Beginner investors: how to avoid taking on too much risk

interactive investor launches a risk page to help private investors, and shares tips for beginners.

Tomorrow, the Financial Conduct Authority (FCA) is expected to publish a paper on younger investors potentially taking on too much risk.

The past year has seen a significant rise in beginner and younger investors, and in Quarter 4 2020, 25% of new interactive investor customers were under 35.

While a whole generation of investors getting into good long-term investment habits is to be celebrated, the FCA is right to sound a note of caution. interactive investor, the UK’s second-largest investment platform for DIY investors, has today launched a risk page for private investors, Risk and You, in its Knowledge Centre.

While interactive investor’s Private Investor Index, published in January 2021, suggests that younger investors, on average, have balanced portfolios, with a good blend of shares, investment trusts and funds (and 18 to 24-year-olds had a clear preference for investment trusts), the Reddit/GameStop (NYSE:GME) saga is a cautionary tale for beginner and more experienced investors alike.

But it isn’t always a case of too much risk being the problem – too little risk can be an issue, too. A report published by interactive investor in December last year, Show Me My Money, found that more than a fifth (22%) of 18 to 34-years-olds have a low-risk pension, suggesting that younger people could be too risk averse when it comes to their pension, potentially damaging their chances of long-term investment growth.

A Mind & Money podcast, aired by interactive investor in February, suggests that young people should be taking more of the right kind of risk with long-term investments, such as a pension, rather than being drawn into the wrong kind of risky ‘get rich quick’ investment opportunities that have grabbed headlines in recent months.

Becky O’Connor, Head of Pensions and Savings, interactive investor, says: “It’s absolutely right that younger people are encouraged to invest. Greater awareness of the benefits of investing among younger people is a good thing, despite the recent Reddit-fuelled rise of GameStop; the rise of social media investment influencers and the constant talk of bitcoin successes driving some young people to act in a very risky way.

“Historically, young adults have been nervous about investing and show tendencies towards risk aversion, perhaps because they are wary of not being good at something new.

“So a rise in awareness may be the silver lining of some of these recent trends, if it helps young people to overcome their usual nervousness as well as inspires them to do more research on the benefits of investing. Engaging young people has always been one area where the industry has struggled.

“But young people need to learn the right kind of risks to be taking, the ‘how’ and the ‘when’ of risk, to meet their life goals over the long term. They need to be taught that there is much more to investing than a quick punt on a hyped-up stock, which might go badly wrong. If the fingers of younger investors get burned now and that puts them off investing in the future, they could miss a golden opportunity to help protect their future well-being, through sensible, long-term investing.”

interactive investor share some tips for first-time investors:

Before you invest, pass these tests

Kyle Caldwell, Collectives Specialist, interactive investor, says: “First, everyone should have some ‘rainy day’ money for emergencies, ideally three to six months’ salary in cash. This will ensure that if something happens and you need to access your cash, you can do so easily and will not have to sell your investments during a potentially disadvantageous time.

“Second, clear debts, tackling the most expensive ones first. While it is important to have rainy-day savings, it is not normally a good idea to prioritise additional savings over reducing debts, because debts usually cost more in interest than savings earn.

“And the third test to pass is to be committed to investing for at least five years, as over the short term the stock market can be pretty unforgiving.”

Make sure you have a balanced portfolio

Global funds and investment trusts are a great place to start, because they spread risk broadly and are available from £25 per month. interactive investor recommends a number of global funds and trusts on its Super 60 and ACE 40 rated lists.

interactive investor also recommends six carefully selected Quick-Start Funds for beginner investors:

ACTIVE/SUSTAINABLE

• BMO Sustainable Universal MAP Cautious. The lowest risk of the three BMO funds. It targets an annualised return of 2% above inflation over five years and can hold as little as 20% and as much as 60% in equities.
• BMO Sustainable Universal MAP Balanced. The medium-risk option. The fund targets an annualised return of 3% above inflation over five years. The fund can hold as little as 30% and as much as 70% in equities.
• BMO Sustainable Universal MAP Growth. The most adventurous, higher risk of the three but with potential for higher gains. The fund targets an annualised return of 4% above inflation over five years and can hold as little as 40% and as much as 80% in equities.

Bear in mind that each target for the funds is just a target and not guaranteed.

PASSIVE

• Vanguard LifeStrategy 20% Equity - for shorter term goals (3-5 years)
• Vanguard LifeStrategy 60% Equity (for 5+ years)
• Vanguard LifeStrategy 80% Equity (for 5-10 years)

Moira O’Neill, Head of Personal Finance, interactive investor, says: “These Quick-Start options are well-diversified, multi-asset portfolios that are very competitively priced. With passive, active and sustainable options covering a range of risk profiles, these are a good starter option and should appeal to a broad range of needs.

“Investors can choose from the six-strong range of one-stop shop solutions, depending on their attitude to risk.”

Keep an eye on costs

Kyle Caldwell says: “Regardless of how you choose to invest – whether through funds, investment trusts or exchanged-traded funds – a certain level of performance cannot be guaranteed in advance.

“However, one thing that investors can control is costs. It is easy to overlook costs, especially when quoted as a percentage but they can make a big difference over the long term if the fund does not outperform.

“Higher returns emphasise the difference a higher charge can make. £10,000 invested over 25 years and growing at 5% a year would be worth £3,597 more with an annual fee of 0.25% rather than 0.75%.”

Diversify - but not too far

Kyle Caldwell says: “Diversification gives a portfolio ample opportunity to grow, while at the same time guarding against serious short-term losses.

“While the theory does work in practice, investors need to avoid the pitfall of over-diversification. This is known as ‘diworsification’ or inefficient diversification, and occurs if you buy too many funds that are similar – for example, several UK funds.

“The risk is that an investor can end up owning most or even all of the companies in an index. This runs the risk of replicating the market, something that can be done much more cheaply through a passive fund – an index tracker or ETF.”

Invest regularly rather than all at once

Moira O’Neill, Head of Personal Finance, interactive investor, says: “Monthly investing takes some of the emotion out of investing, a behavioural flaw that can prove detrimental to returns. It means you buy more shares when prices are low and less when prices are high, smoothing out some of the highs and low in prices. Interactive investor offers free regular investing for funds, investment trusts and popular UK shares.”

Reinvest your dividends

Kyle Caldwell says: “The power of reinvesting dividends makes an enormous difference to long-term investment growth, as the effect of compounding works its magic. Compound growth refers to the way investment returns themselves generate gains. For instance, if you invest £1,000 into a fund returning 5% over one year, you’ll earn £50. Assuming the fund returns 5% the next year and you don’t withdraw any money, then you’ll earn 5% on £1,050, which is £52.50.

“This doesn’t sound like much of an uplift, but as each year passes, the compounding effect multiplies. The effect becomes even more powerful when compounded growth is bolstered by the reinvestment of dividends. Indeed, over the long term, dividend growth is where the vast majority of returns come from.”

Have an annual spring clean

Kyle Caldwell says: “Like most ‘tidying-up’ jobs, reviewing a portfolio twice a year is not something investors are likely to look forward to, but it is necessary as it stops complacency creeping into a portfolio.

“As part of a spring clean, take a look at the winners and consider converting some paper gains into real profits. The proceeds could then be reinvested into areas of the portfolio that have been underperforming but may soon recover their poise.

“It is also a good idea as part of the review to take a step back and remind yourself of your investment goals and attitude to risk.”