Printable page generated Thursday, 26 Nov 2020, 02:09
Use 'Print preview' to check the number of pages and printer settings.
Print functionality varies between browsers.
Printable page generated Thursday, 26 Nov 2020, 02:09

# Week 1: Why and how should we invest for the future?

## Introduction

Welcome to Week 1 of Managing my investments. Martin Upton, Director of the True Potential Centre for the Public Understanding of Finance, based at The Open University Business School, presents a summary of the subjects and issues that will be explored during the next six weeks. Martin is a specialist in personal and corporate finance, and will guide you through this free course.

Skip transcript

#### Transcript

MARTIN UPTON
Hello everyone, I’m Martin Upton of the Open University’s True Potential Centre. Welcome to the first week of Managing My Investments – the course that aims to help you align your investment strategy with your future financial needs.
We start the week by examining the importance of savings and investments for individuals and the economy as a whole. We then take stock of how well we fare in the UK when undertaking investments.
The overall picture presents issues of concern. Arguably we don’t do particularly well, both in terms of how much we save and the range of investments we employ. We’ll try to decipher why this is the case. We’ll then start to assemble the building blocks of an investment strategy by looking at the principles and plans that should underpin investment management. These include understanding your risk appetite and your time horizon for investment planning.
We also start to get to grips with two of the central determinants of investment returns interest rates and share prices. We look at recent trends in these in the UK and the drivers of these trends. It’s all part of the process of starting to build your confidence in understanding what influences the returns you can get for different types of investments.
So, at the end of the first week you should understand the investment record in the UK, the first fundamentals of devising an investment strategy and the features of two major determinants of investment returns. So let’s get going with Week One!
End transcript

Interactive feature not available in single page view (see it in standard view).

In this first week we will explore:

• the current features and recent record of personal investment activity
• the first building blocks for constructing an investment strategy
• the factors that determine the levels of interest rates – one key determinant of investment returns
• the driving forces of movements in share prices – another key determinant of investment returns.

In examining these subjects, you look closely at recent trends in interest rates and share prices and the specific factors that have recently impacted on their levels.

At the end of the week you will have an understanding of personal investment behaviour and two of the most important determinants of returns you get from investing.

This course is presented on OpenLearn with the kind support of True Potential LLP.

The True Potential Centre for the Public Understanding of Finance (True Potential PUFin) is a pioneering Centre of Excellence for research in the development of personal financial capabilities. The establishment and activities of True Potential PUFin have been made possible thanks to the generous support of True Potential LLP, which has committed to a five-year programme of financial support for the Centre totalling £1.4 million.

Before you start, The Open University would really appreciate a few minutes of your time to tell us about yourself and your expectations of the course. Your input will help to further improve the online learning experience. If you’d like to help, and if you haven't done so already, please fill in this optional survey .

## 1.1 Savings and investments

Figure 1 The circular relationship between assets and income

In Charles Dickens’s book David Copperfield , Mr Micawber infamously mused that an annual income of £20, coupled with an expenditure of £19, 19 shillings and sixpence (leaving sixpence over to save) was happiness itself. Whereas the result of spending £20 and sixpence (and having to borrow the difference) would be misery. Linking happiness or misery to having surplus income or surplus expenditure may be somewhat simplistic, but for many people having spare income, and thus an ability to invest for the future, can indeed help make life easier and more rewarding.

Figure 2 WC Fields as Mr. Micawber from the film ‘David Copperfield’, 1935

This course starts by looking at the importance of savings, why households save and invest, and the features of personal investment activity in the UK. We begin by defining some terms you are going to come across.

First, we want to draw a distinction between the definitions of saving and savings. Saving refers to a flow of money in a particular time period – such as putting money into a building society account. By contrast, savings (note the plural) are the current value of the total accumulated sum of previous saving. Savings are therefore the value of the stock of such savings that a household has at a particular point in time. Saving is connected to savings because saving in any given time period will add to the accumulated stock of savings. Consequently, if I already have £100 in a savings account, that £100 is my savings, but if I put an additional £25 a month into the account, I am saving £25 a month – after two months, my savings will have increased to £150 (plus any interest – the return paid on savings – earned).

We use the terms ‘saving’ and ‘savings’ in the same way as the UK Government’s official definitions, to encompass putting money into both ‘savings products’, such as deposit accounts, and ‘investment products’, such as shares, government bonds, and investment funds – including pension funds. However, you will notice that this section is called ‘Savings and investments’. This is because in personal finance a distinction is often made between the two with savings being associated with money held in bank and building society accounts, while investments relate to money held in shares , bonds and funds .

A key point about saving is that it defers (or puts off) consumption today in favour of consumption at some time in the future. This future may be a night out or holiday in the coming months or year, or even many years away in the case of a young person saving for retirement. Saving can even be for after death, such as when people save in order to bequeath or leave money for their children. This contrasts with the taking out of debt, which is bringing consumption forward by buying now and paying later.

You should also note the relationship between assets held in the form of savings and investments and income. The receipt of income immediately adds to assets, for instance, when income is paid into a bank account. Such assets may only be temporary because the money is then used in the typical outgoings of a household, paying bills and living expenses, but any surplus income that isn’t used adds to a household’s savings and other assets. In turn, assets like savings usually produce an income in the form of interest on a savings account, for example. This interrelationship is summarised in the diagram above.

One other important point to note is that households often have debts and savings simultaneously – they are not mutually exclusive. For example, many households have a mortgage and a savings account. They can also be saving (for example, contributing to a pension fund) and taking out more debt (for instance, adding more to a credit card bill).

### 1.1.1 Why should we save and invest?

Saving and investing defers consumption from the present to a time in the future. Therefore, when thinking about the reasons for households to invest, we’re really thinking about why households are deferring consumption rather than consuming now.

One important reason for saving is known as the ‘precautionary motive’ – perhaps more commonly known as ‘saving for a rainy day’. This involves building up funds to provide for unexpected events and bills. If you have no savings and an unexpected event with financial consequences occurs (such as a car being damaged or someone becoming too ill to work and losing their income), then there are only three alternatives:

1. receiving a payout from any insurance taken out against such an unexpected event
2. borrowing money (from family, friends or financial institutions) to pay the unexpected bills
3. defaulting on any commitments, for example not making payments on a car loan or a mortgage, with the consequent risk of repossession and negative impact on future credit ratings.

Having funds set aside in investments is an important means of preparing for unexpected life events – the savings act as a buffer to protect a household against these other possibilities.

A second reason for investing is to do so for a specific purpose. You can put a certain amount aside each month (or week), based on a calculation of how much you need for a particular goal. One of the most significant purposes for saving is for retirement, but investing can also be for many other reasons, for instance saving for a child’s university education, sending money abroad to family or paying the costs of a nursing home for a parent. You can also invest money temporarily – normally in savings accounts – for events that occur in the relatively near future, like a holiday or Christmas, or for buying a car.

A third reason for investing could be to accumulate wealth for which, as yet, there is no defined purpose. The savings may later be spent on a variety of things, for example a second home, a series of holidays after retirement or leaving an inheritance to children.

These three reasons all underline an important overall aim of having investments – to give a sense of independence and autonomy to do things. Having sufficient funds in your investments could enable you to leave a job, to take a break for a few months. It could also enable you to do or buy things that you want, or to take advantage of opportunities that arise (such as being able to pay for education or start a business).

### 1.1.2 Why are savings and investments important for the economy?

Watch the video below to hear Anthony Nutt, an investment fund manager, talk about the importance of personal investments to the economy and the impact of economic policy on savings behaviour.

Skip transcript

#### Transcript

MARTIN UPTON
Anthony, why are savings and investments so important for the UK economy?
ANTHONY NUTT (Retired investment director and fund manager)
Well Martin, if you think of the role that the investor plays within the economy, he’s a provider of capital. Whether he’s saving in fixed interest markets or whether he’s in equity markets, he’s providing capital to businesses; essentially. He may be institutional, he may be personal. But providing that capital plays a very important role for businesses to grow.
MARTIN UPTON
So, OK savings and investments are very important but the record in the UK isn’t very impressive. It doesn’t look like we save enough and it doesn’t look like we plan our investments very well, do you agree?
ANTHONY NUTT
Well, culturally over the last forty years I would argue, we’ve changed from being a nation of essentially savers, people were more prudent than they are now; we’ve been encouraged culturally for all sorts of reasons, we’ll maybe lay the blame at banks, we’ll maybe lay the blame at governments, to consume more and to spend more. So we typically have so much more debt in this country, as individuals, than we had in the past. Disposable income has an important role to play here too and there isn’t at the moment. There is a less amount of money available for people to save. People are struggling, for reasons of economic policies, for cultural reasons that you allude to; to be as strong a saver as they have been in the past.
MARTIN UPTON
When it comes to the saving culture, what role should the government be playing here? Is it up to the government to try and encourage savings?
ANTHONY NUTT
Well, the government always has a very important role to play, but the governments’ role varies depending on economic necessity. We are going through a period now, in 2015, of what’s become known as financial repression. The governments requirements now are to maintain interest rates at such a low level that people who have high levels of debt, be they institutional, be they corporate, be they government and be they retail personal investors can maintain and pay down those levels of debt without going into liquidation, without personally going bankrupt, without having any serious economic consequences for currency etc. So the government likes to encourage saving and from time to time will issue investment vehicles, national savings, gilts, whatever it may be.
MARTIN UPTON
Limits on ISA’s have gone up as well?
ANTHONY NUTT
Exactly, to encourage investors. But it is restrained I think at the moment by the level of debt in the economy. It needs to reduce that level of debt for people to be more, to be saving more.
MARTIN UPTON
Let’s talk about investment planning, let’s say I’m someone who hasn’t got any experience of investments, I’ve got the literal blank sheet of paper, where do I start?
ANTHONY NUTT
Well first of all I would say it’s not as bewildering as it may appear. You know for the person coming to the investment arena for the very first time, it does look bewildering. But believe you me it isn’t.
And the first thing you must do before you consider any investment whatsoever is have a look at what your aims and objectives are. Are you saving for a pension, are you saving for a house, a car? Are you saving for school fees?
And once you’ve decided what your realistic aims and objectives are, you can then have a look at various investments, the whole investment arena. Maybe fixed interest, maybe bonds, maybe equities, maybe property, whatever it may be, maybe vintage cars, whatever you call an investment.
And decide, and determine through the various models that are available, and the promises that are being made to you as an equity investor, or as a bond investor, i.e. what’s the rate of interest you’ll get from that bond? And does it meet your aims and objectives? And if it doesn’t, and I think this is a very important point, if it doesn’t then anything over and above that that you’re expecting is speculative.
It’s less about investment at that point and more about, can I say, gambling. And so often the retail investor mixes the two up. He wants high returns, he thinks he’s investing, but I would argue he’s not investing, he’s actually gambling.
And let me say at this point the essential objective of any investment is less about the price you sell it at but the return you get from it whilst you are an investor in that entity. That is the important thing because the price you see it at can be determined by all sorts of sentiment, maybe a euphoric stock market, maybe a very bearish stock market if we are talking about equities. So that is much more speculative.
So I like to think as an investor if I’m planning for pension, whatever I’m planning for, what is the return and what am I going to get while I retain that investment. Am I going to get a yield of 4 per cent or half a per cent?
MARTIN UPTON
And the time horizon is critical, isn’t it?
ANTHONY NUTT
The time horizon is absolutely critical because if your time horizon is too short then you are going to suffer, or you’re more susceptible to the vagaries of the stock market, if I can call it that.
What does that mean? You’re more susceptible to sentiment, to short term economic policy, to…well it can be most things it could be the weather quite frankly if you’re investing in the insurance industry, but over the long term these things are ironed out.
End transcript

Interactive feature not available in single page view (see it in standard view).

As well as being important for an individual or household, investments are important for the broader economy.

There is interdependence between the household sector and other sectors of the economy, such as the corporate sector. For example, in the act of saving, households are not buying the goods and services that firms sell. However, by saving, households are placing money in financial institutions and this provides a potential source of funds for firms to expand and to invest themselves.

Governments also have an interest in household savings. One reason for this is that governments often spend more than the receipts they have from taxation – this has most certainly been the case since the 2007/2008 financial crisis which saw the budget deficit (the difference between tax receipts and government spending) rise to a record level. To cover such a shortfall, governments have to borrow, including directly from the public. Governments have encouraged people to put money into government savings schemes (and, effectively, loan the government money), such as National Savings and Investments Certificates and Premium Bonds.

### 1.1.3 Savings and the life course

Households are motivated to save at different stages of the life course, such as those depicted in Figure 4, weddings, holidays and motoring.

Households are often targeted by the marketing departments of financial institutions according to their stage in the life course and the type of household. These are significant factors in the selling of different types of saving and investment products.

#### Activity 1.1 Your reasons for saving

Think about the following questions then post your answers in the course forum and discuss with other learners. When posting in the forum you should head your post with the title of the activity so other learners can join in.

• What are your reasons for saving money?
• Are your reasons for saving the same as any of those given in the image above?

## 1.2 Savings behaviour in the UK

So how much savings do UK households have?

Data based on the Family Resources Survey 2012/13 (Department for Work and Pensions (DWP), 2014) provides evidence to explore this question. Remember, by referring to savings we mean the stock of such savings that UK households have.

### Table 1.1 Percentage of households by amounts of savings and investments, 2012/13

SavingsAll households (%)
No savings35
Less than £150013
£1500 but less than £30007
£3000 but less than £800013
£8000 but less than £10,0003
£10,000 but less than £16,0007
£16,000 but less than £20,0003
£20,000 or more20
DWP, 2014, Table 2.8
Note: Figures do not add up to 100, due to rounding.

As you might expect, households have different levels of savings, with 35 per cent having no savings at all, while 20 per cent have savings of more than £20,000.

The Office for National Statistics (ONS) says significant caution needs to be exercised when drawing firm conclusions from data on savings such as that presented above.

### Activity 1.2 Caution

Why do you think the ONS might suggest such caution?

Make some notes in the box below.

You can type text here, but this facility requires a free OU account. Sign in or register.
Interactive feature not available in single page view (see it in standard view).

#### Discussion

The responses provided to surveys where people have to provide personal information – particularly information about their finances – need to be treated with care.

The reason for the caution is linked to how data on savings is collected. Much official government data is based on surveys where households are asked to complete a questionnaire. An estimated one in four households simply does not know the value of its investments, while others may deliberately understate the value of any assets they have. Disclosing financial data can be seen as sensitive, and so collecting such data accurately can be problematic.

### 1.2.1 UK household investments (excluding pensions)

The table below provides a breakdown of the types of savings, investments and accounts that households have in the UK. As you can see, over nine out of ten households have a current account, and over half have other (savings) accounts, with bank or building society savings accounts and ISAs dominating. Lower proportions of households have stocks and shares, and over one-fifth of households have investments in premium bonds. In 2012, two per cent of households had no kind of bank account, let alone any investments. We shall be looking at some of these products in more detail in Week 2.

#### Table 1.2 Types of formal financial assets in UK households, 2010/2012

Type of account% of households
Current account93
NS&I savings account5
Basic bank account6
Post Office Card Account (POCA)6
Individual Savings Account (ISA)39
Other bank/building society account45
Stock & shares/member of a ‘share club’15
Unit trusts3
Endowment policy (not linked to mortgage)1
Company share scheme/profit sharing3
Credit union investments1
Any type of investment1
Any type of account98
Department for Work and Pensions, 2014, Table 2.7

These figures are interesting, but do not tell us very much about exactly why some households have savings and other financial assets and others do not.

The Family Resources Survey (DWP, 2010; DWP, 2014) breaks down investments by some of the social and economic variables such as income, household composition, age and ethnicity of households, and these can help explain the differences in household investment behaviour.

The findings can be summarised as follows:

• As might be expected, low-income households tend to have a lower value of investments and higher-income households have a higher value of investments.

• Households where the named head, or spouse of a household head, is unemployed or disabled are much more likely to have no investments at all.

• Pensioner couples, single male pensioner households, and couples without children tend to have higher investments, while single adults with children households have the lowest levels of investments.

• Asian and Black ethnic groups are slightly more likely to have no investments than White households.

Some of the above points remind us that investing will not be easy for everyone. It is easier to build up investments as household income increases. For those on lower incomes, investments have to be built up through careful budgeting.

### 1.2.2 The UK’s savings ratio

Another type of data to look at, apart from that of savings, is data about saving. This is usually done by examining what is called the household savings ratio (the percentage of annual household disposable income that is saved rather than spent).

Figure 6 shows the household savings ratio for the UK has ranged from less than zero (in other words, borrowing rather than saving) in the late 1940s and early 1950s to a peak of 12.3% in 1980. The savings ratio then dipped to a low of 3.9% in 1988, rising to another peak of 10.8% in 1992. By early 2008 (during the financial crisis), the ratio had slumped to 2% but recovered sharply the following year to reach 6.3%. This shows how the household savings ratio tends to be quite cyclical.

Figure 6 UK household savings ratio 1946–2015

How can we explain these changes? One factor has been the state of the UK economy. When the economy has been growing quickly (and so, personal incomes have been rising), the household savings ratio has been lower. This can be explained by the fact that when things are going well, confidence is high and people tend to spend more. This was the picture in the late 1980s and in the early 2000s. When the economy has experienced very low growth or even recession, such as in the early 1980s, 1989–1992 and again following the financial crisis, and incomes have not risen as fast or have been falling, the household savings ratio was higher. This is because when people are more concerned about their future, they tend to cut back on spending and save more.

Other factors also help to explain the changes in the UK household savings ratio. When inflation was high in the mid and late 1970s, for example, households needed to save more to stop the real value of their savings falling – consequently the household savings ratio increased. The household savings ratio averaged 8.5% during the period of relatively higher inflation between 1969 and 1991 (inflation averaged 10%), but it averaged 4.3% during the periods of relatively low inflation in the 1960s, and 4.3% since 1998 when inflation has again been low.

### 1.2.3 How the housing market affects savings activity

When examining investment behaviour, data suggests the state of the housing market may also be important. Figure 7 shows changes in the household savings ratio and changes in house prices in the UK between 1970 and 2014.

Figure 7 Changes in the household savings ratio and changes in house prices in the UK between 1970 and 2014

#### Acitivity 1.3 House prices and saving

Note your answwers to the following questions:

• Look at the chart and consider any pattern between house prices and the household savings ratio.
• Can you think of any reasons to explain this pattern?
You can type text here, but this facility requires a free OU account. Sign in or register.
Interactive feature not available in single page view (see it in standard view).
##### Discussion

There appears to be an inverse relationship between house prices and the household savings ratio. That is, when house price increases were higher (for example, in the late 1980s and most of the 2000s), the household savings ratio was lower, and when house prices were lower (for instance, in the early 1990s and 2009), the household savings ratio was higher.

This may be because people often feel that they do not have to save as much when their wealth is increasing due to the increased value of their house. Conversely, in 2009 there was an increase in saving as house prices fell and households repaid some of their borrowings. The slight dip in the savings ratio since 2009 may be linked to the pickup in house prices after 2012.

### 1.2.4 Savings in an international context

The UK has a relatively low household savings ratio compared with other countries, as shown in Table 1.3.

#### Table 1.3 Household savings ratios 2012

 Canada 3.3 France 16.1 Germany 11 Italy 4.3 Japan 1.9 Portugal 10.5 Spain 11.6 Switzerland 12.1 United Kingdom 6.6 United States 4.3
Office for Economic Cooperation and Development, 2012
Note: The ratio for the UK in 2012 was measured at a different point in the year to that for the graphs in previous sections.

The data shows the household savings ratio varying significantly between countries. The data is cross-sectional – a snapshot of a moment in time. As a result, we cannot draw too many conclusions – for example, Portugal had a negative savings ratio in 2008, but in 2012 had a savings ratio of 10.5%.

The UK household savings ratio is higher than those of Japan and the United States, but lower than those of many other European Union (EU) countries, such as France and Germany.

The reasons for these differentials are various. Cultural reasons are a key factor with some societies having a stronger tradition of saving and investing – sometimes due to the greater incidence of natural catastrophies. The financial strength of economies is also vital since households with growing affluence are better placed to have surplus income to save for the future. Access to finance is also critical: if you are confident of the ability to be able to borrow money to finance life’s major expenditures or to cover unexpected events, you may be less inclined to save to provide the funds needed to cover these.

### 1.2.5 Why aren’t we saving and investing more?

There are many factors that may explain weak savings behaviour.

• Falling real incomes – after the 2007/2008 financial crisis there was a period where the real value of earnings fell with wage rises on average being less than the prevailing rate of price inflation. This diminished the scope for surplus income to place in investments.
• Poor education – a lack of awareness of products and how to invest may also be impacting on personal investment volumes.
• Delayed benefits of investment – one key behavioural trait when it comes to money is a dislike of delayed rewards. Investing money for the future means forsaking consumption today – and this may deter people from making investments.
• Inertia – while most people know they need to invest for the future to provide for emergencies and a pension, many of us simply don’t get round to doing something about it until we are forced to do so.
• Low returns in recent years – low returns, specifically from savings accounts, may have encouraged many to spend money today rather than save for the future
• Access to debt if there is a need for cash – the continued and widespread availability of personal debt products, albeit some with exorbitant interest charges, may discourage savings. Why save when you can borrow money when needed to cover for a contingency or special occasion?
• The culture of impulse spending rather than impulse saving. Research has shown that adults in the UK spend, on average, £672 a year on impulse purchases. Investing this sum each year over the course of a working life could result in a material enhancement to the pension resources available on retirement.

### 1.2.6 Investment and retirement planning: the UK experience

To complete our review of savings and investment activity, watch this presentation by Alexandra Chesterfield, Head of Behavioural Insights at the consumer organisation ’Which?’. The video explores some features of, and shortcomings in, savings and investment behaviour (including pension planning).

Skip transcript

#### Transcript

ALEX CHESTERFIELD:
I'm going to kick-off by framing some of the issues around real consumers and risk by giving an overview of the current status quo, and the three big issues that exist around savings. I'll talk about why people don't like risk in a pensions context because given that that's the most commonly held form of investment product. Then, I'm going to talk about the potential for guarantees and to the extent to which they impact perceptions and behaviour, again, in a pensions context, and then I'll draw some conclusions, but they're not really conclusions, simply more questions.
In terms of the current status quo, I think it can be summarised by the title, really, fragile financial resilience. At last, the UK is emerging from recession and a prolonged squeeze on incomes and spending. That said, despite the increase in optimism about the economy, that hasn't translated through, to personal finances. I think it's fair to say that for many UK consumers, resilience remains fragile. One in four UK households have no savings, at all, and where people are drawing down on their savings, we're seeing that it's increasingly for day-to-day essentials rather than luxuries, for example. That situation isn't improving as consumers aren't putting more money aside. UK households saved just over 7.3% of their disposable income in 2012, but by the first quarter of 2014, this dropped to 4.9%. That's obviously from a cash savings perspective. In a longer-term, pension saving only half are currently contributing to a personal pension and currently when people are retiring about 80% of pots are below 20K, which is, simply, not enough for people to live on, by their own definition.
For those who are saving, how are they saving, and why are people saving? This chart asks the reasons why people are saving. The top one is for unexpected expenditures; a rainy day, and that's followed by holidays or leisure expenditure, or, simply because they have always saved. I think, taking that all together we can say that consumers had to save for short, medium and long-term goals but there are three, underlying reasons or mind-sets for saving. The first one tends to be for the future or the unknown, so that's for things like retirement or saving for a rainy day. For this kind of reason, the mind-set is really security and safety, so, keeping that nest egg safe is paramount. The second reason is saving to spend, so that's for the more short-term tangible goals like saving for a car or saving for a holiday. Here, I think the underlying need for the savings is liquidity, so, being able to get hold of that money, quickly. Finally, the underlying mind-set is the growing money so that's more of a traditional investment mind-set, but that's very much a minority among the general population, at large. In terms of how people save, cash is king. When you look at product holdings across the UK, it's traditional easy access savings accounts and Isa's. It's a small minority who have investment product. Property, also, is another very common form of saving.
Taking that in the round, there are three key issues with which I am sure we are all familiar. One is that not enough people are saving, two, people aren't saving enough so there is a coverage issue and an adequacy issue, three, people are not saving as well as they could. That's actually looking at the form in which people are saving. Taking those last two issues, adequacy and the form, I'm now going to come on to risk, which impacts both of those issues. Why don't people like risk? I'm going to focus on pensions because one, they're the most widely held investment products and also. Two, the importance of pensions in the wider savings gap, and those challenges I just mentioned, and then finally, they provide a good illustration as to why consumers, generally, don't like products that involve risk.
End transcript

Interactive feature not available in single page view (see it in standard view).

## 1.3 Investment planning needs a long-term perspective

We have now completed our review of savings and investment activity, with an emphasis on the UK. Clearly there is evidence of poor personal investment planning.

To avoid these pitfalls when it comes to our finances we now need to start thinking about how we should go about the business of effective investment management. Let’s build the foundations of an investment strategy.

### Looking ahead – investment planning is a long-term activity

Investment planning means looking ahead – often a great many years ahead. Whether it is for a future major purchase or for retirement, the process of building up investments may take several years or even decades. This long-term time horizon requires us to assess a number of things.

First, it requires a forecast to be made of how inflation will affect the future cost of the item to be acquired or the level of income needed for retirement. When planning investments, it is crucial that inflation is taken into account (planning is done in ‘real terms’). This means that forecasts of future values should all be in terms of today’s money, so that you’re looking at what the money invested might buy after taking into account the possibility of price rises between now and cashing in the investment.

Second, the time horizon is vital in determining the structure of investments. If the horizon is the near future, there is little sense in investing in products that may fall in nominal value. The longer the time horizon, the greater the capacity to ride out periods when investments don’t perform well, in order to benefit from their gains over the medium to longer term.

Recalibration is also vital. Checking regularly (at the very least annually) that your investments are on track to achieve your goals is vital. If they are going off track then decisions may need to be made, including increasing the amount of current income diverted into investments (increasing the sacrifice of today’s spending to benefit from greater income in the future). Alternatively, the structure of the investment portfolio may need to be revised to improve expected performance over the chosen time horizon.

Even if you invest passively and let others (i.e. fund managers) look after the management of your assets, the responsibility for monitoring and managing the investment portfolio ultimately lies with yourself.

### Filling the blank canvas

The planning process should involve:

• Starting with a blank canvas by not letting previous investment experiences and plans dictate what you plan to do now.
• Linking your investment plans to your life’s goals and the timing of these goals – for example, the time you expect your children to go to university and, consequently, require substantial financial support to ensure that they do not become over-indebted with student loans.
• Prioritising your goals. You cannot necessarily achieve all goals, particularly simultaneously, but you can have a list that comprises of ‘must haves’, ‘would like to haves’ and ‘would like to haves, if possible’.
• Taking into account that your investment planning is not a fixed plan that is set in stone. Rather, it is a living document that needs to be reviewed as circumstances change (which may increase or reduce both the need or the ability to invest for the future).
• Embedding investment activities into your life’s routines – for example, by setting up direct debits to make contributions to your investment funds monthly. This will avoid putting off, and perhaps ultimately not undertaking, investments that need to be made for the future. The default should be that you have to take action to stop investing, rather than having to take action to invest.

We can summarise this planning process through the four stage financial management model – a model that can be deployed for making all personal financial decisions including those relating to personal investments (Figure 10).

Figure 10 The four golden rules of investment

You can apply this financial planning model to your own decisions as you work through the course to help you build your investment strategy and compile your portfolio.

### 1.3.1 Retirement: the longest time horizon

Planning for retirement is the most important aspect of investment management.

The scale of the funds that need to be accumulated for a comfortable retirement dwarfs those needed for other investment goals like saving to buy a house or car, or to pay school fees.

The time span between commencing retirement planning and cashing in the investments to provide income in retirement can – and should – span decades rather than years.

Growing longevity also means that despite the choice of many to work well into their 60s, the time period spent in retirement is, on average, growing, with the related implications for the resources needed to provide an adequate pension income.

To consider how an individual or household can plan ahead for their retirement years, a robust financial planning model needs to be adopted and applied. This, or similar planning models, would be used by a financial adviser as the foundation for advice about retirement planning and provides an approach that you can also use for yourself.

Central to the situation is the goal of a comfortable retirement. The need is to have enough income throughout retirement to finance a certain standard of living. The amount required will be determined largely by expectations of spending in retirement.

This raises a question: whose spending needs? Should the financial plan look at the individual or the household? The danger of basing the plan on the household is that many households change over time as, for example, couples split up, family members and friends decide to share a home or leave, or people die.

Traditionally, married couples have adopted the household approach, and the resulting financial plans have often proved inadequate in the face of death or divorce. This is a key reason why women account for such a high proportion of the poorest pensioners today.

The advantage of a retirement plan based on the individual is that each member of the household has their own pension arrangements, which they retain even if the make-up of their household changes.

Spending in retirement can be estimated from the individual’s or household’s current level and pattern of spending. Yet there are some good reasons to think that spending in retirement may be different from spending while working, and that spending needs in early retirement may differ from those later on. You’ll look more closely at this in the next section.

An alternative might be to base estimated spending needs on the spending patterns of current pensioners, but bear in mind that what today’s pensioners actually spend may reflect the constraints of the income they ended up with rather than the income they wanted to have.

Note that Week 5 of this course is entirely devoted to the key personal investment matter of pension planning.

### 1.3.2 Investment returns

The returns that are received from investing fall into two categories – income and capital growth. Income can come in the form of interest on savings accounts and bonds, or dividends on shares.

Capital growth can come in the form of the increase in the value of the assets – higher share prices, increases in indices for investments contractually linked to a market index (like a stock exchange index) and higher bond prices for those bonds that are marketable. For savings accounts, though, there is normally no potential for a growth, or risk of a decline, in capital value. The money placed into an account does not change in nominal value and the only returns received are the interest paid on the account.

Three particular factors need to be borne in mind when measuring and forecasting investment returns:

1. All returns should be measured in real terms, not nominal, by accounting for the impact of price inflation on the value returned to the investor through income or capital growth.
2. Assets whose prices can move can clearly move down in price in nominal terms as well as increasing in price. Care needs to be taken when investing in those assets with price sensitivity – particularly if the investment period is short. As you examine different types of investments in Weeks 2 and 3, you’ll see that there is a relationship between risk and return – this being that those assets that offer the greater returns, are associated with greater risks in terms of the volatility of the value of the investments and the prospect of default by the entity with whom the investment is placed. In Week 3 you’ll look closely at the types of financial risks investments may be exposed to and at how effective risk management is central to investment management.
3. There is an inverse relationship between interest rates and the capital value of assets. A period of high interest rates may have the impact of depressing share prices due to the impact of high rates on economic activity and hence on the performance of companies and, by consequence, their share prices. For some assets, like fixed-rate bonds, there is a certain mathematical relationship between interest rates and asset prices: if interest rates rise, bond prices will fall (and vice versa). You’ll learn more about this in Week 2.

#### Investment returns – tax breaks and tax wrappers

A crucial element to factor into investment planning is the tax treatment of the returns. Some investments have what is referred to as a ‘tax wrapper’, where the returns are protected from tax of either the income they generate or any gains to capital gains. The most common example of these in the UK are New Individual Savings Accounts (NISAs) where returns are tax free (with the exception of the taxation of dividends received on Stocks & Shares NISAs). Elsewhere, even where investment returns are subject to taxation, annual tax-free allowances can be used to protect at least part of the returns from tax deductions. You’ll look at the tax treatment of returns from personal investments in the UK in more detail in Week 2. At this stage, the key point to note is that for your preferred form of investment you should make sure that you take advantage of any tax exemptions on their return.

### 1.3.3 Drivers of returns: what determines the level of interest rates?

Earlier you started to look at the income and capital returns from investing. You will look more closely at these now, starting with the key issue of what determines the level of interest rates on savings and investment products.

To understand what determines the level of interest rates received when you invest money, you first need to understand how ‘official’ interest rates are set.

The video, which features Mark Carney, Governor of the Bank of England at the time of writing this course, sets the scene by looking at the factors taken into consideration when setting official interest rates.

Skip transcript

#### Transcript

HUGH PYM
Forward guidance on interest rates; it was Mark Carney's big idea when he arrived at the Bank of England last summer. But today the Governor, faced with unexpected developments in the economy, had to announce a policy overhaul. Growth is stronger this year and inflation lower than expected but he believes the repair job required on the economy is not yet complete.
MARK CARNEY
The recovery as yet is neither balanced nor sustainable. A few quarters of above trend growth, driven by household spending are a good start but they aren't sufficient for sustained momentum
HUGH PYM
He hinted that the first interest rate rise might be in the spring of next year and there wouldn't be a lot more after that.
MARK CARNEY
One illustration of the possible level of bank rate in the medium term can be derived from the latest forecast of the bank, that is based on a market curve which itself approaches only 2% interest rates three years from now.
HUGH PYM
This is certainly a change of tack by the governor and his colleagues here at the bank. Interest rate decisions have been focused on unemployment falling to a certain level. But now that the 7% threshold has nearly been reached, policy makers instead will concentrate on a whole range of economic variables.
So what do businesses make of it all? This Barnsley based engineering firm invested in new machinery after the bank of England's assurances about low rates last summer. The boss has urged the bank not to abandon it's commitment to keeping a lid on borrowing costs.
INTERVIEWEE
We would really like to see interest rates remaining low and knowing what's gonna happen in the long-term is a really important part for us.
HUGH PYM
Critics argue the Bank of England's credibility has been dented because it's original forecast was wrong and it's now had to drop the unemployment threshold. The bank argues it's simply moved into a new phase. The challenge now is how to communicate it's views on low interest rates. Hugh Pym, BBC News.
End transcript

Interactive feature not available in single page view (see it in standard view).

Before 1997, ‘official’ interest rates in the UK were determined by the UK government, usually after consultation with the Bank of England. Arrangements changed in May 1997 when the incoming Labour government passed responsibility for monetary policy and the setting of interest rates to the Bank of England to make the bank independent of political influence. This matches the arrangement in the USA and in the eurozone, where the official rates are set by the Federal Reserve Bank and the European Central Bank respectively.

The rate set by the Monetary Policy Committee (MPC) known as the ‘Bank Rate’ is the rate at which the Bank of England will lend to the financial institutions. This, in turn, determines the level of bank ‘base rates’ – the minimum level at which the banks will normally lend money. Consequently, Bank Rate (also known as the ‘official rate’) effectively sets the general level of interest rates for the economy as a whole. Bank Rate is therefore hugely influential in the determination of the rate that will be paid on savings and interest-bearing investment products.

Each month, the Bank of England’s MPC meets for two days to consider policy in the light of economic conditions – particularly the prospects for inflation. The MPC’s decision is announced each month at 12 noon on the Thursday after the first Monday in the month.

The prime objective is for the MPC to set interest rates at a level consistent with inflation of 2% p.a. For example, if the MPC believes inflation will go above 2% p.a., it might increase interest rates in order to discourage people from taking on debt – because if people spend less, it could reduce the upward pressure on prices. Conversely, if the MPC believes inflation will be much below 2% p.a. it might lower interest rates (also known as ‘easing monetary policy’) – people might then borrow and spend more.

However, in 2013 and 2014 the policy on the setting of official rates was modified to take greater account of the level of unemployment in the economy. First it was announced that official rates would not be raised while the rate of unemployment was above 7% of the labour force. Subsequently, following a sharp fall in unemployment towards 7%, this stance was modified to one where the MPC would take account of the extent of spare capacity in the economy rather than just the rate of unemployment. The video explores this change of emphasis to the setting of official interest rates in the UK.

Official rates of interest tend to be cyclical, rising to peaks and then falling to troughs. Since 1989, the trend in the UK has been for nominal interest rates to peak at successively lower levels. Nominal rates fell to 3.5% in 2003. In 2009 they hit a record low of 0.5% and were still at this level at the end of 2014. This was because the Bank of England was attempting to stimulate economic activity following the period of recession at the end of the 2000s.

In November 2017 Bank Rate was raised for the first time in 10 years – from 0.25% to 0.5%. The change, although modest, was taken as a signal that future years will see higher interest rates than those experienced since the financial crisis of 2007/08.

### 1.3.4 Real interest rates

Figure 13 Nominal and real interest rates and inflation in the UK, 1980–2017 (Bank of England, 2017; ONS, 2017)

You explored earlier why it is important to take inflation into account when managing your investments. Unless there is no price inflation, the nominal return from an investment – the amount of cash paid to you – is different to its real return, in effect the value to you in terms of the goods it can buy.

Real interest rates are interest rates that have been adjusted to take inflation into account. Looking at the graph, you’ll see that when inflation is higher than the nominal interest rate, real interest rates are negative (as they were in 1980/1981 and again from 2010). Real interest rates are at zero when the rate of inflation and the nominal interest rates are the same, and they are positive when the nominal interest rate exceeds inflation.

Real interest rates were low in the 1990s and 2000s, falling from 7% in 1990 to just under 2% by 2004. Subsequently they fell further. By early 2015 the fall in the (nominal) official interest rate to a historical low of 0.5%, combined with price inflation of 1.4% (as measured by the Retail Prices Index – RPI), resulted in negative real interest rates of -0.9%.

So, if you earn a nominal rate of interest of 1.5% on your savings and price inflation is 2%, you are actually getting a real interest rate on your savings of -0.5% – a negative rate of return. Such a situation where real interest rates are negative is clearly adverse for savers. However it is good news for borrowers if the cost of borrowing is negative in real terms.

Unsurprisingly, the low interest rates offered on savings in recent years have encouraged some households to reduce their debts – particularly credit card debts which have relatively high interest rates – by reducing their savings balances.

### 1.3.5 The benefit to savers of compound interest

The calculation of interest on savings accounts is straightforward. Interest accrues at a rate based on the savings rate and the balance of money in a savings account. So if £1000 is held in an account where the rate is 5% per annum then interest paid at the end of the year is £1000×5/100=£50.

In many cases, with movements into and out of savings accounts taking place, the interest charged will be based on the average balance of the principal sum during the year. For instance, if £10,000 is invested at the start of the year and £100 is withdrawn halfway through each month, then the outstanding balance at the end of the year would be £8800. The average balance of principal outstanding during the year would be the average (mean) of the balance at the start and at the end of the year, or (£10,000+£8800)/2=£9400. Based on this average balance, the interest for the year at 5% p.a. would be £9400×5/100=£470 – less than the £500 if no withdrawals had been made.

What happens if the lender does not withdraw the interest received and adds it to the balance of the account? This would mean that the following period’s interest earnings is going to be higher since the borrower will be paying interest, not only on the original principal sum but also on the re-invested interest. This is known as compounding, and can quickly enlarge savings during periods of high interest rates.

Consider what happens if someone lends £1000 at an interest rate of 3.5% and makes no withdrawals over ten years. Over this period of time, the investment would rise from £1000 to £1411 (£411 interest on top of the £1000 invested). This is more than if interest had been charged on a simple rather than compound basis – simple interest over ten years would have been just £350.

You can test this out for yourself, using our interest calculator .

The precise practice for computing the interest earnings varies among different borrowers – and interest can be calculated at different time intervals. One of the pieces of financial small print it is always vital to read is the basis on which interest is paid – that is, how often and by reference to what terms.

### 1.3.6 Case study: whatever happened to UK savings rates?

A major development that affected millions of investors in the UK after 2007 came with a fall in interest rates paid on savings accounts.

The audio and the supporting graphics set out the decline which resulted in investors earning less than the prevailing rate of price inflation with the consequence that the real value of their savings ended up being reduced. The causes of this development are explained in the audio.

The episode is both a classic case of macro-economic policy having both winners and losers and of the realities of inflation risk on investments. Faced with such meagre returns many investors turned to alternative investments to boost their income – but in so doing took on a variety of alternative investment risks.

Skip transcript

#### Transcript

MARTIN UPTON
This animation looks at the changes to UK saving rates since the financial crisis in 2007 and 2008. So the story starts with the 2007/ 2008 financial crisis and the attempts by the Government and the Bank of England to try to ensure that the resultant economic downturn was neither too deep nor prolonged. This led to cuts in the official rate of interest for the UK to a record low of 0.5% in March 2009. Understandably this pushed down the general level of interest rates on savings products, ... including those rates on new fixed-rate bond offers, but for most of the next four years savers still received interest on their accounts comfortably above the official rate of 0.5%. This was helped by the fact that, at the time, many financial institutions were struggling to access funds from the wholesale markets at a reasonable cost. As a consequence they turned to the savings market and had to pay up for 'retail' funds from the public. This helped savers until 2012, when the Bank of England introduced their Funding-for-Lending Scheme (or FLS).
This scheme offered banks, and other lenders, access to cheap funds costing as little as 0.25% per annum - to encourage greater lending to businesses and households. Unsurprisingly, financial institutions piled in and accessed some £42 billion of funds over the next two years.
Now that there was now much less need to draw in retail money from the public - equally unsurprisingly - the rates on savings accounts were slashed to record lows. And until 2015 most savings rates were below the level of inflation. While this was great news for borrowers it was disastrous for savers, many of whom rely on interest on their savings to top up their pension incomes.
End transcript

Interactive feature not available in single page view (see it in standard view).

## 1.4 The drivers of equity markets

You have seen the factors that can dictate the prevailing level of interest rates in the economy and by inference the returns on interest-bearing investments.

So what drives the levels of share prices? While you will look at share price determination in detail in Week 2, it is important to get a grasp on the key determinants here at the start of the course.

The first important point is to distinguish between the factors that will generally affect the levels of share prices – typically measured by referring to stock market indices like the FTSE 100 (the index comprising the 100 largest companies listed on the London Stock Exchange) – and those factors that specifically affect a particular, individual, share price.

The key drivers of equity markets are:

• the prevailing and expected level of economic activity, as measured by GDP growth, employment levels and movements in the real incomes of households
• the prevailing and expected level of price inflation
• the prevailing and expected level of interest rates
• the trends in and expectations of the financial performance – particularly profitability – of the firms whose shares comprise the equity markets.

In addition to these core drivers, other factors that impact on equity markets include:

• movements in exchange rates
• changes to taxation – particularly on company profits and dividends paid to shareholders
• changes to commodity prices – particularly oil and gas
• random non-financial events like wars and disease epidemics, which are expected to impact on (global) economic activity.

These factors impact, to greater or lesser extents, on the financial performance and expected future performance of the companies whose shares comprise the equity indices that investments in shares are linked to.

A slowdown in economic activity, perhaps reflected in a weakening in price inflation, can be expected to reduce sales and profits. Under these circumstances, companies may be forced to reduce the dividends paid to shareholders or even pay no dividend at all. The attraction of holding shares, relative to other assets, is then reduced exposing the risk of a fall in share prices. The reverse generally holds as well – growing economic activity and a pickup (provided it is not excessive) in inflation are correlated to higher share prices as companies experience growing sales and profits. The relationship between inflation and the performance of stock markets is, though, complex and hotly debated by analysts.

Modest inflation may be favourable to share prices but higher inflation rates raise the prospect that action will be taken to stem inflationary pressures by raising interest rates and depressing economic activity – a scenario which would not be good for share prices. The other factors listed above also have a role in driving share markets. Higher interest rates are bad news for equities as they presage a decline in economic activity – as do higher commodity prices. If exchange rates move adversely – particularly if the domestic currency strengthens against foreign currencies – the equities can be hit since export sales may be reduced.

### 1.4.1 Oil prices and the financial markets

The collapse in oil prices in the second half of 2014 – with the price of crude oil halving between July 2014 and January 2015 – had a mixed impact on financial markets. Listen to the audio, a clip from BBC Radio 5’s ‘Wake Up To Money’ programme, to find out more.

Skip transcript

#### Transcript

MALE INTERVIEWER
Brenda, this oil price, tumble, hitting American stock markets and having an affect here, as well. What is going on?
BRENDA
Well, I suppose it depends on what your take on things is. As a normal person, lower oil prices should lead to higher disposable incomes and cut business costs, but the stock markets really believe that this slide we're seeing in oil prices - and that's from a peak of $115 per barrel to around$50 per barrel - reflects a slow down in the likes of China, and you're also got your recession in Japan, this looming deflation in the Euro zone, and I suppose a little bit of uncertainty in relation to Greece. The oil price supply factor is involved, in the sense that you've got a huge glot of supply with the USA Shale production adding to supplies, but you also have demand worries, as well, and that is what is helping to send the prices lower.
MALE INTERVIEWER
That's the problem when you have a cartel running things.
BRENDA
Well, OPEC run about 40% of the actual oil supply. Saudi Arabia would be one of the biggest players, there, but they have said they wouldn't even get involved if it went to $20 per barrel, and they've said, before, they can break even at about$5 or $6 per barrel, in terms of production costs. I think, if anything, it's down to the supply coming from the US that's adding to this glot and there seems to be no sign of production cut from there, or indeed, from Russia who seem to be adding to supplies over the last little while. MALE INTERVIEWER Where do you see the oil price going? BRENDA I don't see it going any lower than the$45 per barrel, to be honest with you. I think we've seen such a massive decline over 50% since the middle of the summer. I think the decline has been exceptional, and I think it's maybe the pricing in of stuff that hasn't actually happened, already, so I think most of the bad news in relation to the Eurozone - it's still a problem, the Eurozone, in terms of what's going on there; in terms of the lack of growth - but I do feel that, perhaps, it's got a little overdone and we could see it come in at bottom over the next few weeks.
MALE INTERVIEWER
Last week, Rod Sharpon, 'Up all night' did a fascinating interview with T. Boone Pickens, and his comments were quite scary in that, if you continue to produce too much oil, and there's no demand, that price is going to carry on falling.
BRENDA
That's exactly it, and there's a question of whether or not the supply is going to be cut, or whether demand is going to pick up. Of course, it remains to be seen whether or not US, obviously they're pretty much self-sufficient now in terms of their oil production and oil use, so from that point of view that takes a major player of demand out of the market. It's whether or not the Eurozone and China can pick up the pace, in terms of demand, and as I said, the stock markets don't, necessarily, believe that, for the time being.
MALE INTERVIEWER
Let's get a bit more on the tumbling price of oil, on the impact on the world's markets, cause right now, big impact in Asia. Let's speak to Rico, he's on his own in Singapore. Hello, Rico.
RICO
Hi Adam. There's really a lot of concern about these current, low prices which could basically squeeze many energy producers and hurt companies that have close links with the energy sector. Everyone is saying this prolonged slide in oil prices should help economic growth, but investors are starting to worry that the depth of this downturn from more than $110 per barrel to$50 per barrel is fuelling a lot of concern that it might be a sign of a weaker global economy.
MALE INTERVIEWER
So, this isn't just a blip, this is starting to turn into a bit of trend?
RICO
It could be a trend according to some of the analysts I spoke to. Oil prices could still fall between $40 to$45 per barrel. It could be like a de facto stimulus package, many say, but it's having another impact on markets. We'll have to wait and see how this will play out, over the next two to three months.
MALE INTERVIEWER
Let's just whizz you, very quickly, through the financial front pages. The FT energy stock leads with: 'Wall Street lowers US oil - oil dips below \$50' is their lead.
MALE SPEAKER
Yeah, the Times is, very much, the same theme: 'Markets tumble as oil hits another low', and they've actually got a picture, a chart, if you like, of markets at sea, and two big ships, and it gives all the details there. It sums it up, in one line, what's going on in the markets, and why.
End transcript

Interactive feature not available in single page view (see it in standard view).
Figure 16 Price of Brent crude oil against the share price of BP and Royal Dutch Shell

By helping to reduce the overall rate of price inflation, the fall in the price of oil virtually eliminated the risk of a near-term rise in interest rates. This was ‘good news’ for the financial markets – although not for savers. However, the fall in oil prices was seen by some commentators as indicating a slowdown in economic activity globally – a factor that is not good news for equity markets and certainly not good news for the share prices of oil companies.

### 1.4.2 Drivers of share prices: company specific performance

Figure 17 Tesco share price 2014

While the factors mentioned in the previous section provide the general drivers of share prices, the price of an individual share will also be driven by specific factors applying to the company in question.

Commonly, this means that the performance of an individual share outperforms or underperforms the average for the market as a whole. Sometimes this divergence can be so stark that the share price rises when the market as a whole is falling and vice versa. This differential performance is normally sourced in how the direction of company profits and dividend levels contrasts – favourably or unfavourably – with investors’ expectations and with averages for the market.

A classic recent episode in September 2014 came with the performance of the share price of the supermarket, Tesco. This plummeted after it was revealed that the company had been overstating its profits guidance to the markets, prompting a myriad of investigations, including one by the financial services regulator the Financial Conduct Authority (due to Tesco’s banking activities).

Within days Tesco’s share price was down by 30% from its 250p level at the start of the month, despite the fact that in September 2014 the overall level of the FTSE 100 was quite steady, falling by only 3%. Even the renowned investor Warren Buffet took a huge hit, given his 3.7% stake in Tesco, and within weeks he was offloading a proportion of his failed investment. Given the belief that Tesco will be forced to react by aggressive competition in the marketplace, the shares of other UK supermarket groups, like Sainsbury’s, also fell in the wake of the decline in Tesco’s share price – albeit not to the same degree.

Subsequent months saw Tesco announce a record annual loss for the financial year ending in February 2015 of £6.4 billion and a major overhaul of its senior management. Tesco’s share price fell to a low of just under 156p in early 2015, although by 1 May 2015 it had recovered to 225p.

Tesco was a classic case of the crystallisation of specific risk relating to the investment in a specific company as opposed to the market as a whole.

### 1.4.3 Why did the FTSE 100 behave like a rollercoaster in 2016?

Figure 18 The FTSE-100 Index, May-July 2016 (LSE, 2017)

There is no equation that formally links the factors set out in the previous section with the performance of share prices – at best, there are strong correlations at work. Yet all the major swings in equity prices seen in recent decades can be explained by the economic contexts defined by these factors.

Let’s try a recent episode out to test the theory!

#### Activity 1.4 FTSE 100

Have a look at the graph above. It shows the movements in the UK’s leading share index, the FTSE 100, between May and July 2016.

Clearly this was a period of share price volatility with the index falling sharply in June only to stage a very strong recovery into July.

This period saw unremarkable activity in the economy with inflation and interest rates low and with economic growth steady.

So what caused the volatility and what led to investor sentiment first turning negative and then, very quickly, becoming positive?

Here’s a hint: referendum.

You can type text here, but this facility requires a free OU account. Sign in or register.
Interactive feature not available in single page view (see it in standard view).
##### Discussion

The key driver of the volatility in the FTSE 100 was the referendum on the UK’s membership of the European Union (EU). This took place on 23rd June 2016 and resulted in a vote for the UK to leave, with 52% voting for an exit versus 48% voting to stay in the EU. This was an outcome that was not expected by the opinion polls and hence it was a major ‘surprise’ to the public and the financial markets.

Ahead of referendum day the volatility in the FTSE 100 index reflected swings in the opinion polls but the actual result initially led to share prices, taking the index down in the process. The reason for the initial negative reaction was that the outcome was taken to be ‘bad news’ – at least in the medium-term – for the economy (although the actual impact of leaving the EU on the UK economy will only be known in the years after ‘Brexit’).

Within days, though, investor sentiment changed. This was because investors realised that many of the companies that comprise the FTSE 100 earn a significant (or, indeed, a major) proportion of their earnings in overseas (non-UK) economies. These overseas economies are not going to be directly affected by Brexit.

Additionally the vote to leave the EU led to a sharp fall in the value of the UK pound. This fall was forecast to have beneficial effects for many FTSE 100 companies since:

• the sterling value of overseas earnings (e.g. in US dollars) by FTSE 100 companies is increased
• those companies producing goods and services in the UK for export overseas would find it easier to sell them due to the fall in the value of the pound
• UK consumers, faced with a lower value for the pound, would be less likely to buy goods from overseas companies and would divert spending to UK companies.

So the initial adverse response of investors was quickly turned round as careful analysis replaced emotional sentiment in the assessment of the prospects for the FTSE 100 companies.

Since 2016 the FTSE 100 has made further gains hitting ‘all-time highs’ in 2017.

Brexit may be bad for many parts of the economy but this does not necessarily mean it is bad news for the FTSE 100. This index is a measure of the financial health of the top UK companies not a measure of the overall economy’s wellbeing.

## 1.5 Week 1 quiz

Check what you’ve learned this week by taking the end-of-week quiz.

Open the quiz in a new window or tab then come back here when you’re done.

## Week 1 round-up

It has been a very full first week and you will have learned much about the need for effective investment planning and some of the initial building blocks for your strategy.

We looked at why investing for the future is essential for households – particularly in the light of the evidence that we, in the UK, aren’t doing enough to save for the future.

We looked at the first things you need to consider when devising your investment plan and at the importance of the time horizon for your investments and the future spending plans that your investments will support.

We then looked at the drivers of two key determinants of investment returns – interest rates and equity markets.

Next week, we’ll start to examine in detail the characteristics of the spectrum of investment products available for you to employ within your investment strategy.

You can now got to Week 2 .

## References

Bank of England (2014) Funding for Lending Scheme: Usage and Lending Data for the First Part of the Scheme [Online]. Available at www.bankofengland.co.uk/markets/Pages/FLS/data.aspx (Accessed 3 November 2014).
Bank of England (2017) Official Bank Rate History [Online]. Available at www.bankofengland.co.uk/boeapps/iadb/Repo.asp (Accessed 28 November 2017).
Department for Work and Pensions (2014) Family Resources Survey [Online]. Available at www.gov.uk/government/uploads/system/uploads/attachment_data/file/325491/family-resources-survey-statistics-2012-2013.pdf (Accessed 3 October 2014).
London Stock Exchange (LSE) (2017) ‘FTSE-100 Interactive Graph’ [Online]. Available at http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/indices/summary/summary-indices-chart.html?index=UKX (Accessed 5 December 2017).
ONS (2017) RPI All items Index: Jan 1987 =100 [Online]. Available at www.ons.gov.uk/economy/inflationandpriceindices/timeseries/chaw/mm23 (Accessed 28 November 2017).

## Acknowledgements

Except for third party materials and otherwise stated in the acknowledgements section, this content is made available under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 Licence .

The material acknowledged below is Proprietary and used under licence (not subject to Creative Commons Licence). Grateful acknowledgement is made to the following sources for permission to reproduce material in this course:

### Images

Figure 2 © Metro-Goldwyn-Mayer via Getty Images

Figure 16 © Carl Court via Getty Images

Figure 20 © Carl Court via Getty Images

### Audio visual

1.2.7: PUFin www.open.ac.uk/ pufin © The Open University

1.3.3 compilation video contains © BBC archive