If you ask 100 people “how does investing work”? you will get 100 different answers. Each varying in detail and complexity.
Some people love cryptocurrency and trading stocks, whilst others enjoy building real estate empires.
It’s also a matter of perspective. Someone who earns a six-figure-salary or inherited money may give you a completely different answer to someone like myself. My approach is more of a slow burn to financial freedom.
Therefore I really wanted to give you the most straightforward explanation of how investing works. Especially, if you’re starting from scratch with limited time and money.
Disclaimer: This article should not be considered as financial advice. You are responsible for your own financial research and decisions.
Andrew / Mr Money Side Up
How Does Investing Work! – In Less Than 200 words.
- Invest in index funds: Buy one global stock fund that represents the stocks in the country you are from internationally.
- Wrap this in a tax-advantaged account such as a stocks & shares ISA, LISA, SIPP, or workplace pension.
- Automate consistent monthly contribution into this fund so you pound-cost-average through the peaks and troughs of the stock market.
- Forget (almost) about this account, so that you don’t see or react to market corrections or crashes. – Be confident in the logic.
- Review your investment plan occasionally and adjust your contributions or asset allocation accordingly.
So that’s the cliff notes for those of you who really don’t have the time or inclination to read more about investing.
For those of you who want to understand in more detail read on.
How Does Investing Work? – The Slightly Longer Explanation
As I mentioned before, there are three or four places to start with investing. There is the Stocks & Shares ISA, The LISA, SIPP or workplace pension. All have their own perks.
#1 Your Workplace Pension Contribution
One of the easiest places to start with investing is your workplace pension. You’re probably already doing this, but you might be missing out on some FREE money!
It’s compulsory for your employer to contribute a 3% match to your contribution, so whatever you do, don’t opt-out. However, many employers will match up to 6% (like my old employer), 12% or even higher.
Let’s assume that you earn £30,000 per year. Your employer offers you a pound-for-pound company match, up to a 6 percent maximum on your pension contributions.
That means that 6% of your salary equals £1,800.
If you contribute £1,800 into your pension fund, your employer will be obligated to contribute another £1,800.
You can also pay less national insurance, taxes and student loans if your company uses a ‘salary sacrifice’ scheme to pay into your pension.
This is because your 6% pension contribution would be calculated from your gross pay, rather than your net pay – after NI, Tax and student loans.
Where Is Your Workplace Pension Contribution Going?
You have the option to choose your investments when you put money into a company pension plan. There are usually a number of reasonable funds you can direct your money into and this is usually with a company such as BlackRock, Fidelity, Legal and General and so on.
Most people have no qualms with directing thousands of pounds a year into a company pension plan.
This is strange. Why is it strange?
It’s strange because It’s incredibly common for people to feel safe and secure when investing into a company pension plan but not in the stock market. In fact 61% of adults say they find investing in the stock market scary of intimidating.
However, by investing into your pension you ARE investing in the stock market – or at least a high allocation will. Therefore, there really is no reason you should fear the stock market. You’re probably already investing in it!
Your company pension is just the type of wrapper you are holding your investments in.
The stock market is always the stock market, regardless of how it’s presented to you.
#2 How Does DIY Investing Work: Opening A Stocks & Shares ISA
Now remember what I said about the fact you’re prabably already investing in the stock market, don’t get nervous! Think of it like this, your;
- Your account is a tea mug (i.e. pension, stocks and shares ISA).
- Your investments are the tea itself (i.e. stocks, bonds.
So you are just wrapping up stocks in a slightly different way. Although this often comes with more investment choice: Although you can also choose the type of tea you want to drink, it could be:
- Yorkshire Tea with Milk (large-cap stocks),
- Earl Grey (bonds)
- Green Tea (ESG stocks)
- Fruit Tea (Let’s go with small cap stocks)
- Bubble Milk Tea (Emerging market stocks).
For all the different types of tea in the world, there are probably an equal number of investment options.
Choice is great but it often complicates things, can be overwhleming or even distracting. I love to try out different bubble teas and Taro Milk Tea or Matcha Milk Tea are my favourites at the moment.
It’s great to experiment but when it comes to investing you really need to know what you are doing. Too many options can leave to paralysed.
When it comes to investing your best bet is the Yorkshire Tea of investing; low-fee index funds. Simple but effective.
Enough Of The Tea Metaphor Already – What’s An Index Fund
Index funds track the overall broad market, so the results they achieve are as good as the overall economy.
You might think that sounds like a low bar, but historically the U.S. economy has produced returns of around 10% in the long-term.
Statistically speaking, 90% of the ‘experts’ who try to beat the market actually underperform (get worse returns than the overall market).
To add insult to injury, the many of these so-called experts charge higher fees, regardless of the fact that they underperformed.
By contrast, by simply tracking the index you would have been in the top 10% of investors.
#3 Investing In A Stocks And Shares ISA
You can invest up to £20,000 per year into your investment account and pay absolutely zero taxes. What does this mean for you?
Let’s consider a hypothetical situation.
Say you invested £20,000 per year into the stock market without an ISA and this grew 5% per year for 5 years, you would have £116,038 in your portfolio.
If you then withdrew this money after those 5 years, you would pay £4,491 in taxes!
However, if your fund is within a stocks and shares ISA you pay absolutely nothing. This is because any money invested within an ISA is exempt from capital gains tax. As a result you pay no taxes when you buy or sell those stocks or shares, or any other asset.
I can’t see any reason why you would invest without a stocks and shares ISA to protect your investments from further taxes.
Investing into a fund that is ISA protected in dead simple and most index funds are ‘ISA ready’.
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#4 How Does Auto Investing Work?
Automating your investments is an easy way to take the stress and time out of investing.
By investing in something such as an Index fund you don’t have to worry about buying or selling individual stocks.
If you select an ETF fund or responsible wealth manager you can also leave to rebalancing or your portfolio (e.g. the percentage of stocks vs bonds) to them too.
Fintech is making these types of investment decisions ever simpler and easier to implement. For example, startups like ikigai are even designing all-in-one money management solutions which allow you to spend, save and invest, all in one place.
Setting up a direct debit from your savings to investments can also ensure you consistently keep investing overtime. So make sure you find an institution which makes this part of the process easy.
#5 How Does Investing Work When You Have Limited Time or Money
You’ll probably get the impression that I enjoy talking about personal finance and investing. Therefore it might surprise you to hear that I’m actually pretty apathetic when it comes to the actual process of investing.
I don’t want to spend copious amounts of time managing my portfolio. Spending time worrying about what or who to invest in or when to invest would be far too stressful. In fact, hitting any kind of ‘buy now’ button is enough to give me the sweats.
Therefore, finding a wealth manager that makes this process as straightforward as possible is one of the most important factors for me. I want the quickest number of steps from A to B without fretting that I am going to make a mistake.
With this in mind, when I select a wealth manager my top priorities are:
- Transparency: I always want to know the fees and total costs of investing.
- Simplicity: a simple and clear breakdown of where my money is going and why.
- Accessibility: easy to track progress of my investments and amend my plan.
Back when I was a new investor, I kept coming across accounts with complicated fees, a really high investment minimums.
So finding a fund that allowed me to invest at my pace, risk tolerance and the money I had to invest at the time, was super important.
So it’s crucial to find a wealth manager where you can easily understand the portfolio, fees and potential returns.
Although I invest and will continue to invest with the likes of Fidelity or Vanguard. I do really like how the likes of ikagai, Money Box, Money Farm, Nutmeg, Wise (soon), are shaking up the face of investing.
How To Make Investing Work For You
Now you know some of the basics for investing, you should start to think about how you can implement them.
You need specific information (e.g. which index funds you can invest in).
How to open an account step-by-step with a responsible investment company.
However, most importantly you need to make a plan. One which you can take action immediately. You can use my financial independence planner to do this. Otherwise you risk deferring your journey to financial freedom by years if not decades.
Perhaps most crucially (but also the most fun) is to work out how much you need to invest each month to achieve financial independence and retire early. You can use my financial freedom calculator (also below) to do this.
Remember, to also track your progress along the way with my net worth tracker. This is a habit that’s helped me more than triple my net worth in just a few short years.
