Why do people invest their money? In short people invest their money in shares, real estate, financial schemes or commercial ventures with the aim of growing their money over a period of time. Given the extremely low current interest rates on traditional savings accounts offered by banks, it’s easy to understand why people may wish to invest their money instead.
You may be torn between whether to invest your money directly through buying individual shares or indirectly through an investment fund. Before weighing the pros and cons let’s explore how both of these work:
Individual shares - buying individual shares of a company represents fractional ownership in proportion to the total number of company shares. Owning shares in a company i.e. being a shareholder gives you the chance to make gains through:
1. Dividends, which are sums of money paid over a certain period (usually once a year) from a company to its shareholders out of it’s profits.
2. Capital gains, which are the profits gained from the sale of an asset, for example shares or real estate.
However, it is very important to take into account that not all companies pay dividends or pay them every year, this is never 100% guaranteed as companies are not legally obligated to do so. Capital gains are also not promised; it is possible that the value of shares (or assets in general) fall over a period of time or from when you purchased them.
Fees are also charged when buying and selling shares, these will vary depending on the volume of trades and the investment platforms you use, so it’s worth taking these into consideration when doing your analysis as these will diminish your investment earnings.
Funds - investing via funds involves pooling together the money of lots of different investors, a fund manager then invests on their behalf.
Funds are not limited to companies, they can also invest in other assets such as bonds or real estate depending on the type of fund and it’s objectives. The key advantage of investing via a fund is that since your money is spread across multiple names (i.e. diversified) the risk of losses to your overall portfolio is reduced.
There are typically 2 types of funds: active funds and passive funds which are also known as tracker funds.
Active funds are those that are ‘actively’ maintained by a designated fund manager. Fund managers use their research and expertise to select which shares or assets the fund will invest in. A key benefit of having fund managers is that they adjust the fund's holdings on an ongoing basis depending on performance and changes in market conditions. This means that you don’t have to worry about managing your investments yourself, however, in exchange for this ‘active’ management there are ongoing charges. The ongoing charges figure (OCF) consists of the fund manager's fees for running the portfolio as well as other costs such as administration, regulation and marketing.
Passive funds or tracker funds are those that replicate the movement of a particular index, let’s take the FTSE 100 index as an example. If your fund is tracking the FTSE 100 index, it will use the money you deposit in the fund to buy shares in all 100 companies in proportion to their market value, the fund will then move in harmony with the changes in the value of the FTSE 100 index.
Some of the benefits of tracker funds are that their fees are lower and they are low maintenance, so you don’t have to worry about which investments to buy or hold as the fund simply ‘tracks’ the market. A drawback with this type of fund is that your returns depend solely on the performance of the index so if the market drops, so will your earnings.
An analogy that helped me get my head around investing via individual shares and investing via funds is thinking of them as types of restaurant menus when dining out (I know, bear with me!). Imagine the former being an à la carte menu and the latter being a buffet menu respectively; an à la carte menu is one which allows you to order individual dishes from a list (perhaps 1 or 2 for the starter, 1 main dish and a cheeky dessert) whereas a buffet allows you to pick small portions from a variety of foods and dishes. Buying individual shares is like picking a few or more names from a list of shares and investing your money in these names whereas investing via funds is like investing a sum of money and having small shares or portions in a variety of assets. Neither one of these is the ‘right’ way to invest, it simply depends on the preference of each investor.
It’s important to understand what type of investor you are, this will depend on factors such as: