Earlier this year I entered the black for the first time in my life. I paid down all my debts and I was finally in a place where any excess money that I earned was mine. Since then, I've done a lot of research and had a lot of conversations about what I should be doing with that money.
I'm going to share the most important lesson I learned.
If you're able to save money every month and you don't have immediate debts to pay down, this is information that you need to know.
I'm also going to try to keep this as simple as possible. One of the most off-putting things about personal finance is the amount of gatekeeping, jargon and general resistance we have as a society when it comes to talking about money.
You read that right. I save very little of my money. To 'save' money is to ferret it away and store it up for a rainy day, or until you've got enough together for a big purchase like a holiday or a new car. The problem with saving your money is that because of inflation your money will be worth less each year.
Inflation is "a general rise in the price level of an economy over a period of time" which basically means that every year, everything gets more expensive. Check out this graph:
By the graph we can estimate that over the next 5 years everything will get about 2% more expensive, each year. Remember that for later.
Most savings accounts at mainstream banks will offer you an interest rate on any money in your account. According to moneysavingexpert.com the best interest rates available at the moment are 0.65-1.25% on accounts that allow you to retain access to your money, and up to 1.5% on accounts which restrict your access to that money for up to three years.
If you're feeling sharp, you might have spotted the problem. Inflation is estimated to be +2% per year, but the best (and most restrictive) savings accounts only give you 1.5% interest on your savings. That means whatever money you save, it's worth 0.5% less every year. And that really is the best that you can do if you're saving your money.
There's an index fund called the FTSE 100, which is a collection of shares of the top 100 companies listed on the London Stock Exchange. Rather than investing in any single one of these companies, you can invest your money into the FTSE 100, which then invests the money into the top 100 companies on your behalf.
The benefit of this is that you make a single investment, but your portfolio is diverse. One company crashing won't affect your portfolio, which means that your money is much more stable.
Each year, you get a return on your investment, which is determined by the growth of the companies that make up the FTSE 100. From your perspective it works like interest from a bank.
However, the FTSE has an annual average return rate of 7.75% per year since its inception. That means that any money you invest in the FTSE increases by 7.75% each year (on average). Any return that's higher than inflation is 'good enough' in my book, but 7.75% returns blow any savings account out of the water.
One thing that's very important to remember is that all the percentages that I've talked about so far are compounding. Meaning that they stack on top of each other year after year.
If your money is worth 0.5% less every year, that 0.5% gets bigger every year. In other words, if you were to work out the numerical value, you'd find that 0.5% is a bigger chunk of your money every year. Similarly, if you're putting money into your investment account every month, and every year that total amount increases by 7.75%, the numerical value of 7.75% gets bigger each year, and the effects of this can be quite astonishing.
Using a tool like this compound interest calculator we can see that if we start a brand new account with nothing in it and set up a £100 auto payment each month, then forget about it, we would put in £24'000 over 20 years, but at the end of that 20 years we would have £57,105.26 waiting for us. We've made £33'105 for no additional effort. We've doubled our money by doing absolutely nothing, and £100 per month over 20 years is a very reasonable ask.
I'd like to stress that this return is very conservative. In this example, we're not adjusting our savings to account for inflation (which you should do) and we're never saving more than £100 per month so we're not factoring in things like salary increases, bonuses, gifts, etc. Further to that, there are investment funds other than the FTSE 100 which offer a higher return rate, some as high as 10-11%.
Increase that £100 auto payment to £300, and you'd have invested £72'000 after 20 years but your investment would be worth £171'315. You've made nearly £100'000 for doing absolutely nothing.
You've made nearly £100'000 for doing absolutely nothing.
That should sound too good to be true, and that's because it is. There are some catches that make investments unsuitable for some people but for the vast majority this is the best easy thing to do with your money. I’ll address these catches so that you have the full picture:
One year your money could be worth more, and the next it could be worth less. In fact, my own investment portfolio is currently 'down'. One important concept to familiarise yourself with is that no losses or gains are realised until you withdraw your money. If your investment portfolio is down and there's fears of a recession you might panic, withdraw your money and stuff it under the mattress so that you can buy toilet paper after the banks have collapsed and cannibals run rife.
You haven't lost a penny until you withdraw.
The FTSE goes up and down. Sometimes there are recessions, and it crashes. However, over any given period of 20 years it trends upwards. You must play the long game. You must not react emotionally to changes in the market. You haven't lost a penny until you withdraw.
Many of the companies in the FTSE 100 are titans of logistics, power and oil, civil services etc. and if they were to simultaneously fail then we would have some seriously big issues to worry about as a country.
It's so unlikely to happen that I don't think it's a worthwhile consideration.
Nor do I. The FTSE 100 is one option, but there are many other index funds that cater to various criteria like only investing in green companies, or just about any agenda that you could think of. I personally use Circa5000’s Stocks & Shares ISA to invest in their 'people and planet' fund, which has the following sub-themes:
- Pharma breakthrough
- Digital Learning and EdTech
- Cybersecurity and data privacy
- Global clean energy
- Sustainable future of food
- Clean water.
Whatever social or natural causes are most important to you, you can invest in them and know that your money is being put to good use as well as making you more money for nothing.
If you needed your cash at a time when the markets were down, then you could be forced to realise losses. That's why you should only invest money that you won’t need access to any time in the next 5 years.
You should only invest money that you won’t need access to.
You should have a small emergency fund to cover unexpected costs, and you should think carefully about any major savings goals that you have, like buying a house. If you can think of a major purchase that you'll want to make at some point in your near future, then there are special savings accounts that you can make use of which are probably better options than investing the money.
Index fund management is a service, and services cost something. There are many investment platforms that waive the fee for the first year. Some have a percentage-based fee which could be a pittance when you're just starting out. Some have a flat fee which can work out cheaper if you've got a large portfolio. I really wouldn't sweat this too much; your returns will more than likely cover platform fees quite quickly.
Some people are hesitant to invest because they want to maximise their early profits by investing when the market is ‘down’. This is called ‘timing the market’ and it’s not something that you need to consider if you’re new to the game or you’re in it for the long haul.
Time in the market beats timing the market.
You need to open a Stocks and Shares ISA with any provider that you want. There are many to choose from, and a good place to start is with this article on moneysavingexpert.com https://www.moneysavingexpert.com/savings/stocks-shares-isas/ which lists a handful of your best choices.
An ISA is an Independent Savings Account. It's just an imaginary wrapper that goes around your account and labels it as tax-free. A normal savings account would see you pay tax on any interest that you make, but that's not the case with an ISA, so it's worth having one.
I personally use Circa5000 because of their focus on causes that I care about. When I was in stable employment, I kept 1 month of expenses in a bank account as an emergency fund. Now that I’m self-employed I’ve increased that figure to 3 months. Any additional money that I make gets invested in one way or another.
If you don’t have immediate debts to pay, or things to save up for, I firmly recommend you stop saving. Start investing.
Don't take this as financial advice, I am not qualified to tell you the best way to use your money. I'm just sharing the lessons that I've learned. Please do your own research.