Investing is about using money to make more money.
In your day-to-day job, you are swapping your labour for cash. With investing, you are using your spare money to make more cash. (Get it wrong, of course, and you could end up with less).
Now, there are two basic ways to make money from money. There’s lending, and there’s owning.
If you understand these two principles, it will make investing a lot clearer to you. Lending and owning underlie all the different types of investment. So they give you a nice, clear way of thinking about all the different ‘asset classes’ you might come to buy.
So let’s look at each in turn…
1) You can lend money, in exchange for an interest payment
The first way of making money from money is to lend your money to someone else. In return for the privilege of having your money, they pay you regular interest payments.
You could lend money to a government, by buying government bonds. (In the UK, government bonds are known as gilts. In the US, they’re called Treasuries).
Or you could lend money to a company by buying a corporate bond. Or you could lend money to a complete stranger, using a peer-to-peer lending company such as Zopa.
Incidentally, ‘lending’ includes putting your money into a bank account. This is vital to remember: when you put your money in the bank, you think of it as ‘saving’. But in fact, you are lending to the bank.
As long as you have £85,000 or less in the bank, then it’s covered by the government’s deposit insurance scheme, the Financial Services Compensation Scheme (FSCS).
So even if the bank goes bust (which should be unlikely in normal times), you should get 100% of your money back. That’s why you don’t get paid much on your savings – because you aren’t taking much risk.
As a whole, lending tends to be less risky than ownership. If a company goes bust, for example, then lenders come higher up the chain for repayment than owners. But make no mistake, there are plenty of high-risk lending opportunities in the market – we’ll explore some of them later in the series.
Now, let’s move on to the second way of making money from money…
2) You can use it to buy a stake (‘equity’) in an asset
The second way of investing is to buy a ‘piece’ of something, so that you become an owner or part-owner of it. In this case, you’re not lending, you’re buying. And you’re buying with the expectation that its value will rise.
The obvious example here is buying shares in a company through the stock market. But it would also include buying equity in a property, or physically buying a precious metal such as gold, or even buying a piece of artwork.
You can further split this category into equity assets that generate an income, and those that don’t. In general terms, income-producing assets are less risky than those that don’t produce any income.
That’s because an income-producing asset at least starts to pay off your investment almost right away. If an asset produces no income, you are relying on someone else buying it from you for more than you paid for it.
Examples of income-producing assets would be shares that pay dividends, or a property from which you can get paid rent.
The first asset allocation decision you make
Why am I telling you this? Because this decision – how much of your money to lend, and how much to invest in equity – is one of the first ‘asset allocation’ decisions you’ll make.
Asset allocation is about splitting your money between different baskets. The point of putting your money in different baskets is to reduce your risk, without hurting your potential returns too badly.
Also, as I said earlier, by understanding these two principles of investing – lending and owning – you’ll be able to make more sense out of all the different investments on offer.
Under the heading of ‘loans’, you’ll have everything from UK government bonds (gilts) to junk bonds to linkers (inflation-linked gilts). Under the ‘equities’ heading, you’ll have everything from blue-chip stocks to private equity investment trusts to property.
Two baskets – that’s a pretty simple start. Of course, it’s too simple. There’s another vital dimension to asset allocation, and that’s risk. We’ll look at how to subdivide these baskets according to risk levels in the next email.
What to do now
Meanwhile, take a look again at where your money is now. How is it split between ‘lending’ and equity ownership? And how much of it would you class as income-producing, and how much is non-income producing?
Write down the rough split. It’ll be a useful reference for next time.
And finally… a third way to make money from money
There is in fact a third way to make money from money: you can get into the insurance business. This is where one party pays another a sum of money in return for the promise of a future pay-out, should a certain event occur.
For example, you can use insurance to protect your wealth from a given outcome, such as insuring your house against floods or fire damage. But you can also use a similar mechanism to bet on a specific outcome, like betting a share price will reach a certain level by a certain date.
There are financial instruments that will allow you to do this. I will touch on them later in the series. But their values all derive from the basic building blocks of the assets in the above categories: that’s why they’re called ‘derivatives’. So it’s important to understand the basics of lending and owning first.