A Contractors guide to investing through Contractor Financials
Ideally you will look back on your time contracting as the period when you had the opportunity to build a nest egg that ensured financial security for life.
Your income will probably have increased now that you’re freelancing and this offers a unique opportunity to build the foundations of a prosperous future.
The danger is that it is all too easy for an improved monthly budget to be gobbled up by increased monthly expenditure. The solution is to make a firm commitment to invest smaller, more manageable amounts but to also make sure you invest often.
Pound Cost Averaging
As Independent Financial Advisers our experience has shown that regular monthly saving is by far the most effective way to invest. You probably plan your household budget around a monthly/quarterly cycle and so can more easily see what scope you have to set money aside from each invoice. You are also far more likely to maintain a relatively painless direct debit than write a hefty cheque once a year.
Drip-feeding money each month into an equity based investment, say via pension or unit trust also makes a virtue of the fluctuations of the markets. When markets drop, your monthly direct debit buys more investment units as a result of the lower prices on offer. This compensates for previous months when prices were higher and you bought fewer units and so, unlike lump sum investment, timing becomes far less of an issue. In financial circles this process is known as Pound Cost Averaging.
Risk versus Reward
The key to successful investing is to understand how much risk you are prepared to take on your investment.
We encourage clients to accept as much risk as possible in an attempt to gain greater potential rewards. Younger clients can accept that short term fluctuations to values are academic whilst other clients are invariably playing catch up after periods of investing nothing or are making up for periods without pensions as they job hopped up the corporate ladder.
As an investor you may have a wide range of asset classes to choose from but it is important to understand the ‘risks versus reward’ implications of each type of investment before you commit:
- Cash - simple deposit accounts are often regarded as low risk but they are by no means risk free. Inflation, for example, reduces the spending power of cash as it increases the value of goods and services over time. The current low headline rate of inflation masks massive increases in household bills as a result of rising taxes and energy costs. This means that the real value of investments into cash could significantly decrease over time. There is also what is known as an ‘opportunity risk’ of not being exposed to other types of investments – you lose the opportunity to gain greater returns from an alternative type of asset.
- Bonds and Gilts - many low risk investors choose to invest in bonds or fixed interest securities. When investing in a bond you are essentially lending money for a fixed term to either a Government or Company. In return for your money these IOUs pay a rate of interest, usually at regular intervals and the issuer buys back the bond when it matures. The benefit of this type of investment is that the investor receives a fixed income. The risk is that the company, or in extreme cases the government, may default and you may not get back your original investment. There is also a risk that fixed interest securities can go down in value during periods of high inflation, as investors are able to obtain better returns on short-term cash.
- Property - both commercial and residential property investment has historically offered good long-term returns. Investing directly allows the potential to ‘gear’ using bank borrowing to buy a more expensive property but this also increases the potential risks in any slowdown. Risks can be reduced using a pooled unit trust style investment where your funds are grouped with many other investors enabling a manager to purchase bigger properties and diversify your individual holding.
- Equities - historically, the best returns for a long-term investor have been gained from investment in stocks and shares (also referred to as equities). In return for these greater rewards investors have had to accept that there is a risk to their underlying investment. The price of companies trading on a stock market is a reflection of their value as interpreted by supply and demand for the shares by investors. When investing in a company’s shares you are essentially buying rights to a proportion of that company’s future profits. The risk is that this company does not perform and the shares fall in value or become worthless. The risks of equity investment can be especially high if you own shares in only a handful of companies and for this reason, as advisers, we favour a pooled investment for equities based saving where your money is properly managed by a specialist who has the time and resources to research the markets and spread your money across dozens of shares in any one stock market.
Diversification is the key
The potential exposure to risk can be reduced for your entire investment portfolio if you place funds across different asset classes. Spreading your hard earned money across shares, property, bonds and cash means that as one asset class dips in value the chances are that the ‘smart money’ is moving into an area that you are also exposed to. Over time this method of investing has consistently been proven to be the most effective. Too many investors are narrowly focused on one asset type, which increases the risk that opportunities are missed and risks potentially increased.
No investment will ever be risk free but the options open to the ordinary investor today are enormous in comparison with a generation ago. The key is to invest regularly, spread your efforts across a range of asset classes and monitor those investments to ensure they are always in line with your objectives. With the state increasingly unlikely to support us in times of hardship or old age there has never been a bigger impetus for us to take control of our own financial futures. The answer is to make every invoice counts towards that nest egg.