Investing can be quite an overwhelming topic. As there is so much information out there, knowing where or how to start can be quite difficult. Therefore, to make this post as simple and easy to understand as possible, the rest of this post will be a discussion between a father and his son on the topic of investing:
Father: So, you would like me to teach you what I know about investing. Is that correct?
Son: Yes. I have seen those “traders” on Instagram with their extremely luxurious lifestyle and I want to know how they do it.
Father: Huh. Okay. Well, firstly before you start anything that is to do with investing, it is important to make sure you have learned how to make a budget and stick to it, have no consumer debt at all and ensured you have in place insurance policies which cover things you cannot afford to replace.
Son: Blah blah I know. I have been budgeting consistently, got rid of all my consumer debt, and even built a 6-month emergency fund. I also put in place a life insurance policy, income protection insurance policy and a critical illness cover.
Father: Sounds like you are on track. The saying “your home is only as good as the foundation it sits on” could not be more accurate when it comes to building wealth. It is crucial that you have a strong solid financial foundation in place before you start to invest, and it sounds like you have done that well. Okay, where would like us to start? Do you have any questions from which we will expand on?
Son: Yes. First, why do we need to invest? Can’t I just keep putting my money in a savings account? Is that how they do it?
Father: Putting money into a savings account other than the purpose of having an emergency fund is a good idea for short-term goals. For example, a wedding within the next 2-3 years, a PS5 or a fancy holiday next summer. For long term goals, however, a savings account fails to be useful, because of inflation.
Son: Hold on, what is inflation? Do not start using financial jargon assuming I know what you are talking about!
Father: I was about to explain it before you interrupted me, but I am glad you did. I will not explain financial terms using “textbook” definitions but instead will do it through easy to understand and practical examples. After all, you can find the technical definitions by
yourself on Google.
Inflation is when the prices for goods and services increase as time goes on. Let’s say you have £10.00 in your pocket and your mum asked you to go buy some apples. Each apple costs £0.50 so you buy 20 apples. Now let’s go forward in time 30 years. You’re now an adult with kids and you pop down to the grocery store to buy some apples. You have £10.00 but each apple now cost you £2.00 so you can only buy 5 apples, compared to the 20 apples 30 years ago. That’s inflation. You get less “stuff” for the same amount of money.
In financial terms, we say that the “purchasing power” of your money has decreased. Now, does that give you an insight as to why savings accounts for the long-term are not ideal?
Son: I see. So, by keeping my money in a savings account, the purchasing power of my money is decreasing each year, because of inflation. Am I right?
Father: You are quite right. Inflation in the UK is about 3% per year. Which means that the general prices of goods and services increase by 3% each year. If you put your money in a savings account that gives you an interest of 0.5% per year, the purchasing power of your money is decreasing by about 2.5% per year.
Son: That makes sense. I see where this is heading. So, to beat inflation, for long-term goals, I should be investing?
Father: Exactly. This also how pensions work. Pension providers invest your “pension money” to grow it at or above the inflation rate so that by the time you retire you have a somewhat reasonable pot of money to live off.
Son: Great, I get inflation now. Can you show me how to invest?
Father: Sure, but before we do that it is important to understand what you are investing in. Never invest in something you do not understand, and we explore why later. To “invest”, we buy something called “assets”. Think of assets as items which have a monetary value. You buy an asset in the hope you can later sell it at a higher price than what you bought it for, and you make a nice profit.
Father: Now, there are many different types of assets. A house would be considered an asset for example. But what you are interested in I believe, is “stocks” or “shares”.
Son: Yes! I want to learn how these Instagram trader gurus do it!!!!
Father: Let’s not get ahead of ourselves. Do you know what a share even is?
Son: Yes, I am not that ignorant. A share is a tiny piece of a company. So, when I buy a share in let’s say, Tesla, I would own a very tiny % of Tesla. Right?
Father: Correct. A share or stock is exactly that. The share price goes up in value if the company is doing well (or if people believe that is the case) and vice versa. Now, when it comes to investing, there are two types: active and passive investing.
1. Active Investing
Active investing is where you, or a person that is in charge of your money, is actively picking and choosing which company to buy shares in. If you are inexperienced, you would put your money in a mutual fund (where a lot of people pool their money together) and the fund manager is the person who gets to choose which shares to buy or sell. People trust that person to do a good job because the fund manager has the expertise and tools required to increase their chances of achieving a high return on investment.
Son: What is a return on investment (ROI)?
Father: Say you invest £100.00 and you buy 1 share. Tomorrow your 1 share is worth £150.00. Therefore, the return you made on your investment of £100.00 is 50% (150-100 = 50 => 50 / 100 (how much you invested) = 0.5 * 100% = 50%).
Son: Got it. So, what’s passive investing then?
2. Passive Investing
Father: Passive investing is when there is no person actively picking and choosing which companies to invest in.
Son: What? That is so dumb. So, the computer chooses randomly? I do not get it.
Father: Passive investing is also commonly known as indexing.
An index fund simply aims to track the performance of a certain market index. Allow me to explain using an example. Let us say that in the market you have only 10 publicly traded companies, meaning anyone in the public can buy shares in those companies. An index in this context simply means a “measure” of something. One Index could be the measure of performance of all 10 companies. Therefore, a measure of the performance of all 10 companies will be added together and summarised into a number, that number is the index. If the number goes up tomorrow, then we say that the market is performing well. If it goes down, the market is doing badly.
Son: I think I got it. So, an index is essentially a performance measure of multiple listed companies?
Father: In a way, yes. There can be many different indexes. You can have an index for the 5 biggest companies or an index which only contains energy companies etc.
Let’s say you invest in the FTSE 100 index. This index contains shares from the 100 biggest companies in the UK. Think of it like a suitcase that is filled with shares of various companies.
When you buy 1 suitcase, you are essentially investing in all 100 FTSE companies. Therefore, it is called passive because there is no need to do research on which company you should invest in. You buy a big suitcase that contains everything and leave it at that.
Son: I do not understand. Surely there are some bad companies which we should not buy shares in. I am not convinced. Why would anybody invest in these so-called index funds?
Father: This is a logical point. When it comes to investing in stocks and shares, there are 2 concepts which you must get familiar with:
Your level of risk tolerance can have a huge impact on your ROI. Investing carries risk. Most people are quite risk-averse when it comes to their hard-earned money. Meaning that they would like to take some risk, but not too much. In the world of investing, higher risk generally equates to higher rewards, think higher ROI. When you buy shares in a single company, you will make a lot of money if this company performs well in the future, but the opposite can be devastating. You could lose your entire investment.
As you can imagine, having a portfolio (fancy word to essentially describe a ‘box’ that contains all of your investments) that is so volatile is not ideal. Say you have been saving for the past 10 years for a special all around the world trip with your partner. The last thing you would want is having to sell your investments at a loss because you have only invested in a single company which is now heading into bankruptcy. Therefore, we need something more tangible, a little bit more solid to build wealth, and this brings us to the second concept:
By investing in several companies which operate in different industries and sectors, you reduce the level risk involved with investing. If one company or industry does bad, then that would not cause a lot of problems because you are well-diversified. When an umbrella manufacturing company is doing badly in the summer, you also have shares in an ice cream company, so it balances out.
Son: So basically, what you are saying is that I should not put all my eggs in one basket. I reduce risk and therefore volatility by investing in different companies in different industries. That makes sense. However, I am still not convinced with index funds. As I have said earlier, surely some companies are not worth investing in. It would make more sense to pool my money with other people in a mutual fund, and the expert fund manager will be able to only invest in worthwhile companies.
Father: Index funds have a sort of “self-cleansing” attribute to them. Because they are designed to follow a specific index, if a company fails and goes bankrupt, another company in the market will take its place and replace the failed company’s position in that index.
Now, let us get to your point about active fund managers. This is probably the most debated topic of all time in the world of investment strategies. However, the research is quite clear on this matter. Over a 15 year period, 91.6% of actively managed trading funds fail to beat the S&P 500 index (the index of the 500 largest US companies). This percentage gets even higher for periods longer than 15 years.
Besides, even if you think you can invest in an actively managed fund that makes up part of the 8.4% of active funds which overperformed the index, how would you know which active fund is going to achieve just that? In the UK, there are around 3,000 funds you could choose from. Therefore, it becomes more like gambling on which fund is going to outperform their benchmark index, which is how an active fund’s performance is measured. Each active fund performance is compared to a specific index to see if they did or did not outperform the market.
There are also fees to consider. Actively managed funds charge higher fees than their counterpart. This is because the fund is “actively” managed, and therefore the fund managers and their teams need to get paid for the work they do. This is most commonly charging as a fixed % of your portfolio value, and therefore even if the active fund outperforms the index by let us say 1% if they charge you 1.5% fees, then you are worse by 0.5% overall. Not very attractive.
Son: Not sure I am convinced. What do you have to say about Warren Buffet? Or Peter Lynch even?
Father: There will always be some people who are outliers. When I hear this argument, I like to refer to the words of JL Collins “Before you start trying to pick individual stocks and/or fund managers ask yourself this simple question: “Am I Warren Buffett?” If the answer is “no,” keep your feet firmly on the ground with indexing. Let me take a moment to be absolutely clear. I don’t favour indexing just because it is easier, although it is. Or because it is simpler, although it is that too. I favour it because it is more effective and more powerful in building wealth than the alternatives”.
When it comes to investing, a little humility goes a long way. To develop skills needed to reach ROIs like Buffet’s and Lynch’s requires years and years of experience. Long hours spent analysing and thinking about companies’ financial statements, and even then you are not guaranteed to achieve ROIs as high as them.
Remember, over a 15 year period, 91.6% of active managers fail to beat the market and these people have access to tools and information that are way, way better than you can ever hope to get your hands on by yourself. Not to mention the people working under them making forecasts and trying their best to find the next 10-bagger (a stock that increases in value at least 10 times its purchase price) and yet they STILL do not get to beat the market long-term. So, what makes you think that you will?
I can think of better ways to spend my time. I would rather let indexing lift the heavyweight for me, and spend my time making more money to invest, or simply to enjoy life.
The people you see on Instagram who claim to make millions are simply scammers. If they are genuine, they would have absolutely no time to spend teaching people how to make millions trading. The lifestyle they portray is a marketing gimmick designed to draw your attention to them. The way they make money is through “teaching” other people how to invest *cough cough* instead of investing themselves.
If they truly have the skill of Buffet, then I am quite certain they would be extremely famous and would be running a successful mutual fund, instead of an Instagram account showing rented cars.
If you are genuinely passionate about stocks, enjoy reading and analysing financial statements, then give single stock picking a try. However, I believe that should be a hobby and not your main tool to build wealth.
Son: How rude of you! I believe that I can beat the stock market if I invest wisely and do my research!
Father: I would not be surprised if you still think that. The human mind inherently makes us believe that we are individually above average. If you are still going to give this a try, I would recommend tracking your ROI over at least 5 years and compare to a benchmark index to compare your performance against. If you manage to beat the market, then good for you. Whether you continue to do that until your retirement is up to you. If you do not beat the market, then it may be time for you to come down to Earth and put your money and time to better use.
Son: Wow! If that was not condescending then I do not know what condescending is! But deal. I shall think about it. In the meantime, can you please show me how do I go about investing in an index fund? I’m getting impatient now with your long-winded explanations!
Father: My apologies. There are many investment platforms and index funds to choose from. However, my favourite platform is Vanguard, and that is for multiple reasons which I will not get into now. Just know that Vanguard was the first platform to introduce indexing and the way they are structured makes them a very attractive platform to use. I recommend doing some research on them in your own time to see for yourself. If you had invested $10,000 in 1980 in the S&P 500 index, by 2018 you would have a portfolio worth around $760,000. Not bad for doing absolutely nothing for less than 4 decades.
I’m blabbering again! Alright, follow these steps:
1. Head over to https://www.vanguardinvestor.co.uk/
2. Click on “open an account” on the top right corner of the page.
3. Click on “Start my application”
4. Choose “Vanguard stocks and shares ISA” and click on “Open an account”.
Son: WAIT! What on Earth is a stocks and shares ISA (S&S ISA)?
Father: Good question! I should have probably explained this before we got onto the steps. In the UK, an ISA stands for “Individual Savings Account”. There are 3 different types, but this one is called the Stocks and Shares ISA. This allows you to put in £20,000 into the account each tax year (from April to April). Any shares that grow in value inside this account, would be free of capital gains tax when you sell.
Son: Erm.. what’s capital gains tax?
Father: Normally, if you buy an asset at a certain price, and you sell it at a higher price, you must pay tax on the profit you made, and this is called capital gains. However, if you invest using an S&S ISA, there would be absolutely no tax to pay at all when you sell your investments.
Son: Cool! Does that mean I can grow my money and beat inflation all tax free? That is awesome!
Father: Yes, it is pretty good. For most people, you only need an S&S ISA and a pension to build wealth.
5. You will be taken to a general information page. Once you have read it and happy with everything, click on “Proceed”.
6. Here, you are taken to the “Choose Investments” section. As you can see from the screenshot above, there are multiple investment types to choose from. Remember, I am simply showing you what I invest in, based on my individual risk tolerance and research I have done. Before you invest, make sure you do your own research understand what you are investing in.
Click on “Equity funds (36)” in an order to see a list of all the index funds available on Vanguard. They are broken down by geographical location. I like to invest in the “U.S. Equity Index Fund – Accumulation” for many reasons which I may go over at some point in the future.
You can choose to invest in by putting in a fixed sum of money or via a monthly direct debit. 7. Once you have decided which index fund is best for you and how much to put in, the next stage is just filling out standard personal details.
8. Once the “Your details” stage is complete, you will be taken to the final stage “Complete order”. Fill out the details required and hit “confirm”.
9. That is, it! If you have followed the steps, then congrats on making your first investment. Vanguard is a straightforward and easy to use platform, so just have a play around to get familiar with it.
Son: That sounds great! Thanks for guiding me through the steps. I have two more questions and that’ll be all for this session.
Son: What do you recommend I should do when my investment is going down in value? When my ROI is negative!
Father: Good question. If you are invested in a well-diversified index fund and the majority of its components are listed on established stock exchanges like the UK or US, then I would simply recommend to not do anything. Action through inaction is your friend when it comes to index funds. For example, when the Covid-19 pandemic started to show its effects on the stock market, my ROI was down to -22% at its lowest. If I had panicked and sold, I would have “crystallised” those losses. Remember, these “losses” are not real losses until you sell at loss. My portfolio now shows an increase of +31.2% as of today.
Now, this would be absolutely terrible advice if you were to use this cool-headed approach when it comes to single stock investing or Bitcoin for example. The reason you need to stay calm during turbulent times with indexing is that you are investing for the long-term. You are not riding current volatile trends to make a quick buck; you are building wealth. Therefore, the chances of the economy recovering back over a 5 or 10+ year period are very likely. I think this should suffice to give you a quick summary answer to your question. If you would like to learn more about indexing and why you should not panic and sell at a loss, I highly recommend you read “The Simple Path to Wealth” by JL Collins. Best £7.00 you will invest.
Son: Okay, noted. I shall not panic sell when my ROI is showing a negative figure because I am investing for the long-term and the economy is likely to grow back up. That makes sense. This brings us then to my last question: what about bitcoin? I hear friends and people talk about it all the time.
Father: I am not well informed on this topic as of now and therefore should hold my judgement. However, what I can say is this: if you are serious about investing to build wealth and not just to have a play around with stocks and forex, then I would strongly suggest staying away from anything trendy. When there is a lot of hype about a certain asset, the price tends to reach a bubble phase, which lasts for as long as the trend-followers keep buying until it collapses when the trend-followers all rush for the exit door. Such behaviour is dangerous because if you buy an asset without any regards for the asset’s fundamental value, you will be left bleeding by the side of the road, as JL Collins would say. Investing should be boring. Boring investing is profitable investing.
Thanks for reading. There is absolutely no way to talk about everything that is to do with investing without ending up with a short-book and not a blog post. I hope that you at least got some value out of this post and made you think about starting to invest for your future.
This is the last personal finance post for a while. I’m excited to share other ideas soon.
Take care, Ali.