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5 basic financial terms and concepts every investor should know

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It’s tempting to believe that the most important route to building wealth is to find the raciest technology stock imaginable and back it with all your spare cash. It isn’t. Or, at least, it isn’t likely to be. In reality, growing your wealth over time is far more mundane – fortunately, it is also easier. You just need to bear five key concepts in mind:

 

1. Compounding

Making money in their sleep is most people’s idea of a good result: this is pretty much what happens with ‘compounding’. In the first year, an investor puts £100 into an investment and receives, say, 5% in interest or dividends, bringing the investment to £105. In the second year, if he makes 5% again, he not only receives 5% on his original stake, but on the extra £5 he has made. By the end of the second year, his investment is worth £110.25.

The effect is more powerful the longer it goes on, which is why it is worth starting an investment as early as possible and staying invested for as long as you can.

 

2. Staying invested

When Donald Trump is at his keyboard, punching out his latest tweet to the head of a rogue state, it can create stock market volatility. Amid that temporary volatility, it is tempting to panic-sell out of all your investments. However, this is a bad option for two reasons. The first is that you’ll probably get the timing wrong. Nothing personal, but most people do. They sell too early, miss out on rising stock markets and then fail to reinvest in time to benefit from the recovery.

The second problem is that during the time you aren’t invested, you are missing out on dividends. The income on the FTSE All Share index is over 4%. That’s a lot to chuck away while you hide money under the bed hoping to miss the downturn. Better to stay invested and just take the hit. Markets tend to recover over the long-term.

 

3. Dividends

That brings us neatly to dividends – regular cash payouts from certain types of investments – which are the great friends of any investor. Research by Schroders showed that if an investor reinvested their dividends to buy more shares each year for the past 25 years, they would have made a return of 7.8% every single year. If they hadn’t reinvested those dividends, they would have made just 4.1%. Not bad, but no cigar.

Putting that into pounds and pence for the next 25 years, a lump sum of £20,000, invested for 25 years growing at 4.1% would grow to a tidy £55,645 at the end of the term. Growing at 7.8%, it is worth £139,689. Magic.

 

4. Taking enough risk

This sounds crazy – who wants to take a risk with their investments? However, without risk, there is no reward. Without risk, you’re stuck in a savings account getting 1% interest on your cash. This is a bad idea, because your pot is being whittled away by inflation (currently running at 2%).

You need to take enough risk for your savings to grow over time and beat inflation. The stock markets bounce around, but they are not as risky as you think. Research by Willis Owen showed that over any 10-year period in the past 33 years, investors would have made money 98% of the time. The only exceptions were when they bought right at the top of a bull market (in 2000 or 2007) and sold right at the bottom.

IG Index showed a similar pattern: its research showed that looking over every 10-year period since 1986, investors in the FTSE All Share index had a lowest annualised return of -1%, and a best annualised return of +17%. 17% upside for –1% downside – those look like reasonable odds. For those who stay invested, stock market investment isn’t the rollercoaster ride it’s made out to be.

 

5. Diversification

Yes, you might find the raciest technology stock. However, if it turns out to be a dud, you’ve lost all your money and there’s no fun in that. Share prices bounce around and that can be unnerving. Spreading your investments across different sectors, different regions and across large and small companies – diversifying your investments – can ensure you get enough growth in your portfolio, without the wild ride.

There you have it: the five most important concepts in finance. Far easier than looking for that elusive technology stock, and far better for your long-term wealth.

 

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