#HowToInvestWell Stage Three - Compounding
One of the things I wish I was taught when I was young was basic personal finance. I learnt lots about volcanoes and other things I have little use for, yet hardly anything about what finance is and how it all works. This was also around the time I realised I wasn't going to be a Formula 1 driver and therefore would have to find another career. How disappointing...
According to research from the Institute of Fiscal Studies, those in their 30's are half as wealthy as those now in their 40s were at the same age. This means there has been a fundamental shift in the investment landscape in little more than a decade and has resulted in Millennials (like me) lagging behind those born before 1980.
What are the factors that have caused such a shift in the wealth over the last decade? We can point towards a number of factors, such as:
- lower levels of home ownership at an early age causing younger people to miss out on growth
- tighter borrowing rules so you need a larger deposit to get on the property ladder
- lack of access to final salary / defined benefit pension schemes from employers
- low interest rates on cash
How did this happen?
It is fair to say that the financial crisis was probably the catalyst for this shift and when we were young, we were not taught the basic building blocks of personal finance. There has also been a subtle shift in government policy and companies to place the emphasis on the individual to plan their future, rather than relying on the state or the employer to fund pensions and bail us all out.
Simple things can have a powerful impact on your long term wealth and unfortunately most young people are ill prepared for managing their money and are also cynical about using banks and the wider financial services industry following the financial crisis. Many point to high fees, use of complex jargon and a lack of clarity over what their options are, all of which means many younger people are not taking control of their finances.
It is therefore important to educate people early with some key principles which can be applied and that it is therefore up to the individual to find out for themselves and take control of the finances. It starts with a KISS - "Keep It Simple, Stupid"
By applying a simple structure and process, amazing things can happen! So let's look at one important and simple measure to get your money working hard for you.
The power of compounding interest on interest
This is the basic concept of earning interest on interest and it might help to look at a real world example.
The average UK bank account has approximately £1,600 in it. Given interest rates are low, it may well be sat there earning nothing. If we took that £1,600 and apply the current Bank of England base rate of 0.25% (with interest paid monthly), your £1,600 would have generated a miserable £4 in interest at the end of the first year. After 10 years, it would be worth only £1,640.50. That is the problem, there is far too much money is sat earning you nothing.
So what if we earned more interest each year, what would the effect be? If you put your money into something that generated 3% interest, which is not unrealistic, the interest earned in the first year would be £48.67, which is more than the previous example achieved in 10 years. If you then continued to earn 3% each year for 10 years, the effect of earning interest on interest is that your £1,600 would now be £2,158.97. Not too bad then for very little effort.
Now imagine if you could save £100 a month in addition and added this to your pot and earned the same 3% on that too.
This would mean your original £1,600 would be £2,868.35 at the end of the first year. If you repeated this over the course of 10 years, it would mean that you could accumulate a pot of £16,168.04.
Reducing household costs and spending can also be a way to increase your savings, as even a small change can result in a big change in this scenario. By saving a little more and spending a little less, this is the route to financial freedom.
By making your money work hard for you, it can have a significant impact on your long term. It could be the difference between saving a deposit for a house, or being forced to rent for the rest of your life.
Making your money go further
Now let's look at saving for your retirement. Your ability to earn money is your greatest asset and has the greatest influence on what your later life will be like. It is therefore important that you use part of your income to meet future needs, not just what you need now.
This is where time is on your side, as the earlier you start saving, the less you'll have to save each month to build up a pot to generate enough income to have a comfortable retirement. There are very few things that could be described as a free lunch, but saving into a pension and getting both your employer and the taxman to help you save surely has to be one.
The average salary in the UK is £26,500, so if you could save 2% of that, it would mean saving £530 a year. The key is that you actually only pay 0.8% of that, as your employer should pay 1% and the taxman puts in 0.2%, so the £530 only costs you £212. You are therefore missing out on a lot of money by not saving using this method. Many company pension schemes are more generous than the example above and will likely match or exceed the amount you contribute.
This also means you can take a longer term view on what you invest your pension money in. If you can't access the money until age 55 at the earliest, it allows you the time to take more risk than you might with your cash. By compounding returns at a higher rate, this can help you build up sufficient capital to make your retirement comfortable.
It is more important to take the least amount of risk to meet your goal, rather than focusing on taking less risk than you should and not having enough money in retirement - thus not having the standard of living you want when you stop working or even having to keep working longer than your health.
Pensions are part of the equation, but are not a magic bullet, so you should look for a number of simple methods, not just relying on one. Whatever you choose to do with your money, use the simple concept of compounding to guide you.
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