We all have a vision of what a dream life is.
Maybe you haven’t defined it 100% yet, but you have some ideas of what that “if only” life would look like. Well, my friend, I am here to tell you that “if only”is now. Now is the perfect time to turn that dream into a goal by taking action.
By action I mean putting your money to work for you and that means investing.
You may have just recoiled in boredom or maybe horror at the thought of putting your hard earned cash into the volatile stock markets but bear with me and hopefully I can make it less scary (and hopefully a tiny bit less boring!).
First up, you want to take a look at your investment timeline and rationale.
- If you are investing for future security, it is likely you want to ensure you do not end your days financially challenged and dependent on others for support. A pension is suitable for this timeline.
- Planning for goals likely to happen in the medium term (longer than 5 years) requires an easier access investment than a pension. The key here is to look for a tax efficient options to maximise your investment.
- Shorter term plans require the easiest access and a shorter term investment account with a relatively high interest rate would be suitable for this.
A Pension is a tax efficient long-term investment in yourself to create the life you want to live
You may be reluctant to reduce your cash available by investing into a pension now and rather plan to start when you are earning more. Sadly though, as we earn more we very easily find alternative places to use it and it becomes a big procrastination exercise as we wait for that elusive excess cash flow day.
What if you thought about your pension as an investment into your dreams and aspirations for your big life? A contrary view to simply frittering cash away for an older version of you that you can barely envisage and probably don’t want to!
The attractiveness of saving into a pension is the tax advantage tied to it which quite simply result in more cash being added into your investment pot. In addition, if you are employed, your employer may match your contribution up to a given percentage. It makes sense, if you can, to contribute the maximum percentage that the employer will add as it effectively gives you a bonus from your employer as well!
While it may still cross your mind to leave pension investing for the future when you could be earning more, the trick is that the sooner you start contributing the longer your money will have to grow. And by grow I mean exponentially using the compounding effect.
The compounding effect, where the cash your investment earns is reinvested and attracts additional earnings, makes a massive difference.
Simply put, if I invested £100 at 10% per month. In the first month I would earn £10 interest. In month two I would have £110 in the account and earn interest of £11, in month three I would have £121 in the account and earn £12.10 interest. This is a very optimistic and unrealistic example given where market related returns are currently, however it does give a clear picture of what compounding can do for your investment.
Albert Einstein is widely believed to have referred to compound interest as the Eighth Wonder of the World!
The trick is to get started with what you have available to invest, no matter how small, and to simply keep growing this amount as your income grows.
And for those of us who view investing with extreme trepidation, you are able to choose the risk level of the portfolio your pension money is invested into. The longer you have until retirement, the riskier you can choose to make your portfolio. A riskier portfolio would have a higher concentration of equity investments. These investments carry higher risk but generally that leads to a higher return. Furthermore, as you approach retirement the risk profile can be changed or automatically adjusted to be more conservative.
The stock market has consistently done better than cash over the long term.
Cash held in the bank is perfect as an emergency fund or for extremely short term goals. The benefit of holding it in an accessible savings account is that you have immediate access to it, the amount does not fluctuate with market moves and there is generally no cost to extract it.
The downside to this is that the return you earn on it is low, and in some cases may be less than inflation. Inflation is the general rise of prices of goods over time. This results in your cash losing purchasing power. For example £1.99 could buy you a Starbucks tall latte in 2009, today, the same coffee costs around £2.95, an increase of 48% over the 10 years! To keep up with this, your money is going to need to earn more than the paltry 0.20% paid in some savings accounts in the UK.
Your medium to long term savings can be built up more effectively in the stock market and other asset classes. The stock market is riskier than a savings account but gives the opportunity to grow your investment from the higher return offered as a result of that risk.
As you plan to be in the stock market for a long period of time your returns smooth themselves out over this longer term. It is a given that the stock market is volatile and will go up and down, however growth in the economy and companies therein tends to drive the rise and fall to follow an upward trajectory over time.
The UK FTSE 350, an index that covers 90% of UK companies listed on the stock exchange, earned an average return over the last 10 years of 92.31%. This has been achieved over a period when the highest return was 107% and the low was -14%. A huge rollercoaster ride but if you strap yourself in and go the distance you are likely to get rewarded.
Look out for investment vehicles that offer tax benefits. In the UK there is the ISA. Up to £20,000 per year of after-tax money can be invested into assets to be held within the ISA. All the growth in the investments in the ISA from dividends and market value increases are tax free. Referring back to the 92.31% growth in the FTSE 350 this could be a huge benefit.
An important element in decreasing the risk of long term investing, is to create a well-diversified portfolio, with investments in different types of assets, geographies and industries. The diversification into assets and geographies that respond differently to market movements, evens out the volatility across your portfolio. Simply put by not putting all of your eggs into 1 basket you decrease your overall risk.
Shorter term investments are more suitable for goals planned for 5 years or less
Life isn’t meant to be lived where all the fun of it is put off until some far distant financial vision. It is just as important to enjoy every day and to plan for all the exciting goals you want to achieve along your financial journey. Travel, fun experiences, buying a house, treating your family and contributing to society.
After you have saved your 6 to 12 months emergency fund into your readily accessible savings account, you can comfortably target your shorter term goals. Your emergency fund will cover any financial challenges that pop up, and this means that you don’t have to go into debt to deal with a broken dishwasher, unexpected car maintenance or emergency plumbers.
Your short term goals are those you wish to complete in the next 5 years and would be best achieved by saving your money in specific savings accounts or money market investments that offer a relatively higher interest rate than that offered on regular savings accounts. These investments would generally involve locking up your investment for a selected period of time which is all the better for it to be left alone to grow.
The short story to the previous long story is that consistent financial actions taken based on a clear financial masterplan create a rich and fulfilling life on your terms.
If you are feeling confused by all the jargon, I am sorry, I wanted this to be as jargon free as possible ! I invite you to comment or head book in a Clarity call. I would love to connect with you and hear your thoughts on this.