk.
- You must hold the VCT for 5 years or you lose the tax relief.
How to start tax planning with investments
Any use of the above tax planning ideas should start with a plan of action to establish how the investments may impact on other areas of your finances. We do this via our Prosper service. If you’d like to discuss tax planning with investments contact us.
Ethical investment and socially responsible investment
Ethical investment (sometimes called socially responsible investment, or SRI) aims to ensure that your investments avoid negative industries, or alternatively aim to have a positive impact on the world. This sounds straightforward, but there are a wide variety of ethical investment approaches. You should be careful to understand the implications of ethical investing before you start. At the core, ethical investing is about making your money work to fit your moral values. Most ethical investors aim to avoid companies or industries that do harm to the environment, or society. Other approaches are less restrictive, and aim to reward the best in a particular industry. You can see that these ethical approaches are quite different, and can lead to confusion: it would be a pity to think you are buying one type of ethical investment, but to get something different.
Who might be an ethical investor?
- Conscience You want to avoid investing in companies that do harm. This might include a number of industries, such as animal rights, tobacco, gambling, human rights, or the arms trade. Negative screening is likely to be the best approach to avoid harmful sectors.
- Sustainability You want to help companies that make a difference – perhaps through green energy, or social good. Positive screening will allow you to find these companies.
- Activism You want to use your clout as an investor to engage with companies to do the right thing – perhaps sustainable or socially responsible business practices. Engagement will help you to exert influence.
Ethical investing - negative screening
How negative screening works with ethical investing
Your ethical fund manager will start with all the available investments in their chosen sector. They will then run these investments through a policy to screen out any companies that do not meet the standards set by the fund. This ethical screening policy is generally set by a separate committee, so that the fund manager does not have any influence over the decisions. This can limit the choices that the ethical fund manager has, and could lead to greater investment volatility as a result, since fewer choices might mean less attractive investments can be made from a purely financial perspective. Negative screening is therefore the most robust form of ethical investing.
Negative screening criteria
Each ethical investment applies its own negative screening criteria. This means that there is not a set definition of all negative screening criteria. Each fund will advertise the criteria it uses.
Here is a list of typical ethical investing negative screening criteria:
- Alcohol production
Companies that generate income from alcohol sales;
- Animal testing
Companies that test their products on animals;
- Animal welfare
Companies that do not have ethical animal welfare practices, such as factory farming;
- Environmental damage
Companies that damage the environment, such as use of chemicals, pesticides, or greenhouse gas emissions;
- Employment practices
Companies that use child labour, abuse health & safety rules, or other bad employment practices;
- Fur trade
Companies that manufacture or sell fur goods;
Companies that generate income from gambling;
- Human rights
Companies that are accused of human rights violations, or operate in countries where uses regularly take place;
- Break milk substitutes
Companies that adopt aggressive marketing campaigns to promote breast milk substitutes;
- Nuclear energy
Companies that generate profits from the nuclear energy industry;
Companies the generate revenue from adult entertainment services;
Companies that generate revenue from the tobacco industry or supply tobacco products;
Companies that manufacture or sell weapons.
This list is not exhaustive! Individual ethical investment funds will apply one or more of these negative screening criteria.
Ethical investing - best-in-class or positive screening
Typical best-in-class ethical investing issues
These issues will often be important to best-in-class investment funds:
Companies that have a positive impact on the environment, or contribute to reducing the impact of harmful industries. For example, environmental technologies such as renewable energy or conservation;
- Human rights
Companies that respect the human rights of their employees and customers, or provide access to services that are considered basic human rights (such as education, sanitation, water, or heath care);
Companies that use strong labour practices, and health & safety policies;
companies that uphold high standards of ethical standards with employees and customers.
UN global compact and sustainable development goals
Best-in-class ethical investments may apply sustainable development goals from the United Nations. These are a list of positive goals that governments should aim to achieve.
These also apply to companies through the UN global compact. This is a voluntary initiative, which companies can use to demonstrate best practices in these 17 areas.
Ethical investing - engagement
Ethical engagement is often separate to the ethical investment policy of a particular fund. It is usually applied at a company level for investment providers, rather then within specific ethical investment funds. For example, Investment Company X might choose to have a particular approach to ethical engagement with all of their investment funds (ethical or not). They will then apply a stricter approach with specific ethical funds, but not all funds in their range. Therefore, it is likely that all ethical funds in the company’s range would apply the ethical engagement approach; however, non-ethical funds are unlikely to apply stricter measures (such as positive or negative screening).
Sadly, unscrupulous behaviours leads to greenwashing. For example, it is easy to call an investment fund a new name that sounds like it applies an ethical approach. Unfortunately, this may not be the case, apart from some window dressing. Therefore, it is important to understand fully the ethical investment criteria of your choices, so that you can be sure that your ethical fund processes are robust enough to apply to all of the issues that you believe are important to you.
Risks of ethical investment
Ethical investing can be riskier than standard investing, but this does not necessarily have to be the case.
Typical risks of ethical investing
- Fewer investment choices
Ethical investment funds are designed to limit investment choices either through negative or positive screening. This naturally reduces the amount of investments that an ethical fund manager can choose. For example, a standard fund might have 2,000 companies to choose from, but an ethical fund might be limited to 200 companies within the same sector. This might therefore mean that an ethical investment fund has to make compromises, choosing a company to invest in that they might not have otherwise chosen. Of course, the counter argument to this is that ethical investors would be happy with this choice, since they want their money to avoid unscrupulous companies. Ethical investors might also argue that the unethical companies take additional risks with their money and reputation. In fact, many ethical funds outperfom their non-ethical peers, especially in the longer term.
- Increased volatility
Ethical investing can lead to additional volatility, but not always so. For example, many cyclical companies are avoided because of ethical issues, since their business practices are not whiter-than-white. This can mean that ethical funds use smaller companies on average than standard investment funds. Smaller companies tend to have more volatile returns, and this can increase risks, at least in the short term. Ethical fund managers would argue that they are better positioned to avoid longer-term headwinds from outmoded practices.
- Unavailability within sectors
It is easier to apply an ethical investment approach in certain sectors than with others. Typically, it is easier to run ethical investment funds within established investment markets like the UK. Less established, or more widely spread investment markets have more difficulty in applying ethical criteria. this can either be because the investment sector does not have as stringent standards, or because the sector is too diverse. What this means for the ethical investor is that certain compromises may have to be taken to rule our investments in areas that cannot apply an ethical investment standard as easily.
- Additional costs
Ethical investing does mean additional work for the fund managers, and so investment costs can be more expensive than for standard funds. Interestingly, this is one reason why certain unscrupulous fund managers have applied greenwashing (see above), in an attempt to apply higher fees, for greater profits.
Overall, these risks are real, but are not insurmountable. It is important to be aware of the risks of ethical investing, so that you understand what you are buying. If you know the ethical investment risks, and are still prepared to continue, then ethical investing should be right for you.
When investing money you should also choose the right product, or tax wrapper for your investments. We consider some of the main investment tax wrappers below. Of course, many other investment products are available, but these are your main choices when investing money.
You can invest money by buying directly from the sources. This might be a simple account like a bank account, or direct holdings such as shares.
In general, this will probably be the cheapest way to hold assets when investing money, as you will avoid additional administrative expenses. However, you should only take the direct approach if you are confident with your choices, and are prepared to deal with the additional administration.
Direct investments – advantages
- Cheaper to buy as no additional administrative expenses
- More control – you can buy anything, not just what your investment provider offers
Direct investments – disadvantages
- More administration and complexity – you will need to deal with each direct investment
- Greater risk – you are less likely to diversify direct holdings as widely as a typical investment fund
- Tax – most direct investments are taxable investments
General investment account
A general investment account is a taxable investment account that allows you to hold a variety of directly held investments such as shares, or pooled investments like funds.
This is usually a more convenient way to hold investments, as the general investment account provider will handle all of the administration for you. Effectively, you pay additional fees in exchange for simplified administration, and access to a wide choice of investments.
General investment account – advantages
- Lower administration and convenience – the product provider will handle all of the buys, sales, and tax issues of investing money
- Access to investments – you can usually choose from a wide variety of investment types, including some not available to direct investors
- Flexibility – you can move money in and out of the account at will
- Reporting – the product provider will give you all the tax reports and data you need to run your investments efficiently
General investment account – disadvantages
- Cost – obviously, you will need to pay additional fees for managing your account, as well as transaction fees
- Tax – general investment accounts are taxable investments
Individual Savings Account (ISA)
An Individual Savings Account (ISA) is a tax-free tax wrapper around another account. The most common ISAs are cash ISAs, which make a bank account tax-free; the alternative is an investment ISA, which makes a general investment account tax-free. Growth, income, and withdrawals from ISAs are tax-free.
ISAs – advantages
- Tax – growth and income is tax-free
- Lower administration and convenience – the product provider will handle all of the buys, sales, and tax issues of investing money
- Access to investments – you can usually choose from a wide variety of investment types, including some not available to direct investors
- Flexibility – you can move money in and out of the account at will
- Reporting – the product provider will give you all the tax reports and data you need to run your investments efficiently
ISAs – disadvantages
- Cost – obviously, you will need to pay additional fees for managing your account, as well as transaction fees
Have you heard of ‘ISA season’? Every March, just before the end of the tax year, we read in the financial press about how you should ‘use your ISA allowance, or lose it’. This section explains the flaw in the logic of ISA season, and how our clients do not wait until the end of the tax year to use their ISA allowance, and save tax.
For our clients, ISA season is in April. We show an example of how you could save £3,143 in tax by moving your ISA contribution to the earliest point in the tax year.
What is ISA season?
Every year, savvy financial commentators tell us that we have an annual ISA allowance. This allows you to shelter £20,000 per person, per tax year, away from all tax. It is a valuable allowance, and could save you an amazing amount of tax over time.
ISA season crops up each March, towards the end of the current tax year (which ends on 5th April each year). The marketing tells you to use your ISA allowance, or lose it. This is all valid (and no doubt creates a sense of urgency).
When is the real ISA season?
Of course you should use your ISA allowance if you have the funds available. However, the most effective use of your ISA allowance is to use it as soon as possible, at the start of the tax year. The real ISA season is at the start of the tax year, not the end of the tax year.
If you think about it, by waiting until the end of the tax year to save money into your ISA, you spend a whole year paying tax on your savings or investments. You can avoid this tax earlier by getting organised.
A typical ISA investment scenario
Set out below is a simple diagram of how an investment account might look for many people. You may hold an investment account with a combination of:
- A taxable general investment account
This account is subject to tax on income from interest, and dividends, plus capital gains tax on investment sales and capital withdrawals; and
- A tax-free investment ISA
This account is free of income tax and capital gains tax.
Of course, you could swap this diagram for taxable bank accounts and tax-free cash ISAs. The principle is the same, although you are likely to pay less tax within your bank accounts, simply because they pay much less income (and no capital growth).
How we organise ISA season for our clients
If you want to shelter the maximum amount of money from tax, you need to use your ISA allowance as soon as possible. This means using your allowance after 6th April, and not waiting until the following March.
This is especially true if you have money in a taxable investment account or bank account. It makes sense to move this money into an ISA as soon as possible in April, up to the limit.
As you can see, by moving money from your taxable investment account to the tax-free investment ISA in April, you potentially gain a whole extra year of tax-free income and capital growth. As we explore below, this can add up to significant tax savings over time.
How ISA season works with our Prosper service
Our Prosper service is designed to allow you to have control over your financial future. We help you to plan the future direction of your finances, and to manage your investments in a sensible way. We also help you to save tax by making the process as easy as possible. ISA season is one example of this, as we set out below.
We handle all the calculations and transactions for clients, to make the process as easy as possible. Every March we contact you to deal with the following issues:
- ISA allowance remaining for the current tax year
Most clients use up their ISA allowance as early as possible (in April) during the tax year. However, if you did not have funds available at that time, you can top up any remaining ISA allowance. In addition, if you took withdrawals from your ISA during the tax year, you can replace these before the end of March. This includes any fees taken from your ISA.
- Capital gains tax calculations
If you have any taxable investment funds, it makes sense to use this money to pay into your ISA. However, any sales from your taxable investment account could lead to capital gains tax. Therefore, we handle these calculations to be sure that you do not pay more tax than you need to. If there is no tax to pay, you should use your taxable investments to top up your investment ISAs. If there is tax to pay, you can instead make a cash payment into your investment ISAs.
- ISA allowance for the next tax year
Of course, you should aim to use your ISA allowance in April, so if you have taxable investments available, you need to get ready for this contribution in March. We perform a further capital gains tax calculation on your taxable investment account with the aim of making sales from this account in March. This uses your available capital gains tax annual allowance in the current tax year, leaving a full annual allowance for the next tax year. We can then transfer funds to your investment ISAs in April, with maximum tax efficiency.
How much tax could you save?
In another article, we explored how much tax you can save by maximising your ISA allowance over time, especially between a married couple.
We have run similar calculations to compare the tax saved with a £200,000 investment over a 10-year period, simply by moving ISA season from March to the previous April, thus using your ISA allowance a whole year sooner.
- £3,143 for a 40% income tax payer
- £1,174 for a 20% income tax payer
Note: this calculation only shows the benefit of moving the ISA contribution forward. It does not include the expected capital growth over the period, nor does it include the tax saved by using an ISA over a taxable investment account.
If we were to add in the tax savings of the ISA over the taxable general investment account as well as the benefit of using the ISA allowance as soon as possible, the same scenario would generate tax savings of £36,174 for the 40% tax payer, or £25,671 for the 20% tax payer.
Clearly, you should use your ISA allowance as soon as possible in April. Consider making sales from taxable investment account in the previous March, if you have your capital gains tax annual allowance available.
- £200,000 investment into a single-person general investment account
- Transfer £20,000 into an ISA every April, rather than the following March
- Capital growth rate 4%
- Dividend rate 1.5%
- Interest rate 1.5%
- ISA allowance growth 3% per year
- CGT allowance growth rate 3% per year
- All taxable investment annual sales to fund ISAs fall within the annual allowance for capital gains tax
- No capital gains tax allowances used at other times
- Capital gains tax paid at 20%
- No other taxable savings or investments are made
These calculations are made for general comparisons only, and should not be relied on for tax advice or financial advice. Each situation is different, and you should seek professional advice before making any changes to your investments.
Personal pension plan
Pension plans – advantages
- Tax relief – contributions to pension plans benefit from tax relief either to personal income tax, or to companies against corporation tax
- Tax-free growth – pension investments grow free of tax
- Tax-free cash – you can take up to 25% of your pension investments as a tax-free lump sum (or in stages)
- Inheritance tax – you can pass your pension plan on death, free of inheritance tax.
Pension plans – disadvantages
- Access – you cannot access your pension plan investments until at least age 55.
- Tax on income – withdrawals (over the tax-free cash) are taxed as income
- Complexity – pension rules are very complex, and should be considered in more detail than this article allows
Tax wrapper comparison video
Tax wrappers enable you to shelter your money from tax and allows you to grow your money faster.
In this video, Dan compares four of the most popular wrapper options available to you. Please note that this video uses tax rates from 2020/21, which are slightly different to current tax rates.
How are regulated investments protected?
If you are interested in how to invest, you will also wish to understand how your investments are protected if something goes wrong.
This section aims to show how regulated investments are protected. Obviously, this does not apply to unregulated investments (so be warned if you have money in such schemes).
Of course, all investing comes with risk, and investments can fall in value as well as rise. In general it is extremely unlikely that the financial institution will fail, but of course this does happen. It is because of past financial failures that the regulated protections outlined below exist.
Bear in mind that regulated protection does not cover general investment risk of loss, which is a fact of life for such products (investments can go down as well as up).
Research into financial strength of companies
When we conduct research to recommend investment plans, part of this process includes assessing the financial strength of the product provider. We do this by using ratings agencies which provide us with insight into their opinion on the ability of that company or platform to meet its liabilities in the event of insolvency. This is a good indication of the strength and stability of the companies we recommend, but we do have to remember that this is based on opinion, which can sometimes be wrong.
FCA Client Asset rules (CASS)
Financial services providers must ensure that they protect your cash according to strict regulations. The regulations insist that all client money is kept separately from the assets of the financial institution. This is designed to ring-fence client cash so that in the worst case scenario this will not be affected. It is typical of investment companies to hold your cash in a trustee or nominee account to keep your investments protected.
Further to this, financial institutions typically spread cash around a number of different accounts with different banks. This helps to spread the risk of default.
The Financial Services Compensation Scheme (FSCS)
This is a fund set up by legislation and paid for by a levy of all regulated financial institutions (including financial advisers, banks and investment companies). If your investment provider becomes insolvent you can make a claim on the FSCS.
This fund does not pay out simply because your investments fall in value. More information on the Financial Services Compensation Scheme.
What if my investment provider becomes insolvent?
You can claim up to £85,000 per person per investment in the event of loss due to misleading advice, or misrepresentation if that firm fails.
This may increase to 100% protection for insurance-backed investments like investment bonds.
- Failure of your pension provider
100% of your pension is protected;
You can claim up to £85,000 per person per investment for the failure of the provider, or in the event of loss due to misleading advice, or misrepresentation if that firm fails.
The FSCS would pay compensation up to the limit of £85,000 per person, per authorised bank or building society.
This limit applies to each person, so a married couple could hold 2 accounts with a value up to £170,000 with the same bank.
Some banks trade under the same authorisation. If each of the banks is covered by a single authorisation the FSCS would pay compensation up to a total limit of £85,000 once. This limit will be for the total of all the accounts you have with the different bank brands under the authorisation.
Which investments are not covered by the FSCS?
The following is a list of common investments not usually covered by the FSCS. This does not always make these investment riskier, but if you are not an experienced investor you may prefer the security of the protection provided by the FSCS.
- Cryptocurrency (e.g. Bitcoin)
- Investment trusts
- Exchange traded funds (ETFs)
- Venture capital trusts (VCTs)
- Enterprise investment schemes (EISs)
- Structured products
- Peer to peer lending
- Non-UK investments (although these can be covered by alternative regulations in the relevant country).
Once you have chosen to invest money, you need to search the market to choose the investments that match your criteria, risk profile and asset allocation. This section give some information on how to conduct investment research.
How to conduct investment research
How we conduct investment research
We analyse the investment market quarterly to prepare model investment portfolios. These use 5 risk profiles (from cautious to adventurous), and are divided between portfolios for capital growth, or income. We publish our model portfolio past performance at here. Our investment process examines all the funds available through your selected contract and analyses which funds would be appropriate for your needs, based on the model portfolio mix for your risk profile. We measure your current investments against the ideal model and will make recommendations to change investments only where there is a clear reason to do so. Funds must have 5 years of past data to be considered. We remove any (active) funds which cannot demonstrate above average past performance, as well as those which do not have a fund manager in place for at least 3 years. Following this, we rank funds according to statistical data. This enables us to identify funds which consistently perform well. We look for funds which demonstrate a consistent performance history, which do not take too much risk to achieve this, and do not charge too much. We give more attention to certain risk metrics to give these data points more weight. We also give more weight to charges as this has a significant impact on long-term returns.
Sources of investment information
If you choose to invest via a product provider, they will have a lot of information on the product charges and features. The product provider website will give access to more data on the investments held within the products, many of which will be reproduced from the original investment company.
Investment company website
All investment companies will have a lot of data on their products and investment funds. Most have data comparison tools, and also ways to assess the risks of an investment.
Most investments produce a summary factsheet. This lists the key information you might expect to see, plus some technical data. Be aware that not all factsheets contain the same data points, so you may not be able to use these documents to compare all investments. Factsheets may not be completely up-to-date, so are less useful when assessing tactical decisions.
Key Investor Information Documents (KIIDs) are required to be produced by the financial regulator. These compare the same data points for each investment fund, so that you can assess their relative merits. They work much like factsheets, but probably have fewer data points. Be aware that this is general information, so might not precisely match the charges levied by your particular product provider. KIIDs might not be up-to-date.
Most investment providers produce a wide variety of technical data, such as:
- Fund prices You can see basic technical data such as performance and income yield, and link to fund factsheets.
- Fund manager commentary This document might give you some insight into the way a fund operates, and how the fund manager views future prospects. Be wary, as this may not give you a balanced assessment.
- Fund prospectus This document gives you an overview of the fund and its objectives.
- Annual reports These documents give a summary of the performance of the investment for the past year.
- Document library This section might give you access to fund information in one place.
3rd party research systems
We prefer to use a 3rd party system to gather the data for investment research. This gives us the ability to filter through the marketing from investment funds, and to remove those investments that do not meet our criteria. Many investment advisers and firms do not use a defined research process to guide their investment recommendations. Many simply use the free investment company factsheets which are available. In our view, this compromises their independence, and does not allow for a thorough examination of the investment market. Worse, many advisers working in the same firm do not even share the same investment process. We use a complex and sophisticated investment management tool. This allows us to examine every investment vehicle on the open market, and includes an amazing amount of data points for us to use. This allows us to research free from the marketing messages pushed at us from investment companies. Instead we base our recommendations on results; without this analysis we would not be able to provide you with a robust investment service.
Get your free guide to
Our Investment Philosophy
Our investment philosophy document gives you an insight into our investment research process. Fill out the form to download your guide instantly.
Do you require a simple system to achieve clarity in your finances?
Focus on the 7 most important figures necessary to create your own basic financial plan.
Discover a straightforward way to eliminate the clutter in your financial life to gain clarity on what is actually important with your money.
About Dan Woodruff
Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.