A very short beginner's guide to investing

If you're just starting out in investing, then sooner rather than later, you are likely to come across the labels, "passive" and "active".

"Passive" describes investment funds that simply track an underlying stock market. This underlying stock market might be the FTSE All-Share for the UK, say, or the S&P 500 in the US.

"Active", meanwhile, describes those that try to beat the market, rather than track it.

I’ve never really liked these labels.

The view they give of the investment process is way too simplistic. And the choice that they suggest – that of a lazy investor willing to accept second-best, as opposed to a dynamic one willing to risk it all for glory – is misleading, particularly for those less familiar with the financial industry jargon.

The fact is, everyone has to make “active” investment choices - even if they would prefer not to.

Let me explain, with the aid of a typical beginner investor’s journey.

Here’s what you need to do before you even start thinking about investing

Making the decision to start taking investing seriously is anything but passive. As an individual investor, the first thing you need to do – before you even consider sprinting into the maw of the stockmarket – is to work out where all your money is right now.

Because unless you really are just starting out, you probably have bits of company or public sector pensions hanging around, the odd insurance policy, savings accounts, you name it – our finances, like our desks, can become remarkably untidy over time.

So first you need to get a handle on where everything is right now.

Then you need to sit down and work out where you want it to be.

The good news is that for most of us, this really isn’t complicated. First, clear your debt, except your mortgage or student loans (these two are a whole other topic). There’s no point on saving and investing at one end if you’re paying out double-digit interest on a loan at the other end.

Second, think about what you are saving for. Again, for most people, this is pretty simple. You need a “rainy day” cash fund of about three to six months’ salary, so get that stashed away first.

Beyond that, most people’s savings goals boil down to two things: a house and retirement. (If you’ve got enough money to deal with those two, you can then start to worry about what I like to think of as “luxury” financial goals – these include the kids’ education, future deposits for homes for your offspring, funding a career break or gap year, and the like.)

If you’re saving for a deposit on a house, that’s a short-term goal, so realistically, most, if not all, of that money has to be saved in cash. (To be clear, buying a house is not the right decision for everyone or at every point in time. This is just a generalised illustration of what most people want).

Once you’ve paid off your debt; set aside some cash for emergencies; and satisfied your housing needs, then what’s left is retirement.

Again, this is not complicated. One day you will want to, or have to, stop working. Put another way, you will no longer be swapping your time for an income.

So what you need to do now is to build up a pot of money for the distant (or not-so-distant) future, to take the place of that income. Do it property, and not only will your time be your own to spend as you wish, but you will also be able to maintain your standard of living, using the money you saved up during your working lifetime.

In the UK, there are two main savings vehicles that are used for these long-term savings: Isas, and pensions. I won’t go into the details of each here, but the point is that they are both tax-efficient in different ways. Tax efficiency simply means that you don't get taxed as heavily on these savings, which allows your money to go further. So your investments should be held in one or other or both of these tax-efficient "wrappers" (as they are often known).

The wonderful world of asset allocation

Now, I don’t know about you, but to me that’s a lot of activity simply to get to the point where we can even start talking about investing. And now that we're at that point, there are a lot more decisions to make.

You know you want to save for the long run. But what should you invest in? This is where asset allocation comes in. And this is where you have to get seriously active.

I like to keep asset allocation simple. Simplicity is good, because it stops you from getting overwhelmed and making too many decisions, which is one of the main obstacles to developing good investment habits.

From that point of view, there are five basic things that you can invest in. Equities (shares), bonds (IOUs), property (directly or through funds), gold, and cash.

I'm not going to explain their specific properties here, or why I've chosen these categories, as that is really another topic.

But the key is that they all behave a bit differently to one another. That’s the point of asset allocation. If the world is going through a period that’s bad for shares, then chances are it’s not as bad for bonds. If it’s bad for gold, it’s probably good for lots of other things.

But how much should you put in each type of asset? That really depends on two things.

One is your time horizon. If you have lots of time to go until you will need this money (eg, you are in your 30s, say), then you can afford to own more “risky” assets. So you might have the vast majority of your portfolio in equities, with small allocations to the other four asset classes.

As you get closer to retiring, and – probably more importantly – closer to the size of pot that you think will be sufficient to fund your retirement, you want to reduce your risk. So you’d probably increase your allocation to bonds and cash, and reduce it to equities (again it’s more complicated than this, but we’re talking broadly here).

What’s the other thing to consider when doing your asset allocation? That’s your attitude towards risk. As far as I’m concerned this should be dictated almost purely by your time horizon. If you’ve got 40 years to go until you retire, stick your money in equities, and ignore it. Grin and bear the fact that you may well live through another 2008.

But if you know that you can’t handle that, then you might want to take less risk (and in the meantime, try to develop a better understanding of risk so that you can develop healthier investment habits).

A quick point to emphasise, while we’re here – if you only remember one thing about risk management, make it this: once you have “enough”, the upside you get from having “more than enough” is far, far lower than the downside you experience from dropping from “enough” to “insufficiency”.

In other words, if you've hit your financial goals, then preserving your wealth (which can be a challenge in itself) should move a lot higher up your priority list, than taking the extra risks needed to keep growing it.

It’s not so much active vs passive, as expensive vs cheap

So there you go. You’ve tidied up your finances and set your financial goals. You’ve decided on your asset allocation. That’s a lot of activity.

Now you’re close to the finishing line. You want to put some of your money in equities. Which equities? The UK stock market? The US stock market? The Japanese stock market? Emerging markets?

Again, this is way too big a topic to go into here, but as a general rule, go for a geographical split, and resist “home bias” (the desire to stick most of your money in your local stock market). The UK accounts for a small proportion of global market capitalisation so it certainly shouldn’t be taking up 50% of your investment portfolio.

So that’s a whole lot more decisions you have to make and research you have to do.

Only once you’ve decided on the make-up of your portfolio, can you finally figure out how you’re going to buy them.

And now, finally, at this very late stage in the process, this is where the “active” vs “passive” terminology comes up.

Say you want to invest in the FTSE All-Share. You can buy an “active” fund: the manager tries to beat the market (hence the “active” name). They will charge you for their efforts. The problem is that most of them fail to beat the market consistently. (There are ways to improve your odds of tracking down decent active managers, so don’t dismiss them out of hand, but you need to do your homework.)

Or you can buy a “passive” tracker fund or exchange-traded fund (ETF). These simply track the market (hence the “passive” name). You will get the same return as the underlying stock market – you won’t have any chance of beating it. But because the fund is effectively automated, you will pay a lot less for this than for an active fund. And the less you pay out, the more of the return you get to keep, and the quicker your investments can compound.

So there we go. I hope we can agree that this quick run through the beginner's investment journey demonstrates that “active” vs “passive” is a misnomer. We’re all active investors.

A better and more truthful terminology for funds, I think (with a few admirable exceptions), would be “expensive” vs “cheap”.

This article is taken from the MoneyWeek.com daily investment email, Money Morning. To sign up for Money Morning, click here.

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