Understanding Investments

When to Invest

If you have some spare money left over each month, you have a choice about what to do with it. You can pay off long-term loans such as a mortgage, you can save it somewhere, or you can invest it.

How do you decide what is the best option?

First, if you have large amounts of short-term debt, you should pay this off first before investing. You should not be considering savings or investments if you have large amounts of expensive short-term debt such as credit cards or short-term loans. Any spare money should go on paying off those debts.

However, long-term debt is different. If you have a lump sum, you might choose to pay off some of your long-term debt, such as your mortgage. However, you might also invest your money. What you choose will depend on whether you think your investments will make more money over the long-term than you will spend in interest on the loan.

Beyond that, the choice between savings and investments is usually made based on your time horizon.

Generally speaking, you should save (in cash) if you are going to need the money in the next five years. If your investment horizon is longer than that, you may be better off considering one or more of the other classes of investment.

However, before you embark on any investments, it is a good idea to ask yourself a few questions:

Do you have access to some emergency cash savings in case you need them quickly? You don’t want to be liquidating investments just to fix a broken boiler, especially if the stock market has suddenly dropped.

Can you afford to lock your money away for a longer period? If the answer is no, then savings are your best route.

Can you afford to lose money if the value of your investments goes down? The value of investments can fall as well as rise, and it is important that you are comfortable with the idea that you may lose money.

WARNING! Investing is not a ‘get rich quick’ scheme

Investing is a long-term business. It should never be seen as a way to ‘get rich quick’. If you are thinking of ‘a quick investment’ in ‘a sure thing’ as a way to boost your household income rapidly, then before you invest, you also need to understand your attitude towards financial risk.

Understanding and Managing Financial Risk

Financial risk is defined as the possibility of losing money on an investment.

Every investment carries some level of risk, because it is always possible to lose at least some money on it. A very risky investment would carry a much higher chance of losing all your money.

However, the concept of financial risk is inextricably bound up with the idea of reward. A riskier investment will have a much higher potential pay-off, to compensate investors for the potential risk. In other words, if you are prepared to accept a higher chance of losing your money, you could also make a lot more.

Risk = Probability

Risk is simply a word used to express a specific probability: whether you will lose money on an investment.

Potential investments range from very low risk right up to very high risk. A high-risk investment carries a higher probability of losing money than a low-risk investment. Low-risk investments include putting cash into a savings account, or buying government bonds. There is a very low chance that you will lose money—but it is still possible. There could be a run on the bank. High inflation but low rates of interest could also mean that your money loses value, even if you still get back what you put in., higher risk investments include investing in shares traded on the stock market. The risk is higher if you invest directly in specific companies and even more if you invest in young companies and start-ups. However, you can mitigate the risk by investing in funds that group different categories of investment together.

In financial terms, risk cannot be separated from reward.

An investment that carries a higher risk will also carry a higher reward. The issue is what level of risk you are prepared to accept for the level of reward. Risk is not inherently bad, many people see ‘risk’ as inherently bad: the thing that will lose you moneys