One question my readers seem to ask me regularly is whether ISAs are a good investment. Here I’d tell you why I believe ISAs are one of the best investments around and how you can select the ISA for you.
But let me tell you a story first.
The other day, I met and old friend of mine and, as often happens these days, our conversation over coffee turned to retirement dreams and the provisions we have made. (There was time when we didn’t talk about retirement and minor maladies but about nights spent partying and career ambitions. Oh well…). I mentioned my stocks and shares ISA with Nutmeg, proud that I maxed it out and hopeful that it is the foundation to a more secure future.
“But why are you doing this?” – my friend asked. “I didn’t put much in my ISA last year. The interest rates are so low now that it hardly matters whether you keep your cash in a savings account, under the mattress or in an ISA, right.”
Wrong. Contributing to an ISA, and maxing it out when the opportunity is there, is still very much worth it. It is worth contributing even to a cash ISA though the interest this will bring is on the low side. According to Money Week, the best interest rate on a cash ISA today is 1.95% with building society Principality’s five-year bond and this is branch based and available only if you live in Wales or the Welsh borders. The next best is Paragon Bank’s five-year bond paying 1.75% which is online only. You get the picture.
Despite the low interest rates, cash ISA can be a great saving vehicle.
Now let’s talk about stocks and shares ISAs.
Here are four features that make stocks and shares ISAs a good investment:
#1. Stocks and shares ISAs are a good investment because they are very tax efficient. You know that profit from investments is taxed, right? Well, if you keep your ISA contribution within the tax-free ISA limit (for 2017-2018 this has gone up to £20,000 in case you didn’t know) you won’t pay any tax. This is how ISAs are ‘tax-free’ (remember though that the Government has already taken its cut because you contribute after tax income).
#2. Stocks and shares ISAs are very flexible. This is most easily understood by imagining your investment as a delicious piece of chocolate and the ISA as the rapper around it. You can do two things:
Blend the chocolate and rap it in an ISA. This means that you can select the kind of investments that you can ‘rap’ in an ISA. There are some rules about what kind of investments are allowed but most stocks and shares play. (You are in full charge of selecting, rebalancing etc. your portfolio though it is in an ISA.)
Get a Lindt Dark Chocolate (or another variety you like) that is already rapped. This is the case when you start stocks and shares ISA with a specialised provider and they look after your portfolio for you. You still have to let them know some of your preferences. (An example here will be the Nutmeg ISA; or Scalable Capital ISA.)
#3. Stocks and shares ISAs can start you investing. Okay, to be more specific, the ‘off the shelf’ stocks and shares ISA could start you investing because they take away some of the responsibility for selecting stocks and, through this, some of the paralysing fear of making a mistake. These ISAs also make investing a ‘low entry’ activity since you don’t really need to know much about the technicalities of investing to dip in.
#4. Stocks and shares ISAs are ‘untouchable’. Do you find that you do this on going moving of money between your savings account and your current account? (For my readers in the US ‘checking’ account.) So do I. And do you know why I do it? Because I can always replace the money in my savings account. Guess what? ISAs are not like that. Whatever happens you cannot put in it more than the yearly amount (tax free). As a result, I’ve never ever taken a single penny out of my ISA. This is why I say that ISAs are ‘untouchable’ (and this is exactly as it should be).
Four rules to select the ISA for you
Now that I hope to have convinced you that ISAs are a good investment, particularly stocks and shares ISAs, let me tell you the four things I believe you should consider to select the one for you.
These are not something that I’ve plucked out of thin air. Quite the reverse; these are the four rules that according to Tony Roberts (in his book Unshakable) ensure that our investments are sound without being overly conservative.
Rule 1: Risk awareness or what is the potential loss?
Before you go and open a stocks and shares ISA (never mind the provider) you have to be aware that it is extremely unlikely it will only make profits. There will be times when the value of your ISA (your investment) will go down.
You also need to be aware that I’m not talking about your ISA going a little bit down. Research shows that at least once per year there are dips of 10% or more. Scary stuff, uh?
Well, not really. Despite these steep drops most years the stock market recovers and finishes up (there are very few exceptions).
Apart from that, roughly every three-four years we experience what is known as ‘bear’ market. This is when the stock market drops by 40% or more. This is real scary…in the short run. Again, research shows that the market always recovers and over-recovers; but it may take couple of years or so.
Your ISA doesn’t have to behave so erratically but this will depend some of the things we’ll discuss later. What is important is that you know that dips are normal so that you can ‘sit them out’. The worse thing for you and your ISA would be to pull out of it during a dip.
Rule 2: Profit awareness or what is the potential return?
Profit awareness when selecting an ISA is important but not that easy to judge. One thing you could do – when opening an “off the shelf” stocks and shares ISA – is to look at the returns that the provider has achieved historically.
Not perfect but still something.
Rule 3: Tax/fee awareness or what tax and charges you have to pay?
Taxes and fees can obliterate your earned interest; when compounded it gets really scary.
When you select the ISA for you, please make sure that you understand all fees and taxes you’d incur. Remember when I told you that one of the best things about ISAs, is that they are tax-free?
True. You still need to watch these fees. Some managed ISAs can have rather steep fees and even digital wealth managers divide their fees in several categories.
Remember: the lower the fee, the more likely it is that your ISA is a good investment.
Rule 4: Diversity awareness or how diversified is your ISA?
Any investor, even a beginner, knows that diversification reduces risk (there are caveats but we won’t get into these now).
When selecting an ISA you should make sure that it is diversified across:
Financial instruments: your ISA is a portfolio that can contain equities, bonds, real estate funds, commodities and cash. Usually the proportions would depend on your risk tolerance and the type of market.
Industrial sectors. Having a stocks and shares portfolio of companies from one sector is risky.
Location. Experience shows that the stock market rarely collapses globally at the same time. This means that if you own only UK companies (or US companies) you are exposed to rather severe drops in value. Owning shares in companies in different countries can lower the drop substantially.
The ideal stocks and shares ISA formula:
Ideal ISA = (Relatively) low risk + high (potential) returns + low fees + high diversity
I have to tell you, friends, that my Nutmeg stocks and shares ISA seems to be ideal; particularly given that it is also very low maintenance because it is fully managed by the Nutmeg team.
How does you ISA score on the ideal ISA formula? (If your ISA doesn’t match the ideal formula it may be time for you to start looking around.)
Editor’s note: This is The Money Principle interview with Adam French, founder and CEO of Scalable Capital. Scalable Capital is an online wealth manager and has been in the news lately as the only European start-up included by CNBC in the list of the top 25 in the world. You’ll learn what this online wealth manager is, what it does and how it is different from other online wealth managers.
Maria: Hello, Adam, and let me say first how pleased I am to have you on The Money Principle.
Adam: Thank you very much for having me, Maria.
Maria: My pleasure. Adam, you are the CEO of Scalable Capital. Could you please tell my readers what is Scalable Capital and what does it do?
Adam: Yes sure. Scalable capital is well… we call ourselves a digital wealth manager. What we essentially do is, we provide investment management but digitally: online and through our mobile apps.
We do this for UK investors but also for European investors; we have a regulated entity in Germany. We are one of the few players in the market that operate cross-border and we currently have UK clients and we also have German clients.
What we’re looking to do is to build long-term globally diversified portfolios for our clients so that they can really build their wealth for the future. That is in essence what we are trying to do.
Maria: Adam, I’d like to ask you what is the unique value that scalable capital offers to investors?
Adam: What we are trying to do is to build a technology platform that not only makes the investment journey more convenient and more accessible; you know, having smooth customer journey and having low entry point, we are using technology to improve the investment methodology itself.
Maria: One of the things I’m trying to do on The Money Principle is to encourage more people to invest and particularly women. There is a problem with women and investing; as I put it when we invest we rock but unfortunately very few women invest. How easy, would you say, it is for a beginner to open an account on Scalable Capital?
Adam: I totally believe in what you’re trying to do the because if you look at the data there is a big problem in trying to get women to invest and we will hopefully form a part of the solution to this matter.
Yes, it is easy to open an account on Scalable Capital.
We have a minimum investment of £10,000 which is a hurdle that you will have to reach. We need this money because of the way in which our algorithm for calculating risk works; we need £10,000 for this to work robustly. But the onboarding is very simple. (Note: ‘onboarding’ translates as ‘opening an account’)
Look, investing is complicated and modelling it is complicated as well. But at the end of the day we are doing everything for you. This is very similar to buying a car. When you buy a car, you don’t understand fully how it works but you trust that it will; and if something goes wrong with the car you go and see a mechanic to get it fixed.
People need to think the same way about their finances. The markets are very complicated so they have to outsource investing to someone who is doing something very smart in terms of modelling the markets.
Opening an account on Scalable Capital is very straightforward. At the beginning, there is a questionnaire that guides you to decide on the risk categories that are most appropriate for you. Our clients can get on board within 15 minutes. We provide a lot of information on the way to help people decide whether this is something for them.
Obviously, there’s the website that uses building blocks that start simple but then get into the detail if people are interested in the detail.
We also host regular webinars where people can ask anything and during which I try to present a bit about the company and also a bit about our methodology. We host investment seminars and if you go to the website there is a banner at the top which you can use to get on one of those.
You can also come and meet the team in person. You see, computers are used to do the things that humans are not very good at; mainly number-crunching and removing emotion. We also have a team of 45 people who provide client services, monitor methodology etc. There are real people here and I believe that it should be made clear that it is a digital proposition but this doesn’t mean that there are no people behind it.
Maria: Adam, I may as well tell you that I’m a great admirer of Nutmeg. I have been investing with them since the moment they started. Could you tell my readers what are the main differences between Scalable Capital and Nutmeg?
Adam: I have a lot of respect for Nutmeg and I know the team there. We are different in one main aspect, that we have already covered a little bit, which is the way in which we invest money.
We take risks targeted approach. By focusing on risk, and particularly downside risk, by focusing on the amount you could lose in a certain year and then dynamically changing your allocation to make sure that the risk remains constant we are trying to keep you invested for as long as possible so you can sleep better at night.
The idea of using risk targeted approach, as compared to fixed allocation portfolio or even a human who is making buying and selling decisions, is what really sets us apart from everybody.
When it comes to Nutmeg we’re both low cost, we are both convenient, we both have apps; you know, we are both trying to do good things. I think it is the investment methodology that really differentiates us from each other.
Maria: Adam, I may as well tell you that I’ve opened an account with Scalable Capital and my £10,000 is moving in as we speak. I intend to have a little race and pitch you against Nutmeg. Who would you put your money on: Scalable Capital or Nutmeg?
Adam: This is a loaded question, I think. Still it is an interesting one; I mean nobody is doing this right now. As I said before nobody is looking under the hood. A lot of people compare services, you know, what does it look like, what does it feel like but no one is really looking at what they’re doing. What you are proposing is one way to do that.
I would actually add third instrument into the race: I will do something like a FTSE 100 tracker and compare the three services. Where, I think, you’ll see the difference is…
You see, it is very hard to compare performance over short periods of time because it can take years for the benefits of a particular investment strategy to show themselves against another strategy.
For example, in an upmarket when you invested hundred percent in equities you will do very, very well. But in a downmarket it will obviously do terribly. This is when the risk control strategy comes into its own because in a downmarket you have more protection and it keeps you in the market for longer.
To compare the performance of different investment instruments you will have to go through a full investment cycle.
What is easier for me than trying to predict what will happen in the future, which is difficult for me to predict with certainty, is to have a look at the data. So, using the data that we have, running all the simulations that we have, I am a big fan of the risk targeted approach. Because one it shows versus passive and active investment management strategies that it can outperform them and also from emotional point of view it keeps you, as the end investor, invested for longer.
I like to back the data so that is where my position will be.
Maria: Okay. So, you’re betting on Scalable Capital and I’ll let you know what the result of the race is in about a year.
Adam: Perfect. Sounds like a great idea.
Maria: My final question is: if you were to give one piece of advice to beginner investors what would it be?
Adam: I think it will be start early. You know, the power of compounding is one of the most powerful financial concepts in the world. Getting interest, dividends and income streams from investments and letting it compound really helps.
The flipside of this is obviously if you are in debt which is compounding against you because you have to pay interest on it.
My biggest advice would be: if you have debt pay it off. If you have the opportunity to start saving, start now.
Because, at the end of the day, and this is what people forget, investing is like buying your future self a present. You are not buying something now but in the future, you can buy something nicer. Hopefully it is not buying something nicer, it is getting a great retirement and a great life.
Start early, I think, would be my key advice.
Maria: Adam, thank you so much for coming on The Money Principle.
Editor’s note: Tonight I give you an article on dividend growth investing. Dividend growth investing is the kind of investing I’m yet to learn more about and experiment with. This is why, this post is written by Lewys Thomas who by day is studying for his university degree and by night blogs about dividend investing on his blog FrugalStudent.co.uk. Hope you find this blog post helpful.
Interest rates are rock bottom – The Bank of England cut them another 0.25% because of the uncertainty around Brexit. Banks are slashing the interest rates they are paying customers with the popular Club Lloyds account and Santander 123 account reducing the interest they pay.
Today you have a few choices:
Leave your money in your account and watch it get eroded by inflation; or
Give peer-to-peer lending a try.
With peer to peer lending you could get anything between 2.8 – 7% a year in interest on your money. My problem with peer-to-peer lending was that I was investing in smaller, very risky companies. Sure, RateSetter and Zopa offer fixed rates backed up by solid ‘safeguard funds’ that protect you from bad debts but locking up for 4.2% for 5 years or earning just 2.8%-3.9% for 1years didn’t really appeal to me.
I’m not knocking Peer to Peer lending – it is a good way for people to make a modest return on their money. If you’re interested you can explore the main options below. Just remember that peer-to-peer lending isn’t covered by the FSCS and there’s no ISA option at the time of writing.
Right, since peer-to-peer lending didn’t appeal to me, so what did I do with my cash?
There’s another option that is less well known and needs a higher level of knowledge and understanding; it can also bring decent return.
I present to you
Dividend growth investing
Now, many people share a certain perception of the stock market. They imagine a floor full of screaming traders and the possibility of huge gains and even larger losses. This is the world of complex charts and big earners, right?
Guess what? This is not how it works, really. There are no longer over-excited traders, not that we can see anyway. In fact, today investing in the stock market is relatively silent and solitary activity: it is between you and the internet platform you use to buy and sell shares.
Buying shares, and making profit from it, is always about buying a small part of a very high quality company. There are two main ways to make profit known as value investing and dividend growth investing. In the former case you make money only from the increase in the value of the company, in the latter you make money also through the share of the profit that this company awards its shareholders, or dividend.
These payments, or dividends, are the seeds of dividend growth investing.
Now some of you may be asking ‘What’s a dividend?’
Simply put a dividend is a company’s way of rewarding you for owning their shares.
For example, I own shares in McDonald’s. For every share, I own they pay me close to £4 (depending on currency exchange) dividend. So owning 10 shares would pay a yearly dividend of around £40.
How do you know what to expect? You can check the percent of ‘interest’ a company pays by taking a look at its Dividend Yield. For example, investing £100 (less fees) into a stock that has a 3% dividend yield, means you’ll receive £3 a year in dividends.
The formula for dividend yield is:
Dividend per share/Price per share
Let’s take a look at a real life example!
By going over to Hargreaves Lansdown’s website and searching for ‘Lloyds Banking Group’ in the top right search bar we get the information below:
Highlighted in red here is Lloyds Banking Group’s dividend yield. A 3.45% yield means that £100 invested in Lloyds would pay you £3.45 yearly.
Not that complicated right?
Ok, so now that we understand what dividends are we need to go a step further to understand what dividend growth investing is.
Quite simply, dividend growth investing is investing in dividend paying stocks for a return. I’m a Dividend Growth Investor which means that I buy dividend paying stock in companies that have very long history of increasing their dividend payments. This tells me that pay-out is relatively reliable. Not only that, but as these companies consistently raise their dividend I can expect that my pay-out will rise too!
Look, for example, at Johnson and Johnson’s dividend history.
We can see clearly that Johnson and Johnson has increased its dividend payment, for the last 22 years; were we to take this further back in history, we’ll see that Johnson and Johnson has in fact grown its dividend for the past 54 years! Imagine the power of those increases and what will happen if you reinvest the dividend over just 30 years.
Now, I know that Maria has written an excellent article on ‘the myth’ of compound interest but I do want to show the other side of the coin on this issue. Maria is right – compound interest is somewhat overrated. People usually get the maths wrong and overestimate their future returns.
Nevertheless, compound interest remains a powerful tool if time is on your side and you combine compound interest with yearly increases in this ‘interest’ through dividend increases. Here’s how compound interest works with dividend growth stocks.
It is also worth remembering that you can get up to £5,000 worth of dividends TAX FREE and that you can invest in dividend stocks through an ISA which means you are not going to pay tax on your dividends and on capital gains.
My investing style goes beyond dividend growth investing but I’m trying to keep things simple here. The important point is that my net-worth has gone from zero to over £13,000 invested in the market. I also have a steady, although still small, stream of dividend income.
Dividend growth investing isn’t going to make you rich overnight. It takes patience and perseverance. But a 3% return from dividend payments sounds a lot better than most bank accounts offer right now – and 3.3% the next year sounds even better. Re-invest your dividend payments for long enough and compound interest will start working its magic.
Have you fallen in love with dividend growth investing yet?
By popular demand, I’ve decided to publish a number of blog posts on investing for beginners. Yes, from anyone else this may be a tad patronising. Not me.
I think I could get this one right. Do you know why?
Because until about four years ago I was an investing virgin, so to speak. Yes, I had been paying into a pension but this didn’t really require even basic knowledge: It was a no brainer. My employer used to have one of the best and best run pension schemes in the country so joining was a sign of sanity rather than financial savvy. Yes, we do have a house that has increased in price nearly fivefold in 20 years but this wasn’t down to me either. John had already put an offer on the house when we got serious and the British government didn’t build enough housing.
You see, investment virgin, I tell you. Just like a very sizable proportion of the British population; particularly women. We women, you see, are good at paying off debt, frugality and saving but when it comes to investing we tend to chicken out; or leave it to our men folk who…Okay. I’m not even going to get there.
Four years ago investing wasn’t even in my vocabulary. This is what happens when you grow up in a country where you saved for specific reason and the only source of income was labour. Oh, and connection but this is a different matter.
Then four years ago I decided that investing is something I should learn and start doing. I started dabbling and opened an account with Nutmeg. I started reading and researching.
This is how I know about investing for beginners: I had to learn a lot to become a beginner. Last year, my overall return on investment was 22.6%. It may be beginners luck. I prefer to think that I have learned something; and Fortune smiled on me.
I learned quite a bit about investing and would like to help you start learning as well. Today, I’ll tell you about the five ways to make your money work for you. Knowing about these is, I believe, the corner stone of all investing for beginners.
Investing in financial instruments
Investing in luxury goods
Investing directly in business
Investing in starting a business
Investing in developing your competencies.
(I’m not including investing in property today. This is a specialised kind of investing that is very capital intensive and probably a stage after investing for beginners. If you still would like to check out property investing have a look at the House Crowd and what they do.)
#1. Investing for beginners: investing in financial instruments
Since this is for real beginners, I’m not going to make it more complicated than it has to be. You’ll have to remember, however, that investing in financial instruments is very diverse and complex affair; some would say that this is a minefield for the beginner.
For now, you need to be aware that these instruments include investing in: bonds (bonds are the way of governments (and others) to borrow money from us; options, futures etc. (sorry, not even going to go there – these are fairly speculative, you really need to know what you are doing and even then…); mutual funds (these are investment strategies that allow you to pull your funds together with other investors and purchase a basket of stocks, shares, bonds and other investment instruments); and Exchange Traded Funds (ETFs) (this are basket investment instruments).
One investment instrument possibility that is exceedingly popular (and underpins many of the more complex investment vehicles mentioned above) is investing in stocks and shares.
Trading stocks and shares in on any investing for beginners list while many people are not entirely clear about what this means. When you buy stocks and shares, in effect you buy a (small) part of a company. There are three main ways in which you make money from stocks and shares:
Speculation. This is when the price of a particular share is going up because many people are buying it. Conversely, the price goes down when many people are selling their shares. Buying and selling in this case is subject to rumour, misinterpretation of information, emotion etc. Speculative volatility doesn’t have much to do with the value of the company. A tweet by a celebrity can have a large albeit temporary effect.
Company value. This is when the price of the shares is directly linked to the increase or decrease of the value of the company.
Dividends. This is a sum of money paid by companies (usually once a year) to their shareholder from the company’s profits.
Why am I telling you this?
Because you can do very little about speculative fluctuation except not fall prey to them. Don’t agonise over how your shares are doing and don’t check them every fifteen minutes – this will be a monumental waste of time and opportunity.
The other two, have given rise to two very different types of investing: ‘value investing’ and ‘dividend investing’.
When doing the former you look for companies that are undervalued for some reason with the expectation that their value will increase. My Rule Breakers portfolio is an example of that: I’ve bought companies that are either fairly new or they have had a mishap that is being remedied. And yes, my portfolio is doing well.
Dividend investing is about buying stocks and shares in companies that pay generous dividends. I have a guest post for you on dividend investing that you could read tomorrow: I’m still learning about this one myself and have not experimented with it.
Last but not least, robo-investors ought to be mentioned here. I’ll be writing more about these as well. You know that I have been investing with Nutmeg rather seriously (and persistently) and now I’m starting an experiment with Scalable Capital.
#2. Investing for beginners: investing in luxury goods
This is about investing in things like art, wine, jewellery and vintage cars. In principle, investing in the ‘finer things in life’, particularly investing in wine, is fun. In practice, it needs a lot of specialised knowledge because every time you buy a piece of art you are betting that its value will increase. Only people who understand art have the eye.
You want my advice on this one? Stay out if you don’t have the eye for, and encyclopaedic knowledge about, a particular class of objects; thought this investing can surely spice up your portfolio.
#3. Investing for beginners: investing directly in businesses
This is the investing I’m really keen on and with, what I believe are, rather good reasons.
You see, risk is the bane of any investing and the biggest reason why people don’t do it. What is not very well understood by most every-day investors is that our perception of risk is correlated with our level of control. Simply put, this means that the less control we have over something, the higher risk we perceive it to be.
Don’t believe me? Let me ask you: would you be worried about nuclear war if you controlled the switch? No you wouldn’t.
It is the same with investing. We worry about losing our money on stock market because we have very little control over what is happening. Frankly, it many cases we have imperfect information as well never mind how hard we try to keep abreast.
When you invest in local businesses directly the risk-control seesaw swings.
This is usually the big, scary one that hides in the cupboard and every time it tries to come out you kick the door shut.
Yes, I get it. It is scary to start a business and branch out on your own. You’ll have complete control over how the business develops but the flip side to that is there is no one to blame for anything.
At the same time, investing in starting a business is one of the most satisfying and profitable investments you’ll ever make. Take my case, for instance. When I started dabbling in online publishing I forced myself to see it as a hobby; this way it was less pressure. Now my websites are a very neat side hustle; I have no doubt that were I to take the plunge and focus on these full time they will become a nice, proper online business. What started as a pleasurable way to spend 10-15 hours a week (writing and talking to you) may turn out to be my ticket to fulfilment and location independence.
Acting on ideas is much harder. But it can be learned.
Starting a business, including an online business, is not all flowers. It is still so much worth it!
#5. Investing for beginners: invest in yourself
Finally, a way to make your money work for you is through you. What I mean is that it is always worth investing in yourself, in gaining new and varied competencies.
These can range from cooking and baking to coding and public speaking. Investing in yourself can be spending money to develop a healthy habit; or get rid of a very unhealthy one.
Do you know that the £250 I spent in 2006 on a stop smoking workshop is one of the better investments I’ve made? To start with, I have not smoked for over ten year. Let’s, for simplicity sake, say 10. Are you surprised that by investing £250 for the workshop I’ve saved over £20,000? I am. And my lungs have recovered so my health has benefited. You see now why this is a cracking investment.
Remember also that education always pays off. And I’m talking about education, not degrees.
These are the five ways to make your money work for you that every manual about investing for beginners should include.
I know this is too much to take if you are just starting out. If you think this will help bookmark this post and see it as the skeleton on which we’ll be putting more muscle. Eventually we’ll get to the skin and even make up; have some faith.
Have you started to invest? What have you invested in? (Please don’t be shy and share; we can all learn from each other.)
Do you live your life or life keeps happening to you?
Life happens to you at least some of the time? I thought so.
This is the case with most of us; we inhabit a personal space – mental or physical – where our control over the events shaping our lives is fairly limited.
It doesn’t have to be like that. Moving away from ‘life just happens to me’ to ‘I live my life’ is a matter, I’d say, of maturity, confidence, self-esteem and a substantial freedom fund.
Life happened to my sister. I’ll never forget the hot summer day when she broke down in tears and told me what her married life is really like. It was a life of early passion, followed by drink, infidelity and psychological and physical abuse.
‘How long has this been going on?’ – I asked.
‘Over a decade.’ – she mumbled.
‘Why don’t you get out?’
‘I don’t have money to get divorced and how am I going to raise my daughter as a single mother?’
We helped her get out. We paid for her divorce, my parents supported her emotionally and psychologically and we pledged to pay for my niece’s university education (incidentally, one of the best investments we ever made including buying the apartment in Sofia for her to live in).
And if you think that finding yourself in the tight corners of life is exclusively for women, think again.
One of my friends – a man and a very high achiever at that – found himself with nothing but the clothes on his back and the cash in his wallet when he left his wife. He sorted it all out later, as it happens, but living his life was touch and go for some time.
Life used to happen to me as well.
Debt happened to me.
Worrying about how we’ll pay for our modest but fun wedding happened to me.
Heck, life still, occasionally, happens to me. Most of the time though I live my life.
What made the difference?
Many things. I’m older, have more experience, feel more secure and confident and have got to grips with my mortality. Even more importantly, I have choices in life sustained by having a rather generous freedom fund.
Guys, most people will tell you that to ‘take life by the horns’ you need to find yourself, to figure out who you are and what you stand for. This is true. Still, your ability to act on what you find depends on whether you are able to meet the money obligations that come with standing by your principles; in other words it comes down to you having a freedom fund.
Much has been written in personal finance about having an emergency fund; this is money that you keep to be able to pay for life events that may happen to you. A bit has been written about having a ‘f*ck you’ fund.
In my book, positivity rates very highly. So, I won’t be talking to you about starting and emergency fund or building up a f*ck you fund.
Today I’ll ask you to start a freedom fun; this is money that will give you the option to do what you want to do.
You know what the difference is? A freedom fund is about you and your level of control over your life; it is not about what may happen to you or getting your own back.
#1. What is a freedom fund?
A freedom fund is a fund that allows you to do what you want in your life; it allows you to plan and finance life events you value and welcome in your life. Incidentally, a freedom fund would afford you control over the emergencies, the do-dads, in your life as well.
Generally, a freedom fund does ‘exactly what it says on the tin’: it gives you the freedom to live your life on your own terms.
#2. Why do you need a freedom fund
Each and every one of us needs a freedom fund. It doesn’t matter whether you are a woman or a man, whether you have safe job that you enjoy or not. Your freedom fund is the one thing that stands between you and the unpleasantness of life that could happen. Having a freedom fund means that you have a level of control over your life; over what you keep and bring into it.
More specifically, you need a freedom fund because:
Things may change at work
Even if you love your job today employers have a way with changing conditions and doing away with the parts of the job you enjoy.
Employers change their goals, they can change the way in which they go about achieving these goals and this can have a large negative effect on your job and working conditions.
Now, the thing is that whenever your employer, their demands and your job description change you have three possible ways to react.
One, you may be completely attuned with the change and fit into the new job description like a hand in a well cut glove. If this were the case you are very lucky.
Another way to react, would be to decide that there are other things that matter. In other words, you are not attuned with the change, you have a problem with the new demands of the job but you think that you can still do it because there things on the fringes that still feel right.
And last, you can refuse to comply and adjust. In this case you have to leave immediately.
In my experience, when employers change their demands the latter two options are the more likely outcome. If you don’t have a freedom fund this can cause a lot of personal unhappiness and life disturbance.
If you have freedom fund, on the other hand, this can be the best opportunity that life threw you as a curveball.
Things may change at home
Okay, I get it!
You really, really love this guy/girl next to you and you have made public promises to stick by them for the rest of your life. You trust him/her. Until one day he/she gets so mad at you that they hit you.
He/she is apologetic; what’s more you shouldn’t have got him/her so mad, right?
Wrong. Abuse is abuse and you don’t have to put up with it for any length of time.
You don’t have to put up with it particularly and specifically because you don’t have the money to leave the relationship. Now here is where having a personal freedom fund can come very handy.
Oh, and abusers can be men or women.
Life will happen to you anyway
Do know what I mean?
There are life events that are difficult to avoid.
People get born.
People get married.
Are these emergencies? Not really. These are life events we know will happen (well most of them anyway) but we have no way of predicting when they will happen.
A freedom fund gives you peace of mind; when such events occur it is your choice to decide how to tackle them.
#3. How large should your freedom fund be
A good question but why do you ask me?
The size of your freedom fund is a very personal matter; a matter that only you can settle. How large or small your freedom fund needs to be, among other things, depends on:
how expensive is your lifestyle;
how long do you take to sort your sh*t out; and
your freedom purpose (what is the freedom you want, freedom from what and for what).
I intend to write more about the freedoms we crave and how to calculate how much these cost you. For now, I can only tell you how large is my freedom fund.
I have a personal freedom fund that would allow me to sort out my life were everything to go wrong (e.g. leave job, leave family). This fund is roughly 8 months of my personal living expenses (allowing for accommodation of course).
We also have a family freedom fund. This assumes that I stop working and we stay in the house we live in. We keep approximately a year worth of expenses above our monthly passive income (this is not yet large enough to cover all our expenses).
#4. How do you build a freedom fund
You do it just like you build up any other fund: with patience and persistence. You have to persist with the persistence of a drug addict.
Only caveat is that if you try to save this fund from what you normally bring home every month can be a stretch; and despite all dedication and persistence you may claim other savings and spending will easily take priority.
I’m a great believer in making more money. Build your freedom fund by thinking of side hustle, building it up and keeping at it.
I built my personal freedom fund from my site hustle – all money earned from activities other than my job were directed to build this fund. Our family freedom fund was built by our positive cash flow minus what we keep for investments.
There are novel and imaginative ways to build a freedom fund fast. Some have used GoFundMe.com to garner support and raise funds for their freedom.
While this can, and indeed does, work remember that there are severe limitation. To begin with, you will still depend on the benevolence of others for your freedom and this can be granted or withdrawn. Further, your success would depend greatly on your ability to ‘sell’ your story and not everyone has that. And lastly, you need considerable media savvy because crowd funding is a very noisy space.
In balance, it is better and easier to build your own freedom fund.
We all need a freedom fund. You need a freedom fund and you need it now.
So, stop surfing the net and go get yourself a side hustle; save the money from this side hustle; and very soon you’d have your freedom fund.
Start now. Trust me: it feels better than smooth chocolate melting on your tongue; better than running silk velvet through your fingers.
Do you have a freedom fund? How long did it take to build?
You know, I can hardly look through the personal finance articles of the day without reading something that extols the power and beauty of compound interest.
Personal finance geeks will tell you to start saving as early as you can so you don’t miss out on compound interest. They’d tell you that saving small amounts regularly and not withdrawing your money will make you, eventually, a millionaire. They’d tell you that compound interest is a wonder.
Call me contrary but I’m not convinced. Never have been and never will be.
Why, you may wonder, the attractions of compound interest leave me cold?
It is simple: for compound interest to generate monetary results that are not entirely negligible you either need a very long time or very large amounts of money.
I’ll explain this further and will add some other reasons why I believe that compound interest is overrated. I’d illustrate my arguments with examples and different scenarios (where necessary and possible).
Before I get down to business, I feel it necessary to remind you of a quote by Albert Einstein that is often used to support the claims of the compound interest supporters.
This goes like this:
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein
This quote is often taken to mean that even a genius like Albert Einstein bowed to the power of compound interest and the wonder of making money, and a lot of it, this way.
Have you ever read any of the biographies of Albert Einstein, my friend?
Because I have. And what I’ve learned is that Albert Einstein had very rudimentary understanding of, and virtually no interest, in money. His preoccupation was with the workings of the universe. (Biographers mention that Einstein’s wife negotiated his university salary.)
Knowing that, I suspect that his statement has a meaning broader than money. You see, in the universe things don’t just appear and/or disappear. Einstein’s famous formula is about the equivalence of matter and energy. Seen through the eyes of a physicist, compound interest is a wonder: you get something for nothing because more money appears without you putting more labour or capital in.
I’d urge you to interpret Einstein’s quote with caution because I believe it is rather ‘tongue in cheek’. And he found the equivalence in that some earn it and some pay it…
This out of the way, let me tell you why I believe that compound interest is overrated.
#1. Decent outcome of compound interest needs very long time
Here I simply have to mention another case of which the proponents of compound interest make a very big deal.
Have you heard about Ben Franklin’s experiment?
Okay; here it is.
In his will Benjamin Franklin, who died in 1790, left $4,400 each to the cities of Boston and Philadelphia. There was a condition that this money is used to offer loans to young apprentices that had proven worthy of a loan. His will also stipulated that the cities would have access to some of the funds after 100 years and receive the rest after 200 years.
Now the part about which the compound interest geeks get really excited: when the cities received their balances after 200 years, the combined bequest had grown to $6.5 million!
Can you see anything wrong with this?
Let me help you. This money took 200 years to compound to this staggering amount. Correct me if I’m wrong but there are no vampires amongst you. So, you don’t have 200 year.
Also, once we take inflation into account the number stops being that impressive.
#2. Decent compounding needs high interest rate
There are different ways to shorten the time that note-worthy compounding takes.
One of these is to find high(er) interest rates.
For instance, were you to put your money into an account that compounds at 10% per year, your money will double in 7 years.
Regretfully, what we consider a ‘decent’ interest rate is more like 2% per year. At this rate you can expect your money to double in approximately 35 years.
Which brings us back to the small matter of the span of human life.
#3. Decent compounding needs a lot of cash
Another way to maximise the results of compound interest would be to start with a lot of cash to begin with.
For example, if you have £20,000 compounding at 2% annual interest rate, in 10 years you will have the princely sum of £24,424. In other words, you made £4,424 in ten years which is probably less than the amount your money inflated by.
On the other hand, if you start with £200,000 at the same annual interest rate, in ten years you will have £244,240. This is compound interest of £44,240 which looks a bit more respectable (though the inflation concerns hold).
#4. Compound interest is often over-estimated
This is about something that we’ve already gleaned.
Having your savings/investments make 10% annual interest and double every 7 years sound sexy, doesn’t it?
It sounds great but you may be very unpleasantly surprised when you do your accounting in 7 years and discover that your money hasn’t doubled.
Because when you started out so full of hope 7 years ago, you forgot to deduce inflation and taxes from your calculation. Which more than halves the level of compounding.
(Please note that the tax systems work very differently in the UK and the US. In the UK we pay marginal tax on earned interest above £5,000 except in the case of ISAs where the interest earned is not taxed.)
#5. Sh*t happens
This one is straight forward, really.
Because earning notable compound interest takes a long time, life can – and indeed it does – get in the way.
And it is not only personal life that can get in the way. We know that banks can fail, the economy can collapse and cataclysmic historical events do occur. Think about what would have happened to an equivalent of Ben Franklin’s endowment made in Russia in 1790, for example? Remember this thing knows as the Bolshevik Revolution of 1917? Yep. It would have messed up the whole compound interest thing big time.
#6. Your money is locked in
Yep; this is correct.
To take advantage of compound interest, such as it is, you have to keep your money in the compounding account.
What if better opportunities come about?
#7. Compounding is speculative
This one is a particular pet objection of mine. You see, compound interest is ‘interest on interest’. It is money born from speculation, not from adding value to people’s lives and the economy. (Remember that value is added by labour?)
‘Money for nothing’ concerns me; it, I believe, increases the imbalance between money and value in our economies and ends in a cataclysm like a financial crash or economic downturn.
#8. Banks are the winners of compounding
Ask yourself why banks offer you interest on your savings?
Yes, this is it. Bank offer you interest because in effect they are borrowing your money to use as they please. They use it mostly to land to other (for much higher interest than they give you) and to speculate big time (according to some, banks are involved in high frequency trading big time).
#9. Investing in yourself probably compounds better
This may be a bit of a controversial statement but…
If you are in your 20s and people tell you to start saving/investing so that you don’t lose on compound interest I’d urge you to think very carefully.
Because investing small sums over a long time is less effective in terms of compounding than investing large sums over a much shorter time span.
Let’s do some numbers here.
Case 1: Joe is in his early 20s and he is saving £300 per month in an account that brings 4% annual interest. Joe doesn’t have much spare cash but what he has goes in savings. He gets married, has family and continues to save £300 per month – he cannot afford any more. He does this for 40 years. In his early 60s this has compounded to the tidy sum of £355,770.
Case 2: Joanne is also in her early 20s. She has a bit of money put on the side for the do-dads of life (unexpected things you have to pay) but all her spare cash goes on developing herself. She enrols in professional courses and develops competencies that get her higher paid positions. She get married, has family and her money goes on life – housing, opportunities for the kids etc. When she is 45 her expenses drop and her salary is still going up. She can put aside £2,000 per month. She stashes it in an account that brings 4% annual interest for 15 years. When Joanne is 60 she has £493,821 in her account.
Who is better off?
I’d say Joanne; and it is because she cleverly invested in herself.
(If you think that Joanne’s case is hypothetical, think again. Joanne is very much me and how my life has panned out. And I still invest in myself a lot.)
It had to be said and I had to say it.
Compound interest is very much a myth of personal finance today.
I believe it’s wrong to live with the worry about the next debt payment, about losing your house, your job or whether you’d have dignity in old age. So I’ve dedicated myself to teaching people in financial trouble how to build sustainable wealth.