What to invest in when getting started: a beginner’s guide

With so many options, choosing what to buy first can be confusing. This guide makes the decision easier. 

Once beginner investors have got to grips with the nuts and bolts of the stock market, the next step is to weigh up the various options to start the investment journey. 

• How to invest in the stock market: a beginner's guide

This guide runs through what those options are and details the pros and cons of each: funds, investment trusts, exchange-traded funds (ETFs) and shares.

Funds

A fund is a type of pooled investment, where lots of investors put money in and a fund manager makes the investment decisions. If a manager invests in shares, they own a spread of companies, with 40 to 60 in a single fund being fairly typical. Such a number spreads risk far and wide, rather than owning a handful of shares, which is much higher risk.

Funds are structured as either unit trusts or open-ended investment companies (OEICs), but in practice there’s little difference between the two as far as investors are concerned. To learn more about the subtle differences between the two, we explain everything you need to know in the link below. 

• What are OEICs and Unit Trusts?

Funds invest across a range of different shares and/or other assets such as bonds or property.

Funds are run by a professional manager in line with the fund’s objectives. Most funds typically aim to deliver growth, income or a combination of the two. Some have targets, such as producing a certain level of income each year, or aiming to outperform inflation over a certain period.

Some funds invest in shares that focus on a particular region, such as the UK, the US, Europe, Japan, Asia Pacific and emerging markets. There are also global funds that invest across all regions.

Funds are housed in fund sectors alongside funds that have a similar investment objective, such as investing in the same region. Fund sectors are a useful way for investors to assess how a fund’s performance compares to peers.

Bond funds also invest regionally, as well as focusing on a particular part of the bond market, such as high-yield bonds.  

Funds managed by professionals are ‘actively managed’. The manager is aiming to outperform a comparable index, such as the FTSE All-Share for a UK fund investing in domestic shares. However, there are no guarantees the fund will beat the index.

Investors who buy actively managed funds choose this option in the hope that the manager’s choices will perform better than the stock market and add value. 

As part of your research into different funds, check out interactive investor’s Super 60 list of investment ideas, which contains our analysts’ favourite options.  

Multi-asset funds are viewed as a sensible starting point for a beginner investor. These funds split your money across a mix of different assets, but they mainly buy shares, bonds and property. Some may also have a small amount of exposure to so-called alternative assets, such as gold.

A mix of assets will theoretically perform differently from one other in different market conditions, which will help your portfolio grow and avoid large fluctuations in overall value when stock markets fall. 

interactive investor has six Quick-start Funds aimed at beginner investors to help make investing easy. Each fund invests in both shares and bonds. We offer a choice of three passively managed funds from Vanguard and three actively managed funds from Royal London Asset Management.   

• Three golden rules to become a better fund investor

Pros

• Exposure is spread across many assets (diversification) without a large investment
• Investment decisions are taken by an experienced professional manager
• Plenty of choice. There are thousands of multi-asset funds to choose from with options mixing shares, bonds, property and alternative investments
• Useful for investors who do not have the time or inclination to buy shares.

Cons

• No guarantees the fund manager will outperform a comparable index (called a benchmark)
• You still pay an annual fund charge to the fund management group, regardless of how well or poorly the fund performs 
• Active funds cost more than a tracker fund or ETF that simply replicate an index or market
• Key person risk – the fund manager could leave.

Investment trusts 

Investment trusts are also a type of pooled investment. They invest in what is often referred to as a 'basket', or selection, of underlying assets such as shares, bonds or property.

But, unlike funds, investment trusts are listed on the London Stock Exchange (LSE) and have several structural differences that investors can use to their advantage.

As an investment trust is listed on the LSE, there are two 'layers' of activity: the performance of the underlying investments within the investment trust, and its share price.

Just like any other share, the share price of an investment trust goes up and down according to investor demand and supply. An investment trust that has a higher share price than the underlying investments are worth (the net asset value, or NAV) is said to trade on a premium, while an investment trust with a share price lower than what the underlying investments are worth is said to trade on a discount.   

The ability to buy an investment trust on a discount – at a cheaper price than the value of all the investments it owns – is one of the ‘perks’ of the investment trust structure for investors, as returns are enhanced if the discount shrinks. It can, of course, work against investors if the discount increases, or widens, as this magnifies losses.

Another difference between funds and trusts is that investment trusts are allowed to gear (or borrow) to invest. The main thing to get to grips with here is that the ability to gear can boost performance if markets rise, but greater losses can occur if the market falls.

Trusts don’t have to distribute all the income generated by their assets every year. They can hold back up to 15% of income generated each year, which means they can build up a ‘rainy day’ reserve to bolster dividend payouts in leaner years. In contrast, funds must return to investors all the income generated each year.

This is a key advantage for income investors, as it means that dividends are more sustainable and continue to be paid during tough periods, with 2020 being a good example. Over the course of that year, scores of UK companies reduced, suspended or cut dividend payments to shareholders. But despite the difficult backdrop, most trusts (around 80%) managed to avoid cutting their dividends, mainly due to dipping into the rainy day reserves.   

Another difference between investment trusts and funds is that the former has an independent board of directors. The role of a board includes exercising independent oversight, holding fund managers to account (with the ability to sack them) and looking after the interests of shareholders (such as by driving down costs).  

In addition, as a shareholder in an investment trust, you have the same voting rights as shareholders in other companies. This gives you the opportunity to have your say and exert an influence.

• How to use investment trusts in your ISA 
• Investment trust shareholder rights: a beginner's guide

Pros

• Instant diversification without a large investment
• Over the long term, investment trusts tend to outperform funds due to their various structural advantages
• Trusts are much more consistent at raising or maintaining dividend payments compared to funds, due to their ability to hold back up to 15% of income generated every year 
• Investment trusts are allowed to gear, or borrow, to invest. In a rising market, gearing magnifies gains.

Cons

• There’s no guarantee the manager will outperform a comparable index 
• You still pay an annual fund charge to the fund management group, regardless of how well or poorly the investment trust performs
• Generally, trusts are more volatile than a fund, due to the potential for losses to be magnified by gearing and discount movements
• Investment trusts can trade on a premium, so investors who buy at a premium are paying more than the underlying assets are worth.

Index funds and exchange-traded funds (ETFs)

The other main type of fund doesn’t attempt to beat the market. An index fund or tracker fund aims to replicate the performance of a particular index.

Exchange-traded funds (ETFs) aim to do the same thing, although there’s one main difference in that an ETF can be bought and sold throughout the trading day, much like individual shares. Index funds, however, can be bought and sold only once a day.

With index funds and ETFs, the performance will never beat the return of the index, although this isn’t necessarily something that an actively managed fund will do either.

The up and down tracking is usually achieved by physically holding most or all the constituents of the index. ETFs can be bought and sold on the stock market.

Usually, the goal of an index fund or ETF will be to provide a portfolio that mirrors an index, thereby providing the performance of that index (minus its fees).

Most ETFs track long-established equity indices such as the FTSE 100 or S&P 500, which are viewed as sensible starting points for beginner investors. 

There are also ETFs that track bond market indices, a basket of commodities, baskets of currencies and property.

The main advantage of index funds and ETFs is their low cost. Some track the FTSE 100 or S&P 500 and charge as little as 0.1% of the value of your investment, which works out at £10 on a £10,000 investment. 

Charges for funds and trusts vary, but charges (called the ongoing charges figure, or OCF) are typically around 0.85% to 1%, which works out at £85 to £100 on a £10,000 investment. The extra fees paid to own a fund or trust versus an ETF will be worth paying if the fund outperforms, but there’s no guarantees this will happen. 

Our ETF guide has further details for beginner investors, including discussion of more sophisticated ETF options, such as so-called smart beta ETFs to use the industry jargon:

• How to invest using ETFs: a beginner’s guide
• How to own the world through index funds and ETFs

Pros

• Low cost and an easy way to access major stock markets  
• Instant diversification
• Access to more exotic markets as well as the better-known indices.

Cons

• ETFs mirroring the performance of a stock market index (minus fees) will not outperform.

Shares

If you invest directly in shares, or equities, you own a small part of a company and will benefit financially if it’s successful. This might be through an increase in the share price – a capital gain – or through dividends, where the company distributes some of the profits it doesn’t reinvest in the business.

Buying shares involves more effort than if you outsourced the investment decision-making process to a fund manager, or bought an ETF. 

For those who have the time and dedication, there are several things to get to grips with when buying individual shares. Key questions you will want to find answers for include: 

• How does the business make money? What is the business model?
• What is its financial position? You will need to read the balance sheet and analyse cash flow
• Analyse the risks the business faces to understand if it might be more or less profitable in the future 
• Is now a good time to buy? You will need to consider the various valuation metrics that indicate whether a share price is overvalued or undervalued. 

Of course, not everyone who buys shares in individual companies is a forensic accountant, and many investors do not fully understand balance sheets, accounting jargon or every industry valuation measure. 

This doesn’t mean that you shouldn’t buy company shares. People choose to do so for many reasons. You might enjoy the intellectual stimulation, you may have read a recommendation in the newspapers, or you could be interested in smaller, more speculative companies that aren’t available in funds or trusts. 

In return for the higher risk that comes with buying individual shares, potential rewards can often be higher too. This is a major part of the appeal. 

One approach for those wishing to invest directly in one share would be to make a small investment to keep a lid on risk, say, no more than 5% of your overall portfolio. Having a large amount of exposure to the fortunes of just one company is a very high-risk approach. 

Pros

• You can choose which companies you want to invest in
• Your potential gains can be many times the returns on offer via funds and trusts
• As a shareholder you can usually vote on some company decisions.

Cons

• Lack of diversity. Unless you hold a portfolio of shares, your investment is concentrated in one company
• Buying shares requires time to investigate investment opportunities and some knowledge to understand the business you want to invest in 
• Building a portfolio of shares is more expensive than simply buying a basket of shares via a fund, trust or ETF.