Investing in stocks and shares: a beginner's guide
While there is some risk involved, if you're putting money away for the long term, there are a number of reason why it pays to invest in stocks and shares.
With its financial jargon, pinstriped suits and city traders, the investment world can seem a very daunting place.
But, while there is some risk involved, if you're putting money away for the long term, there are a number of reason why it pays to invest in stocks and shares rather than plump for a more traditional savings account.
The main benefit of investing rather than saving is that, over time, stocks and shares have the potential to deliver a higher return. Even though their performance may fluctuate, studies have shown that if you're able to leave your money invested, it will deliver a higher return than if you'd opted for a savings account.
This can be seen in the Barclays Capital Equity Gilt Study 2013. This compares the performance of different asset classes since 1899 and it found that if you had invested over any five-year period since then, the performance of the UK stock market would have beaten cash 74 per cent of the time. Increase the time period to 10 years and this outperformance increases to 90 per cent of the time and, if you invest for an 18-year period, the probability that equities will outperform is 99 per cent.
To further illustrate the power of equity investment, the study also showed that if you had invested £100 at the end of 1899, by 2013 it would have grown to £1,837,824 compared to just £20,294 if it was in cash or £32,961 if in gilts.
Reach your goals faster
These potentially higher returns mean you can achieve your financial goals quicker. For example, say you wanted to save £30,000 towards a mortgage deposit and you were able to put aside £200 a month. If you saved it into a deposit account paying an interest rate of 2 per cent after tax, it would take you 11 years and three months before you reached your target.
Invest it into shares giving an annual return of 5 per cent after tax and it would take nine years and 10 months before you could go house hunting. If stock markets perform well and you achieve an average annual return of 7 per cent, you'll only need to wait nine years and a month.
Where your time horizons are longer, the difference in returns between savings and investments is even more marked. For example, if you decide to save £200 on a regular basis, over a 30-year period this would amount to £98,252 if it was in a savings account paying 2 per cent after tax or to £163,075 if it was invested and achieved an average growth of 5 per cent a year.
In addition to an opportunity to beat interest rates on savings, investing in shares also improves your chances of beating inflation. Keeping ahead of inflation is important: allow the return to fall behind and the purchasing power of your money will be eroded.
For example if you held £10,000 in a savings account for five years receiving interest at 2 per cent but inflation was 2.5 per cent, at the end of the period the spending power of your money would have fallen to £9,752.
While getting the balance right is essential to beat inflation, to illustrate how savings and investments stack up, consider the consumer price index figures for September 2013 when it was 2.7 per cent. At the time, data from Moneyfacts showed there were just a handful of four and five-year fixed-rate cash Isas and a couple of seven-year fixed-rate savings bonds with rates that would have beaten this. In contrast, the FTSE All-Share index had significantly beaten inflation with an increase of 13.92 per cent for the 10 months to the beginning of November 2013.
Additionally, while the past performance of the stocks and shares is no guarantee of future returns, as inflation is based on the price of the goods you buy, it makes sense to invest in the companies that produce or sell these goods. As inflation rises, their fortunes should see an uptick too.
Investing can also give you access to a number of tax breaks that you simply won't get from a savings account. Stick with savings and you'll be able to squirrel away your annual cash Isa allowance (£5,760 in the 2013/14 tax year) and take advantage of some of the NS&I tax-free savings certificates when they are available.
But as an investment in stocks and shares is effectively an investment into a company, the government has created a variety of tax wrappers to help encourage stock market investment and boost the UK's economy.
These include a more generous Isa allowance (up to £11,520 in 2013/14 minus anything paid into a cash Isa), pensions, venture capital trusts and enterprise investment schemes.
Another important advantage of investing over saving is the huge choice that is available. While you might need to weigh up the interest rate, the strength of the bank or building society and any terms and conditions around access on a savings account, with an investment you'll look at factors such as the type of company, its management and location, its past performance and growth plans, to assess whether it's a good investment.
Although this can seem daunting when you're selecting your first investments, many investors start out with shares in companies they know and understand, for example their employer or their favourite high street retailers, before learning about other sectors.
Alternatively, some investors prefer to pass the bulk of the decisions over to an experienced professional by investing through a fund or investment trust where the manager picks the underlying holdings on their behalf.
However you choose to invest, this diversity also means that you can pick investments in line with your principles. For example, if you want to support renewable energy projects you could look for companies involved in this area or if you had strong views on smoking you could avoid investing in the tobacco industry.
But, although investing offers a number of benefits, it's also important to remember it's not a risk-free way to make money. The value of your investment can fall as well as rise and, although time can smooth out the ups and downs, understanding how to invest can make it a much more comfortable ride.
If you want to buy shares please consider Interactive Investor, our sister site and award winning brokerage.
We make every effort to ensure our beginner's guides are kept up-to-date. However, in the constantly shifting environment of investment and financial services, occasions may arise where elements of a guide become out-of-date. Please double-check the facts before taking any important financial decisions.