Even if you’re not mathematically-minded, it’s worth wrapping your head around these concepts when you're working out your investment plan.
Softly, Softly (or Pound-Cost Averaging)
You don’t have to be rich to rule your financial future, as Tom Jones might have considered singing. A common misconception of planning for retirement is that you need to start with a large pot of money. In fact, putting aside a smaller amount on a monthly basis can be a very sensible way of investing for the future. It’s less of a burden on the bank account, it ensures a disciplined approach to investing, and it helps mitigate emotional decision-making.
‘Pound-cost averaging’, as it’s unexcitingly known, means drip-feeding money—say, £200 per month—into an investment. This investment could be, for example, a global equity tracker fund within an ISA wrapper. The peaks and troughs of the stock market cycle are thus smoothed out when you invest bit by bit, and the risk of investing at a peak or trough is spread out. Do note, however, that while this strategy can help you avoid the worst of the losses, it also means you’ll miss the best of the wins. For a more in-depth explanation, click here.
Of course, if you’ve saved up a large chunk of cash or you’ve recently received a windfall, you might want to put it all into your portfolio to avoid getting tempted into ill-advised expenditure. If that’s the case, make sure you read our article ‘4 Tips for Investing a Windfall’.
Money Grows on Money (or Compound Interest)
‘Compound interest’ is often called the eighth wonder of the world because it seems to possess magical powers like turning a penny into £5 million. The great thing about compound interest is that it helps us to achieve our financial goals, whether they are so ambitious as to become a millionaire or simply to retire comfortably, free from financial worries.
The principle is simple: invest one pound for a year at an annual interest rate of, say, 10% and your money will be worth £1.10 at the end of the year. Continue to invest the £1.10 for another year, get the same 10% on the whole amount and you’ll end up with £1.21 after two years. The first year earned you only £0.10, but the second generated £0.11.
In this example the extra penny earned might seem insignificant, but extrapolate this relationship out a few years, and input some larger numbers, and the significance quickly becomes apparent. To read more about how the numbers stack up, click here.
Spreading the Love (or Diversification)
Not strictly a mathematical concept, but diversification is still your friend. In essence, the act of spreading your invested money across different asset classes and investments should mean that regardless of what happens, your portfolio is protected from extreme volatility and steep drops in value.
It’s easy to imagine that if you invested £10,000 in companies that manufacture cigarettes and then the world’s governments outlawed smoking, your portfolio could go up in smoke. If, however, only 20% of your assets were in tobacco firms, while the remaining 80% was split between shares in pharmaceuticals companies, financial services companies, oil & gas explorers and technology stocks, the ban on smoking wouldn’t hurt so much. Of course, in this scenario, you’d still be at risk in the case of a stock market crash, since 100% of your portfolio is in equities, so again, you could mitigate this risk by also investing in fixed income (government and corporate bonds), property, commodities and also keeping some cash tucked away. Of course, if you diversify your portfolio in this way, and then the world’s governments make smoking compulsory for all, you would likely have been better off with the first portfolio of 100% tobacco manufacturing stocks.
The question here is: how well do you want to sleep at night? If you’d rather rest peacefully, happy in the knowledge that you’ve done your best to prepare for all situations, then diversification is for you. Alternatively, you might be a risk-junkie who prefers to stay awake at night trying to find the best time to get into—or out of—the market. But for most investors, diversification is the best way forward.
In a nutshell, instead of trying to select individual asset classes based on current market conditions, financial advisers would recommend you simply build a broadly diversified portfolio consisting of multiple assets classes. In most cases, the four main asset classes of Cash, Fixed Interest (Bonds), Property (Real Estate) and Equity (Shares) should be enough to construct a portfolio with the desired risk and return characteristics. A good financial planner should be able to help you assess your own risk tolerance (your risk comfort zone) and, perhaps more importantly, your risk capacity (the amount of risk you need to take to have a reasonable chance of meeting your objectives). This is often a balancing act requiring a considerable amount of fine-tuning to arrive at an acceptable investment portfolio.
