Effective Investing
Page 3
£6,782
£10,944
10%
£2,128
£4,527
£9,633
£20,497
£43,614
Invested
£1,000
£1,000
£1,000
£1,000
£1,000
Table 2.3: The impact of compounding your money over time, in real terms, after accounting for inflation of 2% per annum.
After 20 years, to take the same example as before, your fund has grown by just over two and a half times what you have put in, as opposed to nearly 3.7 times before inflation. That is still a big improvement on leaving your money uninvested, but also a useful reality check about how corrosive inflation can be. Over 40 and 50 years the difference between the pre- and post-inflation value of your notional investment fund is even wider still. Inflation at just 2% can wipe out as much as a half to two thirds of the amount you would have had if there had been no inflation.
If we now go back and look again at the table of returns from the main asset classes, you can see the importance of looking at inflation-adjusted figures rather than the raw returns. We can translate the actual returns on offer over the last few decades and translate them into what they would be worth today, given a range of different starting points. The annualised rates of return may appear very modest, but in practice, thanks to compounding, they have generated significant sums for anyone who has been able to go down the investing route.
Real value of £1,000 invested
At historical rates of return
Number of years invested
10
20
30
50
Equities
£1,495
£2,458
£6,078
£13,869
Conventional gilts
£1,438
£2,704
£4,576
£4,602
Commercial property
£1,305
£2,951
£5,055
-
Residential property
£970
£2,068
£2,037
-
Index-linked gilts
£1,411
£2,366
£3,151
-
Cash
£932
£1,245
£2,098
£2,105
Building society
£860
£1,000
£1,473
£1,489
Historic inflation rate
3.1%
2.9%
3.5%
5.6%
Table 2.4: Long run returns in monetary terms.
It is easier to grasp what real returns mean in practice by expressing the figures in the table above as cash sums – the amount you would have had at the end of each time period, again after adjusting for inflation. The points to note are (a) that the wonder of compounding helps returns grow disproportionately large as time goes by; (b) that investing in the right assets can make a material difference to your wealth; and (c) that so-called risk assets like shares and property tend to produce the highest returns over time, although not consistently over all periods.
See your finances in the round
One of the biggest mistakes I have found people make is failing to see their finances in the round. They tend to think of their house, their pension, their investments and their cash reserves as distinct ‘buckets’, rather than as what they really are: just different elements of one bigger picture. The various pieces may have different tax and risk characteristics, which certainly need to be taken into account, but in reality it is the overall balance of your money that is going to determine how well you fare in achieving your objectives.
Most people want to own their own home and that typically provides them with nearly all the exposure to property they need (although buy-to-let has become a fashionable option which I discuss later2). The biggest question for DIY investors is mainly about how they divide up their remaining financial assets between equities, bonds and cash. Bonds and cash are typically used to provide lower but more certain returns, while equities provide the best hope, other than property, for beating inflation and achieving higher but less certain capital and income gains over the longer term.
From the tables you can also clearly see that equities and property have historically provided the highest returns, both before and more importantly after adjusting for inflation. They are sometimes called ‘real assets’ for this reason. These higher returns come at a price, however, which is much greater volatility. What that means is that while they typically produce the best results in the end, you have to live with the fact that their value moves up and down more dramatically from one year to the next. That makes them inherently riskier, at least in the short term.
It is important also to note that the long-term averages are just that – averages. The pattern of returns from the four main asset classes can vary a lot from one period to the next. In the next table I show the annual rates of return of the big four asset classes from one ten-year period to the next, going back to the start of the 20th century (we don’t have good enough data for the others going back that far). The first half of the 20th century, for example, which included two world wars, produced a very different pattern of returns to the second half, which was more peaceful but included a period of very high global inflation.
The ranking of the four asset classes can also change over time. Over the long run, equities come out on top, ahead of property, followed by bonds and cash – but there is nothing pre-ordained about that result. In any ten or 20-year period the order can be reversed, depending on the prevailing historical circumstances. What works best at one point won’t work so well at another. For example, if you use the figures from 1990, they show that government bonds (also known as gilts) have produced almost exactly the same return as those of shares – something that has happened rarely in the past. (There are some specific reasons for that, mainly to do with the fact that the last 30 years have been marked by a long and steady decline in the level of interest rates, not just in the UK but in most countries around the world. Falling interest rates are generally good for fixed-interest securities like bonds, and vice versa.)
Real investment returns (% pa)
Equities
Gilts
Index-linked
Cash
1904–1914
2.1
&nb
sp; -0.1
1.5
1914–24
0.4
-3.1
-1.7
1924–34
9.2
11.7
5.6
1934–44
3.0
-1.4
-2.4
1944–54
5.3
-2.6
-2.8
1954–64
7.1
-2.6
1.4
1964–74
-6.0
-6.3
0.0
1974–84
17.4
5.6
-0.3
1984–94
9.4
5.8
2.8
5.5
1994–2004
5.0
6.5
5.3
3.0
2004–2014
4.1
3.7
3.5
-0.7
Table 2.5. Real investment returns by decade.
Every decade in history produces a different pattern of returns by asset class. But there has only been one decade since the start of the 20th century when equities produced negative returns, and several when gilts and cash did so – in every case as the result of inflation eroding the real value of investors’ savings. The trouble is that while equities produce the best long-term returns, they have fallen more than once by as much as 50% over shorter periods than a decade, which scares many people out of sticking with them. The first index-linked gilt was issued in 1981 so there is no earlier history.
Source: Barclays Research
The final point to make here is that a lot depends on when you start investing and whether the asset classes you buy are relatively cheap or expensive at the time you buy them. The cheaper they are, the better they are likely to perform over time – that is common sense. If they are expensive, the odds are you won’t do as well as the historical averages. While there is no guarantee that future rates of return will be similar to those achieved in the past, the historical pattern is sufficiently consistent to make it reasonable to use the averages as a general starting point for looking to what might happen in the future. Learning to assess whether the price of financial assets are a bargain or a steal is an important part of the investor’s challenge. If you can invest regularly – so much a month – the valuation issue is not quite so important, as things tend to even out over time.
The importance of avoiding taxes
The figures I have quoted take no account of tax. It is obvious that the more tax you can avoid paying as your investments grow, the bigger the amount you will have left at the end of the process. Back in the 1970s it was difficult to avoid paying tax on investment gains. Today that is no longer the case, thanks to those powerful tax incentives which I mentioned in chapter 1 (see ‘ISAs, SIPPs and pensions’ on the next page). An important reason why it so essential to make maximum use of the tax allowances and other exemptions that the government makes available is that any money you can save and avoid paying tax on can also benefit from the wonders of compounding.
Think of it like this. Every £1,000 you can save legitimately from the grasp of the taxman each year is freed to go on growing for the rest of your life if you invest it – becoming, potentially, a huge and tidy sum. If you can save an extra £1,000 a year by avoiding tax for the next 40 years, assuming that money can be invested to make a return of 5% a year, the extra you have saved and invested will be worth no less than £134,000 at the end of that period. Put it another way: if you are lucky enough to be able to save £8,000 a year from the taxman, it could be worth more than £1 million by the time you retire 40 years later.
ISAs, SIPPs and pensions
The first thing any investor should do is check out the tax breaks which the government offers to those who save and invest. There are different advantages to saving into an Individual Savings Account (an ISA) and saving for a pension. In my view, most people should aim to do both as soon as they can. The chancellor also announced in 2015 that the first £5,000 of dividend income from shares and the first £1,000 of interest on bank and building society deposits, even if held outside an ISA ‘tax wrapper’, can also be received free of income tax.
The attraction of ISAs is that any gains and income you receive from the investments you hold within this tax wrapper will remain exempt from tax, whatever the amounts involved, and however long you hold them. The annual limit on the amount you can pay each year into an ISA is now more than £15,000 and the limits are normally increased each year, meaning that for most people all their investing can effectively be done tax-free. Funds, shares and cash are all capable of being held inside an ISA. Any money held in an ISA does not have to be included in your annual tax return.
The tax savings on pension contributions can potentially be even greater, as the basic principle is that any contributions you make to your pension scheme (whether it is a personal pension or a company scheme) qualify for tax relief up to certain annual and lifetime limits.As of 2015, if you are a higher-rate taxpayer that means every £100 you put aside for your pension effectively reduces your income tax bill by 40% of that amount. For standard-rate taxpayers, the rate is 20%.
Self-invested personal pensions, known as SIPPs, have become popular vehicles for many investors, although the government continues – annoyingly – to change the rules on how much tax relief you can receive from one year to the next. In 2015, except for the highest earners, who are more harshly treated, the maximum annual contribution you could claim tax relief for was set at £40,000 a year. There was also a lifetime limit of £1m. (The annual limits are a relatively new thing, and there may be scope to add more money by using up prior year allowances that have been not used.)
The great advantage of an ISA is that you can take the capital out at any time without having to pay any further tax, whereas with any kind of pension, under the current rules, you can only take out a maximum of 25% of your accumulated savings as tax-free cash after the age of 55. Any additional withdrawals, however you take them, are taxable at your marginal tax rate. Under the latest government rules, you are no longer required to buy an annuity at the age of 75, as was the case before.
Confused? Understanding what is going on in the pensions field is frankly a bit of a nightmare, as the rules change almost every year (and will do again in 2016). It is one area where specialist advice is definitely worth taking. The good news is that there is plenty of information about the pension rules online – both on official government sites and elsewhere.
A good investment platform will summarise the latest rules for you and my advice is that you should check what they are at least once a year. The key point is that investing in a pension, as with an ISA, is a highly tax-efficient way to invest and one of the obvious options for any would-be DIY investor to consider.
Don’t forget costs
As well as taxes, the figures I have quoted about asset-class returns also exclude the cost of investing. Any kind of investment inevitably carries costs with it. The higher the cost, the better the investment has to d
o in order to justify what you have paid for it. Unfortunately, the real cost of investing is often much higher than it may appear, as we’ll cover later in this book. It is vitally important to understand exactly what costs you are incurring. Only then can you know if they are worth it or whether they are going to eat too far into the returns you can make as an investor. It makes a huge difference whether an investment that earns 5% a year costs 1% or 2% per annum to own. The good news is that the costs of investing are starting to come down and DIY investing has become more cost-effective than in the past.
Putting it all together
To summarise, how much money your investments will make over time depends on the investment returns you can obtain after the deduction of tax and costs. What you can then do with that money will be determined by how successful you are in beating inflation. Your objective is to maximise the ‘real’ return on your investments after taking account of taxes, costs and one other crucial factor – risk. Different types of investment carry different levels of risk. Shares, for example, are generally riskier than fixed-income investments. A riskier investment is one that may produce a higher rate of return, but only at the cost of a higher chance of loss.
The only certain way to reduce your risk is to diversify: to spread your investments across a range of different investments. Not all types of investment move in tandem, so a well-balanced portfolio will not rise and fall as dramatically as one that has all its eggs in one basket – say, 100% in shares or property. In general, you have a better chance of obtaining a higher rate of return from a risky investment the longer you are able to hold it. It follows that the more years of investing you have ahead of you, the greater the chance of doing exceptionally – rather than averagely – well. It also follows that the earlier in life you can start investing for the future, the better off you stand to become.