Getting your money to work for you
Getting your money to work for you, is something that many people, myself included, put off. There are always a 100 and 1 other things to do, and although we all recognize effective money management as important, we don’t view it as urgent. Putting your money to work for you a year earlier can give you an additional £50,000+*. That is a pretty good incentive to think about it sooner rather than later.
Ok, so you agree with the importance of putting your money to work for you, but you haven’t got around to it, because you see there as being far too many options. It was found that people reach analysis paralysis when they are trying to make a decision as insignificant as choosing from a range of jams, so when making the much more important decision of where to put your money, it’s no wonder people put off taking action.
This short post will highlight my own approach to making my money work for me, after finally making a bit of time to do some research.
Are you halving your future net worth with your current approach?
No-one likes to lose money. In fact, we dislike losing money twice as much as we like gaining it. In a game with a chance of losing £100, the upside must be, on average, double, £200, for people to agree to participate. That is why many people opt for the simple option of putting their savings into a bank account with (virtually) no risk of losing it, and with low interest rates (1-3%). This approach means that they do not feel any pain at the loss of their money. However, taking this zero tolerance to risk approach dramatically inhibits your investment growth. Using the same assumptions* as the prior example of compound interest over your working lifetime, a 2% interest bank account will provide ~£400,000 compared to a 5% return which will provide ~£900,000. That’s more than double!
So what are the alternatives?
I won’t go into the detail of the many, and varied, approaches to personal finance investment. I’ll keep this blog simple, and highlight the approach that the leading personal financial investment experts agree on, and recommend, which I have opted for with my own personal finances.
Before I talk about the approach I settled on, I’ll share the principles of sensible investing that I came across again and again. This way you can evaluate the approach for yourself.
Principles of sensible investing:
1.) Keep your losses low
- Avoid loss: Warren Buffet’s most important rule for investing is to never lose money. And his number 2 rule is to never forget the first rule. “Don’t be frivolous. Don’t gamble. Don’t go into an investment with a cavalier attitude that it’s OK to lose. Be informed. Do your homework.”*
“Rule number one: never lose money. Rule number two: never forget rule number one.” – Warren Buffett
- Diversify to minimize risk: An important step to protecting against loss is to balance your portfolio to minimize market downturns and shocks. This can be done by choosing assets – stocks, bonds, cash or others – that are not correlated. Choose assets that have historically moved inversely correlated to one another. In addition to a range of asset classes, you should diversify within asset classes, such as shares across a range of geographies and industries. You can read more about portfolio diversification here.
- Ensure that you have enough liquidity to weather the downturns: With the stock market dropping dramatically every 7 years on average, there will be shocks to your portfolio. To avoid this being an issue, you need to have enough cash available to avoid selling low and materialising these losses. Every time the market has crashed, it has eventually returned back to record levels. Common advice is to have 6 months of living expenses available to avoid the risk of needing to sell for a major loss.
- As you get closer to retirement, reduce your exposure to risk: When you are younger, and have much of your working life ahead of you, you can afford to take more (sensible) risk. When you are nearing retirement, you should reduce your level of risk, and switch from more higher yield, higher risk assets to, to lower risk (and most likely lower yield) assets. The rough rule of thumb is to have a proportion of stocks to government bonds of 100 minus your age. For example, if you are 25, you should have (as a rough rule of thumb) 75% in stocks. If you are 60, you should have 40%. As people are living longer some are suggesting that this calculation should be 110 or 120 minus your age*.
- Protect against your irrational self: Whilst financial wealth management should be a logical process, even the best plans are at risk of being torpedoed by decisions driven by emotion such as fear, or fearlessness. To avoid this, many experts, including suggest that you create your own decision making checklist, to act as a check and balance to emotion driven decision making.
2.) Utilise compound interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
When asked what led to his great wealth, Warren Buffet credits compound interest as one of the most important factors. Compound interest is a simple concept. It’s how money grows over time with a recurring (often annual) interest. It is a large part of the reason why your savings can grow to close to £1M over the course of 43 years with as little as £500 monthly contributions (a £10k starting saving is used in this calculation). Over that period you only put in £270,000, and compound interest grows it by ~£700,000 to £960,000! You can learn more about compound interest here, and you can use a simple compound interest calculator here.
3.) Keep fees low
One of the most significant detractors from the power of compound interest is the annual fees associated with the asset(s). The higher the fees, the weaker the impact of compound interest. There are two main types of fees:
1.) Transaction fees: There may be a charge when you buy an asset. For example,it is not uncommon for a stock purchase to have a £12+ transaction fee, or a % commission charge. If you adopt a habit of over trading, these fees can really eat into any profits.
2.) Annual fees: If you buy into a fund, then there are usually fees associated with them. These can range from the low fees of passive index funds (e.g. Vanguard S&P 500’s fees of 0.04%), to the much higher fees of actively managed funds (0.75% to 1.25%). This may not sound like much of a difference, but with the same base assumptions, it can mean a difference of £160,000 to £210,000! (CHECK ALL CALCULATIONS HAVE CONSISTENT ASSUMPTIONS)
3.) Tax: Not strictly a ‘fee’, but it can also reduce your gains year to year, which will inhibit the power of compound interest.
With these principles in mind, what approach have I adopted?
So, keeping these investment principles in mind, I have decided to move 75% of my savings from a matured cash ISA, to a stocks and shares ISA. This enables me to access the higher annual (average) growth of the stock market, compared to the lower interest rates of my saving accounts (1.5%). This will put me at risk of my savings going down as well as up, but on balance, I think that this a worthwhile change.
The first step was to choose a company that would provide the stocks and shares ISA. I opted for Hargreaves Lansdown, as they are a market leader, and are known for their intuitive user interface, and low charges. I completed a simple form, and they handle the money transfer (It surprises me that this process still requires a paper form – why is it not yet fully online?). Easy.
The second step was to choose the stocks and shares ISA portfolio mix. I like to evaluate the different options, so I spent some time researching what the index funds were with the lowest fees, and their track record. I used their top “Wealth 150+” list, focusing on the trackers (index funds) as a starting point, ensuring that I looked at funds from a range of geographies. I also looked at fund past performance, but do be careful, as past performance does not determine future performance. I was surprised to see that a number of funds (Including those with the lowest fees) achieved 20% to 40% growth in 2016-2017! This is clearly well above the average of 5-7%. What a monster year! This is atypical. But do you now wish that you had adopted this approach in 2016 or earlier? I certainly do.
I used Morning Star’s Portfolio X-ray tool to get a better view on the diversification within each index fund.
I eventually settled on the portfolio mix of the following:
Create a google data studio, visualization of my portfolio mix…
- Note: HL dashboard has all of this information;
- Pie chart of Stocks, Shares, Bonds, etc.
- View of split by ETF (% of ETF portfolio) – Bar chart?
- Average net annual fee % (fee * portfolio %)
- Sector view: https://markets.ft.com/data/funds/tearsheet/holdings?s=0P00008A8U
- Next level of detail:
- Breakdown of ETF holdings: https://etfdailynews.com/etf/VOO/
- Note: data will be accurate as of date extracted, and will change slightly over time….
The final step was to choose buy the funds. A recommended technique for this is ‘dollar cost averaging’, which essentially means that you buy them gradually over time, rather than all at once. This provides you greater protection against market fluctuations.
Quick useful facts:
Note: The ISA wrapper protects the gains from being taxed. If you earn <£45,000, you have a £1000 allowance before you are taxed on your gains from interest. If you earn >£45,000, then this allowance is reduced to £500*.
If you are a UK citizen, then you will want to consider a Lifetime ISA (LISA), where the government will add an additional 25% per year to your savings.
1.) You put £500 a month into savings (As you get older this will likely be higher)
2.) You achieve a 5% a year return (This is below the average growth of index funds)
3.) Regardless of how much you currently have in savings (most people will have some savings)
4.) You are currently aged 24, and you calculate the value at retirement age (likely to be 67+ by the time you retire), assuming 43 years of compound interest.
5.) This does not take into account any large outlays, such as for buying property, rather, it demonstrates the principle of the value of saving sooner, and getting your money to work for you.
If you would like to see the calculation with your own assumptions, you can use this tool.