Time for some financial talk! Let’s take a look at risk, reward, investment, and more.
Are you a risk taker?
Generally, the more of a risk you take, the more money you can make. But, you also need to be prepared for the fact that you could lose a considerable amount of money. You could go for a low-risk approach, but you won’t make a lot of money. There is no right or wrong risk profile, everyone is different, and understanding this is key.
Different risk profiles:
- Cautious investors – This applies to people that aren’t comfortable with risk. In most cases, the profits they make will simply counteract the impact of inflation, as opposed to providing them with money in the bank.
- Intermediate investors – This refers to people that are comfortable with a moderate amount of risk. They accept that there could be ups and downs with their investment, and they want to make a good profit, but they’re not prepared to put their money into highly volatile markets.
- Adventurous investors – This relates to people that are comfortable with risk. They are prepared for the fact that they could lose all of their money, but they could also make a huge profit.
Different types of investments
- Stocks & Shares – You will invest in a company, owning a portion of it. This is a high-risk high-return investment.
- Bonds – Bonds can vary greatly in their risk profile. This is because you have everything from corporate bonds to UK government bonds, which are generally the least risky. With a bond, you basically loan money to the entity, and you make money on interest.
- Property – You could invest in property in the UK or overseas, like a 3 room resale flat, with the view of renting it out or selling it for a higher return.
- Cash – If you hold your cash in a bank or building society account you will make money in terms of interest. This is a low-risk low-return approach.
- Pooled funds – You will give your money to a professional fund management team who will invest in various assets on your behalf.
It’s important to consider the impact of time when it comes to investing. If your investment is a long-term project, you can afford to take more risk. This is because you have time to recover. Take the recession that occurred in 2008 as an example. This would have been a nightmare for some investors, but those with time on their side would have been able to wait it out, allowing the market to recover, meaning they didn’t take the big hit.
Your age will also play a big role when determining your risk profile. If you are in your 20s, you’re not going to be as worried about taking risks, as you will have time to recover. If you are older, in your 50s, for example, you will be more concerned about protecting your wealth and ensuring it is not lost.
Don’t put all your eggs in one basket
One of the best ways to reduce risk without becoming a cautious investor is to diversify. Don’t put all of your money in one investment. If you have a diverse investment portfolio, i.e. you invest in various companies and sectors, and you have other investments, property for example, you will protect yourself. If one of your investments fails, you will have others to fall back on. But, be careful not to spread yourself too thinly, as you will struggle to manage all of your investments.
Another way to diversify is to mix your investment strategies, not just your investments. This involves having defensive strategies and aggressive strategies. Defensive strategies are those aimed at reducing risk. This means your money will be invested in shares that are not as volatile but they won’t make a huge return either. An aggressive strategy is the opposite; you will take a high level of risk with these investments to make a big return. Your defensive investments will be there to fall back on if your aggressive ones fail.
Comparing financial products
There are some financial products that are important for everyday life, for example, a bank account. There are then some financial products that are designed to help us make more money; for instance, a pension is designed to help us accumulate more money for our future. You then have financial products that are designed for protection, such as insurance policies that will cover you in case of an event occurring.
Knowing how to compare these financial products effectively is imperative if you are to choose with care. This can be confusing as a lot of different terminology is used that you may not be familiar with. But don’t fret; we have you covered.
I don’t know my APR from AER
When looking for financial services, you may often see ‘APR’ and ‘AER’, and it is important to know the difference between the two.
These are two terms that are used to describe ‘interest rate’. Interest rate is essentially the price you are going to pay for borrowing money or the amount you will receive on money you’ve saved. For example, let’s say you take out a loan of £2000 from the bank, with a 30% interest rate. You will have to pay back £2600. £2000 is the money you have borrowed, and £600 is the interest rate. (30% of 2000 is 600).
- APR – APR stands for Annual Percentage Rate. This is the official rate for BORROWING. All financial services companies need to provide this figure. It takes into account the cost of borrowing and any fees that are associated, for example, an arrangement fee, giving you a full picture of the cost of the debt. This means that consumers are easily able to compare the rate of interest from one company to another. A lender is legally obliged to provide you with this before you sign an agreement. It is all about making it easy for you to compare one financial product with another.
- AER – AER stands for Annual Equivalent Rate. This is the official rate for SAVING. This rate is used with savings account and the idea is that it shows you what you would get if you put money in your account for a year and you left it there. The alternative would be the gross rate; this is simply the flat rate of interest that is paid. AER attempts to give you a more well-rounded view of what will actually happen. It also takes compounding into account. What’s compounding I here you ask? Let’s take a look…
How compound interest works
Understanding compounding is really important, as it is one of the building blocks when it comes to borrowing and saving. The best way to illustrate this is with an example! So…
Let’s say you have £5,000 in your savings account. Every year, after tax, you get 10% interest (ok we’re dreaming here, you’d never get this much, but let’s not test our maths too much).
After the first year, you would have £5,000 in your account, plus another £500 – the amount you’ve made on interest.
Now you have £5,500 in your account by the end of year two. At this point you will make £550 interest. This is because you make £500 on the original £5,000 in your account, and then another £50 on the £500 interest you receive.
By the third year, you’ve got £6050 in your account, so you will make £605 from the interest.
This is known as compounding. Essentially, it makes you are going to make more money as your money grows because you are not only earning interest on the money you have saved, but you are going to earn interest on the interest. Thus, the longer you save, the bigger this effect will be.
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