by Mark Dampier
Part of the reason for writing this book is my belief that the more confident you are that you can grow your money by investing, the more likely it is that you will in fact put aside money for that purpose, rather than spend it some other way. And the more committed you are with your investments, the less time it will take to arrive at any given financial objective. In a world where bank accounts pay virtually nothing in the way of interest, the one certainty is that unless you do invest your money profitably, it cannot grow in value and you are never going to improve your quality of life as much as you want.
You need to have a plan
Having decided that you want to improve the quality of your life in the future, where to start? In my view there is no avoiding having a financial plan, however basic. The clients we see at Hargreaves Lansdown come in all shapes and sizes. Some have more than £25m invested with us and own almost every kind of investment that exists. Others may be putting as little as £25 a month into a single savings scheme. As far as I am concerned, that doesn’t make any difference: whoever you are, and whatever your circumstances, you still need to find the time to sit down and put together a sensible financial plan.
Such a plan involves working out:
what money you have today
what money you need now and in the future
what you are trying to achieve over the course of your investing life.
Of course, other than death and taxation, nothing in life is ever certain. Everybody’s circumstances are different. Some things can only be estimated very roughly and life expectancy is a lottery. But without the discipline of at least a rudimentary financial plan you cannot really hope to make effective investment decisions for the future. You wouldn’t dream of setting off in a car without knowing where you are going and how long it might take. Managing your money is no different. Nearly everyone can do it – just as long as they are willing to make the effort.
The DIY approach
In my opinion, money spent getting professional help to put together a financial plan for your life is almost always money well-spent. It may cost you a few hundred pounds. People seem only to take financial advice when their personal circumstances change – such as after death, divorce or the arrival of children – but having a regular professional check-up every few years is sensible.
Nevertheless, it is not impossible to put together the rudiments of a financial plan yourself. A good financial plan does not need to be complicated. It is better to be roughly right than precisely wrong. But it does need to be thorough.
1. What you earn
The plan starts with the figures for what you and your family earn now, with a realistic assessment of how income from all sources might grow over the next few years, allowing for tax, national insurance and other deductions.
2. What you spend
The next step is to work out your outgoings, starting with essentials such as food, housing costs (mortgage or rent), utility bills and life insurance, followed by the amounts you spend on discretionary items, including eating out, entertainment and holidays.
People are frequently surprised to discover exactly how much money they spend on transitory lifestyle items. Having a coffee at Starbucks every day, for example, can easily cost you more than £600 a year. This part of the financial plan can be a useful time to evaluate how many of the things you spend money on today are ones you might be willing or able to give up in order to have more wealth and security in the future.
Estate planning
Preparing your financial plan is also a good stage to think about the future of your children and wider family when you die. If you die young or unexpectedly, life insurance can provide part of the answer. The same goes for critical illness cover. But for anyone who expects to live a normal span it is essential both to have some investments and to think through what might happen to those investments after you have gone. This in particular may require some professional help, as the difficult tax and legal consequences of death can almost invariably be ameliorated by careful advance planning.
3. How much you can invest
Once you have the basic income and outgoings, the next step is to try and calculate roughly how much you need to invest today, and for how long, in order to obtain the level of capital or income return that you are likely to want in the future. A number of factors are involved in this:
future inflation rates
potential investment returns
taxes and costs
your investment time frame.
It is particularly important to make realistic assumptions about your life expectancy. This applies especially to pensions, which remain most people’s biggest financial asset after their home. Thanks to medical advances and improvements in standards of living, human beings now live much longer than they did. Life expectancy for the average man is now ten years longer than it was 30 years ago: for women it is 12 years longer. If you are thinking of retiring at the normal age, you are going to have to rely on your savings for much longer in order to go on enjoying the lifestyle that you have planned or hope to have.
Possible future inflation rates
Inflation is one of the most potent and insidious risks facing anyone who chooses to save and invest money. Even modest rates of inflation, like the ones we have experienced in the last few years, can quickly destroy the purchasing power of your money.
If inflation is running at 2% per annum, what you can buy with £100 will decline by 18% (almost a fifth) after ten years and by 32% (or nearly a third) after 20 years. In a normal working lifetime of 40 years, the purchasing power of your money will fall by 55% (more than half) if inflation is 2% per annum. If it goes to 5% per annum, the value of every £100 you have today will be just £16 in ‘real’ terms when you quit working after 40 years.1
Figure 2.1: Inflation since the turn of the century – up for 10 years, then falling fast. The core consumer price index (CPI) excludes food and energy: the headline CPI includes them. What matters most to you, however, is the cost of the lifestyle you have chosen.
Source: J.P.Morgan Asset Management, Guide to the Markets.
That is generally good news, but it does not tell the whole story. Many of the essential things that you have to pay for in life, such as heating and lighting, water, insurance and food (and housing!), are still going up in price more quickly than official inflation figures suggest. A fundamental principle of good investment is that unless your investments can grow at least as fast as the cost of your lifestyle, you are not getting any wealthier – as many people found out in the 1970s, when inflation soared to more than 25% and wiped out the savings of those who had not prepared for such an outcome.
Our current issues are not the same, but don’t be misled into thinking that runaway inflation like that could not happen again. It can and quite probably will, though I don’t know when. The point is that your investment strategy must take account of the possibility. Only if your income and investments can grow by more than the rate of inflation will you be able to afford the same things when you retire as you spend money on today.
Potential rates of return
You cannot know how much you will need to invest without also having an idea of the possible returns that you might be able to make. Putting it at its simplest, there are four main asset classes that investors have to consider. Any sensible investment strategy is likely to include a mixture of these type of investments, which all have their own distinctive characteristics. In all four cases you have the choice of investing directly yourself or using a managed investment fund to gain your exposure. The four are:
equities (the posh word for shares)
bonds (fixed-interest securities)
property
cash.
With the help of historical surveys, it is possible to summarise the historic returns that these four asset classes have produced over long periods of tim
e. It is easy to start with cash, which means not just the money in your purse or wallet but the money you have deposited in the bank or building society. A few years ago it was possible to earn 4%–5% on your deposits, and even though inflation was higher than today it still left you ahead of the rate of inflation.
Since the global financial crisis of 2008, however, that is no longer the case. Interest rates, which are the main weapon that policymakers have to control inflation, have also fallen to record low levels as inflation has subsided. The basic lending rate set by the Bank of England was cut to just 0.5% after the crisis – its lowest level for six centuries – and was still at that rock-bottom rate five years later. That in turn has resulted in derisory returns on deposits at the bank and building society.
Figure 2.2: Returns on bank deposits have fallen dramatically since the global financial crisis in 2008. Having been above the rate of inflation before, they have been well below for several years – not a happy state of affairs for investors.
Source: J.P.Morgan Asset Management.
What about the other so-called ‘asset classes’ I mentioned above? In Table 2.1 I show the annualised rates of return achieved by the different asset classes over long periods of history. At first glance all these figures may seem pitifully small. But remember (a) that these are returns after allowing for inflation; and (b) that they represent the long-run annual percentage rate of growth for each class. The table does not bring out the effect of compounding those modest annualised returns over long periods of time. (For commercial property and index-linked gilts, we do not have such a long series of figures as we do for the others, so the historical record is shorter.)
Asset type
10 years
20 years
30 years
50 years
Equities
4.1
4.6
6.2
5.4
Conventional gilts
3.7
5.1
5.2
3.1
Commercial property
2.7
5.6
5.6
-
Residential property
-0.3
3.6
2.4
-
Index-linked gilts
3.5
4.4
3.9
-
T-bills (cash)
-0.7
1.1
2.5
1.5
Building society
-1.5
0.0
1.3
0.8
After deducting inflation
3.1
2.9
3.5
5.6
Table 2.1: The long run returns from different asset classes after inflation.
This table measures the annual percentage real return from shares, bonds, property and cash over different time periods (data as 31st December 2014). While shares typically produce the highest returns, over shorter periods they can be much more volatile. Another point to note is that bond returns have been well above their long term historical average in the last 20 years and are unlikely to be that good in the next 20 years.
You may be surprised – most first-time investors are – by the enormous positive impact that the wonders of compounding can do for your financial wellbeing. The way to see how dramatic this effect can be is to translate rates of return into cumulative monetary sums. In Table 2.2 I show the long term impact on your wealth if your investments earn a given rate of return over time. You can easily see how even small sums invested at seemingly modest rates of return can grow into something pretty big if you let time do its work. For example if you invest just £1,000 and make a 7% annual rate of return every year, after 20 years, provided you have drawn nothing out, you will have £3,870 – nearly 3.9 times as much as you put in. After 30 years your investment will have grown 7.6 times and after 40 years no less than 14.9 times.
The value of £1,000 invested
Assuming no inflation
Number of years invested
Growth rate
10
20
30
40
50
3%
£1,344
£1,806
£2,427
£3,262
£4,384
5%
£1,629
£2,653
£4,322
£7,040
£11,467
7%
£1,967
£3,870
£7,612
£14,974
£29,457
10%
£2,594
£6,727
£17,449
£45,259
£117,391
Invested
£1,000
£1,000
£1,000
£1,000
£1,000
Table 2.2: The impact of compounding your money over time.
This table shows the effect of investing money at different rates of return over long periods of time. If your working life extends to 40 years, there is clearly a lot of scope to build a worthwhile investment fund or pension pot.
The wonder of compounding is that the higher the growth rate you can achieve, and the longer you are able to invest, the bigger that eventual multiple will be – and the more your investment fund will be worth. This, as I have already mentioned, is one of the most important lessons in thinking about investment: time really is money. It is the fundamental reason why those who can start investing early in life are handsomely rewarded. It is also the reason why the rich tend to get richer. Having money to start with means they have much longer to reap the rewards of investing than someone who has to work their way up to becoming an investor for the first time in say their 40s or 50s.
The figures I have shown are cash figures, before taking account of inflation. The bad news is that inflation also has a compounding effect on the purchasing power of the money you have invested. You need to factor in a future inflation rate to arrive at the final ‘real’ or purchasing power value of your investments. So if you assume a future inflation rate of 2.0% per annum, for example, the figures come out as in Table 2.3. You can see how the multiple of your
investment – how far your wealth can grow in real terms – declines as a result.
The value of £1,000 invested
After inflation at 2% per annum
Number of years invested
Growth rate
10
20
30
40
50
3%
£1,102
£1,215
£1,340
£1,477
£1,629
5%
£1,336
£1,786
£2,386
£3,188
£4,260
7%
£1,614
£2,604
£4,203
