This article was originally published here in February 2002
The first questions for any investor are: "Why invest in the stock market? Surely it's far too risky? Couldn’t you lose all your money? Isn't it safer to put your money in the bank?"
It is certainly true that your money is very safe in a bank. Even if the bank runs into trouble there is a government-backed guarantee for the first £20,000¹ in any account. However, bank accounts do not pay a great rate of return. I am investing for my retirement, an event that is decades away. The superior rate of return from stock markets will smooth out any short-term fluctuations in the value of my portfolio.
When you deposit money with a bank they do not hide it in their vaults. They need the money to grow in order to pay the interest that you expect. Banks lend your money to individuals and businesses. They charge a higher rate of interest than they pay you. This allows them to cover any bad debts and make a profit.
Individuals tend to borrow to spend but businesses usually borrow to invest in themselves to increase profits. They will only borrow money if they think that the payback will be greater than the cost of borrowing. As long as a majority of companies get it right the stock market will outperform the return from bank accounts.
Many people choose to invest in the stock market through unit or investment trusts. These are known as "pooled funds" as your money is placed in a pool along with everyone else's. This pool of money can buy a wider range of investments than you could by yourself. Spreading your money widely makes it safer as you will be less affected by the failure of any one investment the pool has made.
Pooled funds came in for criticism over the past decade as the funds often underperformed the markets they invested in. This gave rise to "index tracker" unit trusts that are low charging funds whose aim is to simply replicate the performance of stock market indexes.
I feel that pooled funds have their uses. If you want to invest in foreign markets like Japan or Eastern Europe it is practically impossible to do this yourself. Investment trusts can create different classes of investments to fill particular needs such as secure growth or high income.
When investing in the UK I prefer to do the job myself. I select companies and invest in them directly. That way I avoid paying someone else to manage my money. I tend to invest in a small number of companies, so as long as they do well I get a higher rate of return compared to a diversified pool of investments.
Life has become much easier since the advent of the internet and online stockbrokers. I remember having to walk down to my bank and wait while they phoned in my order to their dealing room in the city. I can't remember what they charged me but I'm sure it was an arm and a leg.
These days I just bring up my broker's web page and my order is dealt with in seconds. I also use the internet to select which shares to invest in. There is a great deal of free data available and most companies have their annual reports for download.
That is my overall approach to funds and shares, asset allocation in other words. Next month I will detail the criteria I use to choose shares, and how I select winners and avoid losers.
¹ The guarantee has been increased to over £30,000 since I wrote this article