Interactive Investor

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

27th October 2020 10:52

Kyle Caldwell from interactive investor

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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. 

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, or collective investment, where lots of investors all put money in and a fund manager decides which companies to invest it in. This gives investors access to a spread of companies, with 40 to 60 held in a single fund being fairly typical. In turn, this spreads risk far and wide, rather than simply buying one or 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 is little difference between the two as far as investors are concerned. To find out what those subtle differences are, we explain all you need to know here:

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

Not all funds are actively managed: some are run on a passive basis, which means a computer programme replicates the holdings of a stock market index such as the FTSE 100 or the FTSE All-Share. This means the performance of the fund will never beat the return of the index, although this isn't necessarily something that an actively-managed fund – one that is overseen by a fund manager who makes the investing decisions - will do either.

This is the main thing that will potentially put off a beginner investor, or even some more seasoned investors, from picking an active fund manager. Investors are buying in hope (as it cannot be guaranteed) that the fund manager will do better than the stock market and add value. 

Some fund managers have over the years earned their stripes in terms of beating the market handsomely over multiple time periods. However, the reality is that the majority of the 3,000-plus funds available to investors fail to consistently add value. 

As part of conducting research to try and separate the wheat from the chaff, check out interactive investor’s Super 60 rated list, which highlights our favourite options. Just over 40 of the Super 60 list are funds – including both active and passive options. 

ii Super 60 investments: quality options for your portfolio, rigorously selected by our impartial experts

In terms of which types of funds should a beginner investor consider, multi-asset funds are viewed as a sensible starting point. 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 mixture of assets will, in theory, perform differently from each 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 BMO Global Asset Management.  Our guide will help navigate beginner investors through the six choices. 

Pros

  • Exposure is spread across many assets (diversification) without a large investment
  • Investment decisions are taken by an experienced professional manager
  • Plenty of choice – thousands of funds to choose from and different types of investment to pick: shares, bonds, property and alternative investments
  • Useful for investors who do not have 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 tries to replicate an index or market
  • Key person risk – the fund manager could leave

Investment trusts 

Investment trusts are, like funds, a type of pooled investment that invests in what is often referred to as a 'basket', or selection, of underlying assets such as equities, bonds or property.

But, unlike funds, investment trusts are listed on the London Stock Exchange and have a number of structural differences, which investors can use to their advantage.

As an investment trust is listed on the London Stock Exchange, there are two 'layers' of activity: the performance of the underlying investments that are held 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) is said to trade on a premium, whereas 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 bells and whistles in the investment trust structure that investors can benefit from, as returns are enhanced if the discount gets smaller. It can, of course, work against investors, as if the discount goes the other way and increases, or widens, this will instead magnify losses.

Another differentiator between funds and trusts is that investment trusts are allowed to gear (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. Check out our beginner guide to investment trusts, which contains much more detail regarding how gearing works in practice: 

The next thing to point out is that trusts do not have to distribute all the income generated by their assets every year. Investment trusts 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 have to return all of the income generated each year back to investors.

This is a key advantage for income investors, as it means that dividends are more sustainable and can continue to be paid during tough periods, with 2020 being a good example. Over the course of this year scores of UK companies have either reduced, suspended or cut dividend payments to shareholders. But despite the difficult backdrop, the vast majority of trusts (around 80%) have managed to not cut their dividends, mainly due to dipping into the dividend reserves.   

A trust with a well-diversified portfolio is viewed as a good fit for beginner investors. F&C Investment Trust (LSE:FCIT), one of interactive investor’s Super 60 choices, is one option. The trust holds more than 500 companies across 35 countries. 

Pros

  • Instant diversification without a large investment
  • Over the long term, investment trusts tend to outperform funds due to their various structural advantages
  • 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

  • No guarantees that the fund 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, 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

Exchange-traded funds (ETFs)

Another form of collective investment, exchange traded funds (ETFs) seek to replicate the performance of an index, commodity or basket of assets. This up and down tracking is usually achieved by physically holding most or all of the constituents of the index. ETFs can be bought and sold on the stock market.

Usually, the goal of an 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 like 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 primary advantage of ETFs is that they are low cost. Some ETFs that track the FTSE 100 or S&P 500 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, as a rule of thumb, charges (called the ongoing charges figure, or OCF) for a UK or US fund or trust would be around 0.85%, which works out at £85 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, as mentioned earlier, there are no guarantees that this will happen. 

The main disadvantage is that an ETF which tracks a stock market’s variable fortunes will, by design, not outperform the index it is tracking. 

Our ETF beginner guide has further details for beginner investors, including a run through of more sophisticated ETF options, such so-called smart beta ETFs in the industry jargon:

Pros

  • Low cost and 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 is successful. This might either be through an increase in the share price – a capital gain - or through dividends – income - where the company distributes some of the profits it does not reinvest in the business.

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

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

  • How does the business make money? What is its business model?
  • What is its financial position? You will need to read the balance sheet and analyse cash flow
  • Analyse the risks it faces in order to understand if it might be more or less profitable in the future 
  • Is now a good time to buy? You will need to take into account 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 should not 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 their 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 an 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 usually have the opportunity to vote on some company decisions

Cons

  • Lack of diversity - unless you hold a portfolio of shares your investment is concentrated in one company
  • 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 

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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