How different investments work

How different investments work

How different investments work

This page explains how different investments work. There are a number of ways to invest including:

  • By picking stocks and shares in individual companies
  • By investing in a fund
  • By investing in bonds or gilts
  • By investing etfs

Here’s a bit more information about different investments work.

Picking individual stocks and shares:

If a company is a PLC, it offers shares to members of the public- you and me. That means that anyone can buy a proportion of a company.

Here’s a simple example of how shares work. Let’s say you buy 1% of a company for £10. (1% of a company would obviously cost more than this, but this keeps the maths simple.)

If the value of the company grows by 20%, your share that you paid £10 for would be worth £12, making a £2 profit if you sold your 1% share.

The company may choose to pay a dividend out of it’s profits. If it paid a 5% dividend once per year, you’d earn 50p plus you’d still own 1% of the company (and hopefully get a dividend again next year too).

The value of companies can also fall. If the value of the company falls by 50%, your £10 share is only worth £5, and you would make a £5 loss if you sold it. Bear in mind, you don’t make an actual loss until you sell. Share prices rise and fall, so it may recover and soar in value.

If the companies goes bump, that’s basically your money gone and no chance of getting it back.

It’s not a good idea to put all your money into one company for this reason.

These calculations are all theoretical to indicate the impact on your investment in various circumstances.

By investing in a fund

This lets you invest easily in lots of different companies. A fund collects the money of lots of different investors (so your £10 joins with mine and everyone elses’ investments) and is spread across lots of different companies. Your £10 could be split across 100 different companies. Some might do well, some might do badly. There are likely to be periods when the majority do well (resulting in gains for you), and when the majority do badly (resulting in losses for you). Don’t forget, you could see a fall in your investment followed by gains (and vice versa). Selling will guarantee your loss, so don’t sell at the first sign of trouble.

One or more companies could go bump. But the likelihood of all companies within the fund going bump is much slimmer than one on it’s own. Therefore, the risk of loss is lower.

Bonds and gilts

The UK government (and other governments around the world) will sometime issue what are known as government bonds, or in the UK, ‘gilts’. When you invest in this way, you are effectively  lending money to the government for a fixed return.

Government bonds and gilts have a specified term (such as 10 years) and a specified return (such as 2%). They’re generally considered low risk because the chances of the government going bankrupt are considered pretty slim (in spite of our frightening level of national debt!)

They have lower risk than funds and individual stocks and shares, but they also tend not to have as high a returns.

In theory, when stocks and shares do well, gilts are a bad investment, and vice versa. Holding a proportion of your investment in gilts is widely considered a good way to reduce risk in your portfolio.

Gilts can be bought and sold, just like funds. If gilts have risen in value since they were issued, they cost you more to buy.

For example, if the original investor has bought £100 in gilts with a 2% annual return, and people perceive them to have greater value, that £100 in gilts could cost you £120. The original investor no longer has the gilt, but has £20 more than he paid. Although you now hold the gilt, you will only receive 2% on the original value, i.e. £100, even though it cost you £120 to buy.

In the same way that governments can borrow money from investors, companies can also issue bonds to investors.

ETFs

This stands for exchange traded funds. My understanding of these is extremely limited, so rather than give you the wrong information, you’d be better consulting an alternative source!

Does this help you to understand the basics of stocks and shares, investment funds and government and corporate bonds? Do you already invest and what do you have in your portfolio?

 

2 thoughts on “How different investments work

    1. I think it’ll be a while before I pick individual shares if I do at all. Unless my attitude changes over time, they’re more risk and effort than I’d like to take, so the plan is to stick with funds. In the UK, I find the cost of trading is prohibitive but that should change once the size of your investments grow. 🙂

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