In Part One of our Investing for Beginners series, we looked at why people invest, how much we should invest, and covered the basics of risk and return. In this article, we will delve into more detail about the different types of investment, their definitions, and discuss their uses, benefits, and risks.

Where to invest?

There are several different types of investments you could make. Some are tied to specific goals (like pensions), and others are more fluid, relating to increasing wealth and cash reserves.

Let’s start with the most commonly talked about investment type, shares:

Shares

When we think about investing, most of us think about buying shares. Why? Because they are easily accessible, and easy to understand. Think of owning shares as buying small chunks of a specific company. There are two types of shares that you can own: private or public. Public companies make their shares available to be bought by the general public, they are bought and sold on the open market via an exchange. Public companies are businesses like Amazon, Facebook, and Coca Cola. Private companies do not have shares that are on sale to the general public. Private companies are usually owned by the founders or CEO and they take investment through private deals. Private companies are not necessarily ‘small’ businesses though - IKEA, Dyson and Huawei are all private companies.  

Shares come in different classes (some will give you voting rights or let you make choices on things like the CEO’s salary), and most large companies will distribute some of the profits that the company makes via a dividend payment to shareholders. One of the benefits of owning shares is the chance you have to receive dividends and also benefit from an increase in the value of the share itself. However, investing in shares doesn’t come without it’s risk, as share values can go up as well as down.

Pros:

• Easy (in comparison to other investment types) to buy and sell.
• Possible to make significant gains.

Cons:

• Higher risk - markets can experience a lot of volatility.

Investment Funds

Although some people may want to invest in single stocks, choosing companies based on certain characteristics, i.e. the potential to grow or to distribute large dividends, as described above, can come with large risk. Nobody has a crystal ball, and individual companies (even the largest) can experience a downturn in their fortunes or a scandal that sends the share price plummeting. Many people therefore choose to invest in a fund instead, which has a variety of company shares in a portfolio, and so you will own a small proportion of each of those investments. Typically, funds are set-up to either track an index (passive investing)  or hand over the stock selection to an expert to manage the fund (active investing).

Passive vs Active Funds

As mentioned above, passive investing refers to the strategy that some investors prefer to take and is based on investing in an index; where an index is used to track the performance of a group of companies. For example, you may have heard of the FTSE 100, which is an index of the 100 largest companies listed on the London Stock Exchange or the Dow Jones Industrial Average (DJIA) which represents stock values from 30 publicly traded American companies.

Passive investors prefer to track the entire index and not try to outperform it. There’s very little human involvement with Passive investing. They rely on algorithms to track indexes and make changes (buy/sell) based on this. Investing this way is also cheaper than active fund management with some fees as low as 0.1% p.a.

In comparison, active investors seek to make big returns by using people to outsmart and outperform the stock market. This approach is riskier than passive investing as it relies on stock picking and making bets on certain companies or industries thriving. However, investors also pay a higher fee to their fund manager for this, and may pay a performance fee as well if returns are strong. Commonly, fees are around 0.75% p.a. for actively managed funds.

Finally, when it comes to investing in Shares, there is the newer concept of Ethical or ESG investing to consider.

Ethical/ESG Investment

‍There is a growing demand by investors to have more say in where their money goes and who it benefits. There are two main types of ‘moral’ investing - ESG and Ethical. Let’s look at ESG.

ESG stands for ‘Environmental’, ‘Social’ and ‘Governance’. This framework is used by fund managers to assess a company on its financial future concerning their environmental and social impact and how it’s run. The managers are less concerned with the morality of the company itself, but use this criteria to predict how prosperous the company will be in the future. The idea is that the less environmental impact, the higher the social conscious and the more well-governed a company is, the better they will perform vs their competitors. Fund managers will encourage the companies to implement acceptable practices suggesting they improve things like energy efficiency, pay living wages and are transparent with tax. If companies don’t respond favourably, the fund managers may choose not to invest.

Ethical funds use set principals as a guideline for which companies to invest in. They will not invest in specific companies or sectors like tobacco, alcohol, weapons or companies that test on animals.

The increase in the number of Ethical funds available, means that investors have an easy system to ensure that their money is invested based on their personal beliefs. This type of investment is not looking only at the company’s performance, it has a mandate to avoid certain companies and industries. This doesn’t mean that the ethical funds can’t make good returns; but ethical investors may feel that investment returns should not come at any price.

Aside from shares and funds, there are plenty of other asset classes where you can invest as well:

Bonds

This is where you loan a company or government your money in exchange for a fixed amount of interest, over a set amount of time. The agreed interest is paid throughout the time of the loan. After the set time is passed, your initial investment will be returned to you. As you can imagine, government bonds are pretty secure, as they are backed by the state. However, you can also invest in corporate bonds, where investing in smaller, higher-risk companies often come with higher interest rates to tempt investors, as they are less secure.

Pros:

• Less risky than stocks. In the event of liquidation, bondholders are paid back first before shareholders.
• Fixed returns so you’ll know how much you will make.

Cons:

• Exposed to interest rate risk. Bonds are affected by interest rates, so if interest rates go up, the value of the bond will go down because the fixed rate of interest with it is suddenly less desirable.

Property

Buying property for investment purposes can be done directly through buy-to-let or indirectly through Property Funds, which typically buy commercial properties. Whichever instrument is being used, the investor is relying on rental income and hoping the capital of the property rises over time. The risk here is often tied to interest rates: a rise in rates will have a knock-on effect in any mortgage secured to the property, and changes in the property market: falling house prices could leave you with negative equity (which is when a property is worth less than the attached mortgage). On top of this, your money is not very liquid: it takes time to release capital from a direct property, and property funds often have long redemption periods. Not to mention the costs associated with selling the property if you own it yourself.

Pros:

• Opportunity to benefit from house price rises.
• Can make money via rental income.

Cons:

• Property is expensive to buy. You might need a large deposit or mortgage.
• It’s illiquid. Getting the money out to invest or use elsewhere can take a lot of time.

Real Estate Investment Trusts (REIT)

A REIT is a type of alternative way to invest in a property fund, so instead of owning a property outright, you invest in a company that owns or operates income-generating real estate. This can be commercial or residential property, and you're paid dividends on your investment.  

Pros:

• Easier to liquidate your cash than direct ownership, compared to individual property ownership.

Cons:

• Not very diversified. Most REITs only invest in one type of commercial property which could leave it open to economic issues.

Crowdfunding

In recent years, companies, individuals, and charities who want to raise money have been able to pitch for money via a crowdfunding website. It’s significantly easier and faster to invest in a private company (one that you can’t find in the stock market) via a crowdfund as it’s all done on the platform, plus the terms are usually straightforward. There are different types of crowdfunding which you can invest in:

1. Loan crowdfunding: also known as peer-to-peer (P2P) or peer-to-business (P2B) lending. The investor is offered a set interest rate on return of their money.
2. Investment crowdfunding: you invest in a business in return for shares in the business.
3. Reward crowdfunding: your money is given in return for a reward that is tied to the project. For example, a startup clothing store wants to produce a new range of coats made from sustainable fabric. They want to raise £5k to produce the garments. If you invest a set amount, you’ll get a new coat and another product of your choice once they reach their target.
4. Donation crowdfunding: usually for charities, you donate money to their cause and they sometimes offer a reward in return.

Pros:

• Small initial upfront investment. Many crowdfunding opportunities allow you to invest with very low minimums.
• The rewards can be significant. Depending on the level of risk you are willing to take, your investment could really pay off.

Cons:

• It can take a long time to see any returns from private companies.
• It can be really risky, especially if you are investing in startups as they are not yet established and are at a large risk of failure.

Commodities

Commodity trading is one of the oldest forms of investment there is. It has a long history, and many traders turn to commodities during periods of market volatility because they often  move in a different direction to stocks, as investors go after “safer” assets in market turbulence. It’s also a good way for investors to diversify their portfolio. Commodities are goods like gold, oil, natural gas and grains that are traded.  Commodities markets are based on the principles of supply and demand - low supply creates higher prices, and the market can be unpredictable as it’s affected by things like weather patterns, natural disasters, epidemics, and human-made factors (such as war).  

Pros:

• Protects against inflation because as the price of goods rises, so does the price of the commodities needed to produce these goods.
• Good for diversification. They have a low correlation with stocks and bonds, which is good if you want to hedge your bets against your other investments.

Cons:

• Outside of changes in the price, commodities don’t generate any income for the investor.
• Commodities can be very volatile, which may be off-putting for some investors.

Cryptocurrency

Cryptocurrency is one of the newest forms of trading and investment. Bitcoin is the most famous cryptocurrency and the one that probably initially piqued the interest from crypto traders. They are a type of digital asset or virtual currency that is not governed or issued by a central government. They use a network called Blockchain (which is a digital ledger) to secure the transactions of buying and selling. Cryptocurrencies are traded much like traditional stocks, and some have likened them to “digital gold” where the price is created due to a finite supply and determined purely by demand

Pros:

• There are several online exchanges where you can buy and sell your crypto based on the current market value.
• It’s easy to buy and trade - all done online or via apps which makes it quick to get started.

Cons:

• They are not backed by financial organisations or the government, so if your coins get hacked or lost - there’s no way to get them back.
• The markets are also open to manipulation by entities that hold a large amount of crypto - called ‘Whales’. They can alter the market for their gain - buying or dumping a considerable amount of crypto, which changes the base value.

As you can see, where you decide to put your money and for how long is just as important as how much you invest. When choosing the right products and instruments for your money it is important that you understand what it does, the pros and cons, liquidity, and costs; ultimately making sure that it fits into your investment objectives and timelines, which we will cover next week.