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Why invest and what do you look for?

Security vs risk

Return on capital

Access

Your tax situation

Inflation protection

Personal views

 

The immediate answer is often 'for maximum growth' or 'for maximum income' but it pays to take some time to determine exactly what these terms mean to you and to analyse your needs and your aims. It is unwise to make important financial decisions the week you leave work. It is far better to wait until life settles in to its new routines before making long term and binding financial commitments.

  • If, after doing your budget, you find you need additional income, how much do you need, what will you do with any remaining capital. Will your need for income change in the next 10 years. Why and by how much? Will your tax position change or your mortgage or other loans drop away?
  • If, after doing your budget, you find you need additional income, how much do you need, what will you do with any remaining capital. Will your need for income change in the next 10 years. Why and by how much? Will your tax position change or your mortgage or other loans drop away?
  • If you do not need income at the moment, how will you preserve (or increase) the value of your capital? You may need the income it can generate at a later date. 
  • Will you have a specific need for a capital sum during the next 10 years? What for, and can you 'pigeon hole' money for that purpose? (eg. renewing the car). 
  • You may want an 'emergency fund'. Have you decided what an 'emergency' is? (Damage to most major items should be covered by insurance). How much do you need, must it be on immediate access or would, say, thirty days be adequate? How will you replenish it if you withdraw cash?


Security
How 'safe' is your money? This question can apply as much to income as to capital.

One reason frequently quoted for putting money in a building society account is that the capital is safe. That is certainly true if one discounts the effect of inflation, but what about income? Bank and building society rates move up and down so that the resulting income is variable. Income from deposit investments is certainly not risk free and ensuring that income does not fall could be an important aspect after allowing for inflation.

Some investments offer guarantees. It is important to ask what is being guaranteed and is it realistic? If rates are quoted much above the average they may involve increased risk of some sort. How well is the capital protected if income is guaranteed?

Risk
All investments include some form of risk. These range from the unpredictable variations in income if you rely on building society variable interest rates to major changes in the value of your capital when invested in equities which inevitably fluctuate with the markets. The risks need to be understood and put into context when planning.

Risk can be minimised by considering a wide spread of investments rather than putting all your eggs in one basket. For instance, £1000 in each of three unit trusts might be considered rather than £3000 in one.

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Returns
Returns can be in various forms depending on the type of investment. The kind of return you look for will depend on your personal circumstances.

Interest
is paid on deposit investments such as bank and building society accounts. It is the 'rent' they pay you when they borrow your money. It is usually variable and it increases or decreases in response to external factors like inflation and bank base rates. The original capital sum invested will not change but its purchasing power will be eroded by inflation. Over the long term, if the interest is left in the account, and the overall interest rate remains at 20% above inflation, the net return will just keep pace with inflation for a standard rate taxpayer. If the rate is below that, the money is losing purchasing power.

Dividends
Dividends are paid to the holders of shares, unit and investment trusts. They are your share of the profits generated by the underlying companies. Depending on the particular vehicle, the dividends may be reinvested or taken as income. Unless the investment is specifically designed for high income the dividends are usually a smaller percentage of the capital invested than in a deposit account. However, shares are normally intended to provide capital growth which the deposit account does not offer. The dividend income is taxed at source and the tax is not reclaimable for non taxpayers.

Growth of capital
If you invest £1 and some time later, disregarding any dividends or income, it is worth £1.25, the investment has achieved capital growth, ie. the value of the asset of which you have a share, has increased. This growth can only be achieved by some form of equity based investment. It cannot be guaranteed, nor can any rate of increase be predicted. The value may also go down even though dividends may continue to be paid.

This type of investment is used to try to preserve the value of capital over a longer period. Equity based investments have outperformed deposit based returns over most periods in the past but, of course, this is no indication that they will continue to do so. Equally, there is no guarantee that any one share, or even a small portfolio of shares, will follow the main direction of the stock market.

Guaranteed 'income'
Income may be guaranteed to be paid at a fixed level for a fixed time from certain types of investment.

Some 'bonds' from insurance companies offer fixed returns. Generally speaking, the income is generated from the increase in the value of the capital invested via some form of market exposure. If the value increases at the same or a greater rate than you are withdrawing as income, the capital remains intact. If, however, performance falls, the income will still be paid but capital may be used to retain the income guarantee.

Corporate bonds offer fixed interest/income over a period and aim to return the capital intact at a later time.

Government 'Gilts' offer a guaranteed interest and a guaranteed repayment of capital at a fixed time.

Discuss with your financial adviser what kind if return you want, how often and in what form. Ask how the income is generated and what will happen to your capital if performance is lower than anticipated.

Click on Financial Products for more detail.

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Accessibility
Consider why you might need access, to what proportion of your capital, how quickly and how much you might want. Is it likely that you would want to draw all your money out at once?

Many investment options are available, some allow you immediate access to your cash and others require it to be tied up for longer periods. In some cases you have access to cash but only on penalty of losing some interest, in others, the quoted overall interest rate does not become available until late in the term of the investment, as with National Savings Certificates.

Access to your capital is of course, very useful, not just because some emergency could arise when it becomes essential to be able to get at the money, but because the investment climate or the tax rules can change. What originally seemed a good investment may become less attractive over time. All investments need to be reviewed regularly.

There are variations to this theme which need careful consideration when choosing a long term income or capital growth investment product.

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Your tax situation
This may be straightforward or it may change in time - allowances change yearly, your tax rate may change. It is necessary to be aware of these changes and to check whether they affect the tax efficiency of your arrangements.

If you are married, are you ensuring that both sets of tax allowances are being used effectively? (Unmarried partners may also benefit but the necessary transfer of assets may give rise to capital gains tax liabilities).

No one likes to pay tax if they do not have to and if you receive interest or dividends from investments then income tax rules will apply to it. However, if income is not the main priority, it may be better to invest with the objective of capital growth. This would allow Capital Gains tax allowances to be used before being subject to tax on the returns and the advantages can be considerable.

It is equally important to understand how tax exempt Individual Savings Accounts can be used to advantage. These ensure that the income and any capital gains are retained free of tax by the investor.

Care needs to be taken, however, that the investment is made because it is right for your circumstances and not just because of its tax treatment.

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Inflation
A factor often overlooked in planning investments is the effect of inflation. No one can afford to be careless about money, particularly when employment ceases or is interrupted. It is also important, however, not to be so cautious that you become steadily poorer just by trying to avoid taking any risk with your capital. The true value of what may seem to be a satisfactory income can be steadily eroded by inflation.

When the interest rates offered on deposit investments are 20% or more above the level of inflation and all the interest is re-invested, the original capital investment will retain its real purchasing power. If interest is spent as income, the true value of the capital is reduced each year and this in turn erodes the value of its income.

Although inflation is very low at the moment, a steady erosion of capital still occurs if it is kept in accounts offering very low or even no interest. A deposit investment which appears to take no risks can, therefore, lead to falling values of both income and capital. To produce income and retain its true value, it may be necessary to invest some of the capital in real assets such as shares.

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Some personal factors

Age
Your age affects the type of investment you choose. It is as unwise for a 50 year old to take out an annuity as it would be for an 85 year old to lock capital away for ten years. Will you need for income change as you get older? Do you want to preserve capital for a long time or gradually spend down?

Conscience
With a wide range of investment options available, some people choose to select or avoid those with connections or activities which agree with or conflict with their own principles, eg. weapons manufacture, green issues, ethical investments etc.

Involvement
Do you intend to keep up to date with your portfolio and make changes as the situation demands or would you rather put the money away and not worry about it? Your own level of understanding and your peace of mind influences your choice of investments. It is no good having a good investment if you are always worrying why it is not good 'this week'.

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Bucks HP22 6EA
 

Dwildey@call-rcs.co.uk