If you’re looking for a good place to put a lump sum or want to earn a better return on your existing savings, you might be considering investing. In this guide for beginners, we’ll explain how to start investing from scratch. We’ll cover:
- How the stock market works
- Why stocks & shares are popular investments in the UK
- Which circumstances make investing a good option
- How to start investing (step-by-step)
Before we begin, we need to make it clear that this article is not financial advice. If you don’t feel fully informed after reading this article and the best investing books, you have options. You could contact an independent financial adviser who can make recommendations that are tailored to your circumstances, or at least give guidance on what to invest in now.
How to start investing: how shares work
Shares are proof of ownership of a small slice of an organisation. The owners of all of a companies shares collectively own the entire business. As a shareholder, you are entitled to a share of the profits of the business.
The rights of some shares will change in value as the expectations of future profits change. If a company experiences a period of joyful growth, then investors will expect a windfall through share ownership in the future, therefore each share will change hands at a higher price on registered stock exchanges.
What is a stock exchange?
A stock exchange is a financial institution that enables investors to buy and sell shares. In the UK, the London Stock Exchange is the primary stock exchange.
As an investor, you won’t interact with the stock exchange yourself. The stockbroker or investing platform you choose to invest through will execute the transactions on your behalf according to your instructions.
You can’t buy shares in any company. You can only invest in public companies. In the UK, a public company name ends in ‘plc’ or ‘PLC’ and this means that its shares can be freely traded between individuals or on an official exchange.
The alternative category of companies is private companies. The shares of private companies are closely held by a single individual or a small group of individuals and are not for sale.
However, there are still more than 1,000 companies in a variety of sectors and sizes on the London Stock Exchange main market, which is home to the largest companies on the exchange. There are approximately 41,000 public companies worldwide.
How can you profit from owning shares?
There are two exciting ways to earn a profit from investing in shares.
- Dividend income
- Capital Gains
Dividends is the name given to the share of profits paid to shareholders each quarter or year. Each company chooses the size and frequency of their dividends. It’s totally at the discretion of the board of directors in charge of a company.
If you have held shares for an extended period then you will receive dividends via your stockbroker. This process is automatic and is the highlight of the month for keen investors. Dividends appear as a cash deposit which increases your account balance and can be invested or withdrawn immediately as desired.
Capital gains are profits made from holding shares as they appreciate. Just like when buying and selling collectables, antiques, vehicles or games consoles. If you can buy when prices are low and watch their price rise your investment account will now have increased in value.
What % return should you expect to receive when investing?
To predict the future annual returns from investing, we can only look to the past and measure the returns that investors have historically enjoyed over different periods.
The average annual return from UK shares over the last 100 years is approximately 5% per year. This figure is in ‘real terms’ which means it is the return after factoring in that prices rise gradually over time due to inflation.
In comparison, the ‘real return’ of a bank account is close to 0%. While interest rates can range between 1% – 2%, this extra value is offset by prices rising at a similar rate, leaving your savings with the same spending power at the end of the saving year compared to the start.
While stock market returns are higher, future stock market investment returns are not known, and for short periods the return of the stock market could even be negative.
This uncertainty might cause you to feel uncomfortable. After all, we would all prefer to receive a guaranteed profit than a risky one that may not come through for us.
However, you must understand that it is precisely this risk that drives the higher returns you can expect to receive from the stock market. Without the ups and downs of the stock market, shares wouldn’t return more than a bank account. But why is this? Let’s delve into the theory.
Why do shares provide higher returns than a bond?
A guaranteed £1 in the future is worth more today than an uncertain £1. That’s because we will always prefer safety over risk when it comes to personal finances.
Therefore, when investors compare safe investments and risky investments, they will bid less when buying riskier investments that provide the same expected future income. They’ll pay a lower price for the same income because of the risk that it could disappoint.
However, over many investments and across a long period, risky streams of income received by an investor should approximately match their expectation.
This means that ultimately both the safe and risky investments would produce the same amount of income, but the risky investment would have been bought at a discount. Therefore the financial return of a risky investment (its income compared to its cost) will be higher.
This principle is at work in the stock markets. Shares offering income of £100 will be priced at far less than what you’d need to pay into a bank to receive a £100 repayment over the same period. While shares may disappoint in the short term, they should roughly pay what we expect over the long term, meaning the lower valuation you are investing at will drive a premium performance.
How to start investing: step-by-step
Here’s a roadmap for any beginner to follow when starting their investing journey:
- Self-educate yourself on the fundamentals of investing
- Understand your tolerance to risk and your time horizon
- Create a shortlist of what you’d like to invest in
- Choose a UK stockbroker, investment platform or investing app
- Start investing!
Boost your financial literacy by crafting your financial education
The average person on the street and an elite hedge fund manager look like they’re a world apart. But there are only two differences:
- A pile of cash
- A brain full of knowledge taken from real-life experiences and financial theory
Here’s the good news. Your cash will grow over time, and you can study any experience or financial theory in a great financial literacy book.
You are in total control of how quickly you can close that gap. The only limiting factor is your discipline and the quality of economics books you choose to begin with.
Connect with your attitude towards risk
Before you start investing, you’ll want to confirm that investments are suitable for you.
Our risk tolerance questionnaire will help you understand quickly whether you are risk-averse, cautious, balanced or have an adventurous appetite for risk.
You shouldn’t start investing if any of the following statements apply:
- You would not accept a loss of any size
- The prospect of better returns is not worth risking a loss
- You need a minimum level of financial return over a specific period
- You are relying upon this money for basic living costs
If you agree with any of these statements, then you may find that a savings account is more appropriate.
It’s too easy to become so thrilled when investing that you take on more risk than you can stomach. Rather than working backwards from the return you want to make, it’s more useful to start by looking at what your risk tolerance will allow.
How risky are shares as an investment?
We measure risk by looking at how wildly the performance of a share fluctuates around its average return. By this measure, shares are medium to high-risk investments.
The chart below shows the performance of the FTSE 100 over the decade from 2012 to 2022.
As you can see, an investor who invested at the beginning of that decade has seen an excellent return. However, this has not been without significant temporary falls in the market.
In early 2020, the stock market plunged in response to concerns about the economic impact of the coronavirus outbreak. Overall, shares plunged by 33% in one month, although they mostly recouped their losses over the following year.
If you invested 100% of your money in shares, you would have experienced a fall of 33% in that period. Had you applied a balanced approach; investing half of your money in shares, this fall would have been closer to 17%. If you had been cautious then the fall would have been less than 10%.
It is useful to put ourselves in the shoes of an investor during dramatic market swings, because it is only a question of when, and not if, another market crash will return.
Understand whether your time horizon will restrict your investment choice
The chart above paints quite a clear warning for investors; invest for the short term at your peril. As a rule of thumb, shares investments are only suitable if you can refrain from touching your money for at least 5 years. The length of time you can leave your investments alone to grow is known as your investment time horizon. The riskier an investment, the longer the time horizon you will need to hold it comfortably.
An investor who had entered the market in February 2020 would be nursing a small loss to date at the time of writing.
But any investor who invested in the FTSE 100 before December 2017 would currently show a profit on paper.
The stock market fluctuates around an invisible upward trend line. The longer that you are prepared to lock your money away, the more likely it is that your investment returns will look just like the long term averages we discussed earlier in the article (5% per annum).
Create a shortlist of what you’d like to invest in
Do you want to invest in emerging tech stocks, or play a part in the growth of a regional economy? Do you prefer corporate bonds to stocks & shares?
It’s time to create a list of what you’d like to invest in. This is an important prerequisite before you choose an investment platform.
I suggest that you create your investment wishlist before you begin browsing through the full list of stockbrokers because some brokers may support some of your investment types but not all. For example, if you pick a forex broker, you may find that they don’t allow you to also buy shares and funds. The range of foreign company shares available varies from provider to provider.
Compare stockbrokers and choose the right provider for you
We suggest you look for the best stocks & shares ISA if you plan on investing in shares or funds that invest in shares. Stocks and shares ISAs are a type of stockbroker account that shields your money from all income and capital gains taxes on any investments you hold within the account. Here’s a full list of all stocks and shares ISA providers.
You can deposit up to £20,000 per year into a stocks and shares ISA, which makes them quite flexible even if you have a large lump sum to invest.
The best investing apps are easy to use and very accessible and are now beginning to launch stocks and shares ISA variants of their accounts, although not all apps currently have an ISA product
The final step in how to start investing is… to place your first trade. Whether you’re buying a number of company shares, or some units in a fund, you’ll feel a rush of exhilaration when you click ‘buy’ and see your own investments sat in your investment portfolio.
Owning shares is a brilliant test of your self-restraint. It can be addictive to see the value of your investments nudging upward and downward in price with each second that passes. Don’t be surprised if you find yourself logging into your stockbroker account several times each day in the first month of becoming an investor.
This is natural and as you get used to the volatility you will eventually be able to ignore your portfolio for weeks at a time. This portfolio ‘negligence’ is often a positive behaviour as the fewer times you look at your portfolio, the less urge you will feel to begin needlessly tweaking your holdings and over trading, racking up investing costs in the process.
Pitfalls to avoid
Any guide on how to start investing wouldn’t be complete without a few pitfalls you should be aware of:
- Illiquid investments
- Undiversified investment opportunities
Illiquid investments include UK venture capital trusts, enterprise investment schemes, ‘business angel’ investments, private equity and investments in land. These investments, unlike shares, cannot be sold on the open market in a short space of time. You may be locked into these investments indefinitely. Exceptions include listed UK private equity firms.
When you’re starting out as an investor, you may try a few investment approaches before you settle upon the perfect investment portfolio. However, by investing in illiquid schemes you are effectively tying yourself to a high-risk portfolio before you’ve had the time to understand if this is appropriate.
Overtrading is the investing mistake of buying and selling investments in their portfolio more frequently than is needed. Knowing the right time to sell shares is mostly luck. Most of the return of an investment portfolio comes from simply holding investments – not churning through the portfolio like a wall street wizard.
Diversification is the technique of spreading your money across a variety of investments. This protects your account value from the ups and downs of individual investments. An investment portfolio that holds 20 or more investments in equal proportions is classified as diversified.
By using cheap equity exchange traded funds and other funds, you can become immediately diversified across tens or hundreds of companies with a single trade.
A common mistake of new investors is to focus too much of a portfolio value on a preferred investment. This would mean that any change in that individual investors will have an outsized impact upon the overall portfolio.