Having a basic understanding of finance and investing is a must as we are dealing with money every day, there is no escaping it. If you want to start investing, the mumble of terminology and jargon can be off-putting. Do the concepts of bonds, stocks, interest rates, inflation and dividends elude you? Here are some first basics of investing to get to grips with.
But what actually is investing?
Investing is allocating an amount of money, your notional or principal amount, to assets with the expectation of making a profit. You may put money into the stock market, into bonds, cryptocurrencies, or (virtual) property, all with the hope that what you buy today can be sold at a higher price later. When investing, in theory, the entire notional amount you invest is at risk, meaning you may lose all of it. Investments can create better returns than (risk free) savings accounts, especially with interest rates at near zero.
So, what are very common and liquid (meaning you can buy and sell quickly and easily) assets to invest in? Bonds and stocks.
Bonds. What are they?
Bonds are loans issued by governments or businesses (the borrowers) for any period from 1 to 100 years. The borrower pays the lender (you) an interest on the issued loan. This interest payment is called a coupon and is paid at regular intervals. Investors in bonds will have to assess the credit status of the borrower before buying its bond. The better the credit status of the issuer, the lower the risk for the buyer. The credit standing of a borrower is expressed as a rating, ranging from AAA (best) to CCC, not unlike school grades. The ratings are provided by independent, impartial, agencies.
But a low risk also means a low coupon. For example the German government (rated AAA) pays you a 0.0% coupon on a 10 year bond; the UK government (Rated AA) pays a coupon of 0.25% and your mobile phone company Vodafone (Rated BBB) a coupon of 5.9%, all for the same 10 year period (expiry 2032). Vodafone is clearly a higher risk than the German government and hence needs to pay up to attract investors. Buyers of Vodafone bonds may think a 5.9% annual interest is worth that risk.
Bonds can be bought and sold easily, like stocks. Although a bond coupon is fixed, its price is not. If a coupon is 5.9%, like Vodafone’s and interest rates in the UK are 0.25%, do you think the price of the Vodafone bond – set at a 100, called ‘PAR’ at the time of issue – today is worth more than a 100 or less? Would you buy it?
Investing in Stocks
Stocks or shares are totally different from bonds as they represent a fractional ownership in companies that are listed on a Stock Exchange. Businesses sell their shares (equity) to investors to raise funds and investors in turn get a proportionate ownership in that business, they become de facto co-owners. As a shareholder you benefit from the company growing its business as your shares in that business will equally grow in value and – in that case - can be sold for a profit later. The shares of fast-growing businesses, such as tech- and e-commerce companies, as well as cloud providers and electric car manufacturers have appreciated a lot the last couple of years and investors are keen to continue to buy their shares. These high growth companies do not pay out part of their profits (if they have any…) to shareholders. Investors instead have to content themselves with the capital gains they expect to make on their holding.
Companies operating in slower growing industries, like consumer products, insurance, pharmaceuticals or oil- and gas, mostly have shares that appreciate, well, slowly. Such companies, to attract investors, pay out part of their profits in the form of dividends. Dividends work much like bond coupons; it is an amount of money that is paid per share regularly. Unilever, for example, pays shareholders this year £1.44 for each share they hold (current share value £37.91). But, unlike bond coupons, that are fixed for the period of the bond duration, the amount of a dividend payment will depend on the profits made by the company in a given year. During the economic shutdown in the pandemic, for example, many companies suspended their dividend payments. Bond issuers could not do that.
If you like investing in bonds or stocks and you have your (junior) ISA, start by doing your research, create a watchlist of companies and paper-trade for a proper while before diving in. Even when only paper trading, you will learn a ton about finance along the way, which is, once the mumble jumble makes sense, an exciting topic.
Suggested links:
https://www.forbes.com/advisor/investing/what-is-investing/
https://www.hl.co.uk/shares/corporate-bonds-gilts/bond-prices/gbp-bonds?column=maturity&order=desc
https://www.talksforteens.com/finance/invest-the-warren-buffet-way-the-secret-of-compound-returns
https://www.ft.com/content/41d016e5-9b46-4b80-8d40-4a0abbf7f6d6
https://money.cnn.com/2015/04/28/investing/millennial-investor-17-year-old-brandon-fleisher/
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