Understanding the world of investments

Saving and investing are two ways we can make the money we earn today work for us in the future. While saving is a great way to prepare for big expenses in the short term, investing is a better option to work towards financial freedom over a long period of time.

Many people have access to a savings account as soon as they open a bank account. You likely already have an account that earns interest on your cash. However, if you want your money to work harder for you over a longer period, investing in assets such as company shares, bonds or property may be the answer.

The key difference between saving and investing is in the amount of risk you take on with each one. When you put your money into a savings account, it will always grow under normal economic circumstances and there’s very little risk that you’ll lose it unexpectedly. But the interest rate you receive is unlikely to be higher than the rate of inflation, meaning your cash is losing value in inflation-adjusted terms.

Because putting cash in the bank is less risky, savings are ideal for funding short-term expenses like holidays or deposits on a home loan. As a general rule of thumb, you should use a savings account when you need to use the money within a short timeframe, say three years.

With investing, there’s a greater chance that your initial investment could drop in value. But despite being risky in the short term, investments tend to earn more money in the long run than savings do. They’re therefore ideal for expenses ten or more years into the future.

Setting targets for your investments

Setting targets is an important part of investing. You may have a single target at any one time, or multiple aims over different timeframes. For example, you might want to send your child to a good university in 18 years or buy a retirement home in a decade.

Once you know what you want to achieve and by when, you can start thinking about what you’d like to invest in and how much you wish to contribute.

There’s no instant result and you shouldn’t be trying to get rich quickly. But with patience, consistent contributions and a readiness to take some risk, there’s certainly the potential to get rich slowly over time – or at least achieve your financial goals for the future.

For example, let’s say you put £1000 in an investment account that generates 10% returns (£100) every year. If, for ten years, you take that £100 and spend it, you’ll be left with just your initial £1000 deposit – even though you’ve earned an additional £1000.

Now let’s say you leave all your returns in the account, rather than spending them. In year one, a 10% return on £1000 gives you £100 and a total investment pot of £1100. So in year two, you’d earn 10% of £1100 (£110) giving you £1210. This process is called ‘compounding’, and it’s the reason why money that’s been invested for longer earns more money.

See if you can figure out how much money you’ll have in ten years’ time with this short exercise.

The effect of fees and charges compounds in the same way, but with a negative rather than a positive impact. We’ll talk more about this and the other risks of investing later in this course.