If you’re thinking about investing, you need to have a plan
As the saying goes, you can’t plan a journey without knowing where you’re going. In the investment world, this isn’t just a truism. It might sound obvious, but having a plan is one of the most important steps you can make when investing.
This is because what you want your money for and when you need it helps to define the type of investments you should make.
The first step is to establish your time horizon.
How far away is your goal? Is it a long way into the future, like retirement, or is it something you hope to achieve over a shorter timeframe, such as a deposit for a house or school fees? Generally speaking, a short-term goal is one within about eighteen months, a medium-term goal is eighteen months to five years and a long-term goal is one five or more years into the future.
The next step is to work out how much risk you can take.
The greater the risk of the investment, the greater its potential for return – but also the greater its potential for loss. Equities, which represent an ownership stake in a business, are generally riskier than bonds, which are a form of loan. An investment in equities will usually have the potential to grow more than an investment in bonds, but on the flip slide, it could also decrease more.
While your appetite for risk will depend on your personal risk tolerance levels and your circumstances, knowing your time horizon can help inform how much risk you can take. If you know you might need your money in a year or two, it’s probably not a good idea to take on too much risk.
However, if you don’t need your money for a long time, you might feel more comfortable taking on more risk as your longer investment horizon gives you a greater capacity to withstand short-term falls.
Saving for the short term (0-18 months)
If you’re saving for the short-term, you may wish to consider savings rather than investment, or investments like cash deposits or money market funds.
With a near-term goal, your highest priority is probably safety. You need to know that your money is easily accessible if you need it and you probably have less tolerance of investment risk. A short-term goal might be:
- Emergency money (which may need to be accessed any time)
- Building up savings for a holiday
Investing for the medium term (18 months – 5 years)
With a longer timeframe, you may have an opportunity to invest in equities or bonds. Investing in a fund can be a more straightforward way to access equities or bonds or a mix of both. An example of a medium-term goal might be:
- a deposit for a house
- school fees for children
Investing for the long term (5+ years)
The longer you can invest, the greater the chance that it will grow.
This is because a long-term time horizon gives you time to recover from any short-term financial shocks and also allows you to benefit from the power of compounding.
Imagine you invest £5,000 today and you receive a 5% annual return on your investment. That means in a year, you will have £5,250.
Next year, you will hopefully make the same 5% annual return, but instead of earning that return on your initial amount of £5,000, you will earn 5% on the new figure of £5,250.
This may not sound like much, but over a period of 20 years, it can be extremely powerful
The rate of return used here is not an indication of how much you might earn and your rate of return may vary considerably, but it provides an illustration of the power of compounding.
The most common example of a long-term investment goal is retirement.
There are of course many other factors that go in to an investment plan, such as, whether you are looking for income or for growth or a mix of both, and any tax considerations. While a good investment plan will take account of all of these factors, understanding your goals is a crucial first step on your investment journey.