Investments are for everyone, whether you are starting to save for the first time, or have a portfolio worth several million. We understand that the various terms can be confusing. We have put together this short guide to explain the main terms and cut through the jargon.
Types of Investment
A security is the generic term for a direct investment in a financial asset. The main types of security are:
Direct partial ownership in a publicly traded company. A shareholding will entitle you to participate in the growth and profits, as well as the ability to vote on company decisions.
A loan to a company or government. In exchange for your capital investment, you will receive regular interest payments and a return of capital at a set future date.
Shares fluctuate daily, as the price depends on investor demand. Bond values also fluctuate, but to a lesser extent.
A collective investment pools the resources of many investors to buy into a wide range of shares, bonds and other types of asset. It may also be known as a Unit Trust or Open-Ended Investment Company (OEIC), or more generically a Fund. An Investment Trust is another type of collective investment, but it is structured differently and is actually a public company in its own right.
As investors’ money is pooled, the fund benefits from economies of scale and can access investments that may not be available to a typical investor. Management charges apply, but in many cases, this can work out more cost-effective than running a portfolio personally. As a fund invests in a wide range of assets, it is not as risky as purchasing a single share.
A collective investment may be purchased directly, via a platform or through a wrapper such as an ISA.
A collective investment may operate either of the following strategies:
Active – an investment manager selects investments, makes decisions to optimise market conditions and takes advantage of opportunities.
Passive – the fund simply invests in line with a market index rather than taking active decisions.
Active funds are generally more expensive, but are targeting higher performance. Passive funds are usually very low cost, but by their nature produce ‘average’ performance.
Some portfolios hold both active and passive investments.
A wrapper is simply the vehicle through which an investment is held. The main difference between the type of wrapper is the tax treatment. The most commonly used wrappers are:
A tax-advantaged and flexible wrapper. No tax is payable on any of the profits from an ISA, but contributions are limited to £20,000 per year.
Similar to an ISA, however without the tax benefits. Income and gains are taxable if they exceed certain allowances, however there are no contribution limits.
Pension/Self Invested Personal Pension
A wrapper specifically designed to tax-efficiently save for retirement.
A comprehensive financial plan may use all three wrappers in combination to produce the best outcome.
Each wrapper can invest in collective investments, or in some cases directly in shares or bonds.
Investment performance can take two forms:
An increase in the value of each individual share or unit. Generally, prices fluctuate and may rise or fall on a daily basis. The longer you invest, the more likely that your investment will increase in value. You will only be taxed on capital growth when you sell your investment.
The natural income generated by an investment, for example in the form of company dividends, interest or rental income from property. Income can either be withdrawn or re-invested to buy more shares/units. The income is taxable.
A suitable investment portfolio may target growth, income or a balance of both.
The performance of an investment will be measured with reference to a ‘benchmark.’ This helps to assess whether the investment has produced higher or lower returns compared with similar assets. The benchmark may be made up of shares (for example the FTSE All Share), funds (e.g. Mixed Investment indices) or a specific sector (such as Emerging Markets or Smaller Companies).
Risk is measured in various ways. The main purpose of risk analysis is to ensure:
- That you do not take more risk than you are able to cope with.
- That the potential returns compensate for the risk taken.
Your personal risk profile refers to the level of risk that you can take with your investments. This can be as simple as identifying yourself as a ‘balanced’ or ‘cautious’ investor. However, as a financial planning client, risk profiling will usually be much more detailed, and will involve asking some questions about your attitudes and preferences. Your risk profile should take into account:
- Your psychological ability to accept risk
- Your capacity to take risks and sustain losses
- Your requirement for growth
In general, the higher the risk, the higher the potential reward.
Within a fund or portfolio, risk is managed through asset allocation. This involves selecting the right balance of higher and lower risk investments depending on the portfolio’s purpose.
Another method of managing risk is diversification. While it may be clear that a portfolio should hold a certain proportion in (for example) shares, further consideration needs to be given to the type of shares – size of company, business area and geographical location are some of the factors to take into account.
The idea is to select investments that are not closely correlated with each other. When one investment drops in value, others may rise. This reduces the overall risk.
Volatility is a measure of how much variation is expected in an investment’s performance. In simple terms, volatility (or Standard Deviation) determines the extent to which an investment deviates from its average performance. The calculation is complex, but the volatility level is usually expressed as a number. The higher the number, the more the investment is expected to fluctuate.
You may also come across terms such as Beta or Sharpe Ratio. A full explanation of these terms is beyond the scope of this guide, but they are also measures of investment volatility. An investment manager would consider all aspects of risk and volatility before selecting an investment for a portfolio.
Ongoing Charges Figure (OCF)
Your investment charges will impact on the return you achieve. OCF is a term most commonly used when referring to investment funds. It covers the management charges applicable to the fund, as well as any costs such as brokerage charges.
Your investment may also be subject to platform charges, wrapper charges and trading costs. You may also elect to pay financial advice fees via your investments.
While charges are a part of investing, you should make sure you understand the costs. Always ensure that you receive an illustration before undertaking any investment, as this will lay out each component of the charges.
It may also be worth checking the charges on any investments you already hold, to ensure that you are receiving value for money.
Please do not hesitate to contact a member of the team if you would further explanation of any of the above terms, or if you have questions about any of your investments.