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Seems there’s lots of confusion over saving and investing. They’re related, but they aren’t the same. Say you have £10,000. There are three classes of things you can do with this.
- You can spend it – on yachts, or on charity, or Jimmy Choos or paying off your debts, or buying a few more bricks in your wall, otherwise known as paying down your mortgage 1
- You can save it, in bank notes under your bed, or in National Savings ILSCS if they’re available, or a bank deposit account.
- You can invest it – in financial instruments like equities and bonds, or in yourself by training to earn more money, or in your small business buying capital plant or services so you can make more money.
Everybody knows how to spend money, so I won’t bother with describing how you go about that. Where there seems to be serious confusion, however, is between investing and saving.
You usually save for a defined short-term goal (within the next five years, say). Monevator gives you the lowdown on why you don’t do that under your bed. You know you are saving when you consider there to be a vanishingly small chance of you getting fewer pounds out when you come back for you money than when you left it there.
Say you want a new TV, or a car. You save for that. You know roughly how much a TV is, you put a few pounds by and when you have enough you go get it. Unlike the 99% who do their shopping early in life, you aren’t screwed. You don’t even need a credit card, though there are good consumer protections reasons why you might want to buy the TV with a credit card even if you do have the money saved. Either way you get your TV when you want in the way you want and under your own terms.
It’s not just Stuff you save for. Some people who decide that the school system isn’t up to scratch for Their Darlings save to pay school fees of about £20,000 a child. Some people save for a round the world trip when they retire, or save towards a house deposit. Things you save for you generally -
- know what your target is to a fair accuracy
- You save the total amount – ie when you have acquired the goods or services in due course you don’t expect to have any of the associated savings left. You can, of course, save for more than one thing at a time
Just to confuse things, you also save towards the unexpected and the uncertainties of life. The ermine has an Emergency Fund, scattered across a full allocation of NS&I ILSCs and a couple of Cash ISAs. I haven’t saved this for a particular purpose, and when NS&I tell me the ILSC has come to maturity I leave them be and let them roll it over. Unlike the cash ISA, which like radioactive waste loses its value with a half-life of about ten years these days, the ILSC’s hold their value in real terms. That’s nice in an emergency fund, because emergencies don’t usually get cheaper with time. People who know more than I do say that in the long run cash actually offers a real return ahead of inflation. I’m buggered if that’s been my experience other than the ILSCs.
Confusingly when people say they are saving for retirement they are usually investing for retirement So what is that investing lark all about then?
Investing is where you buy an asset that you expect to hold its value and provide you an income or save you money, or you expect it to appreciate in value at a higher rate than inflation. The conundrum with investing is that in some cases the asset is in a marketplace where sentiment ebbs and flows to a shocking extent. In nearly all cases with investing there is some risk that things won’t turn out as you expected. Your stocks may tank, the company may go bust, your small business may not get that order for which you bought all the gear, you may flunk your exams or find the price of the university course was more than your will get from the degree premium because everybody can get a degree nowadays.
There’s nearly always a judgement call associated with investing, which isn’t there when you are saving. Provided you save less than £85,000 with any one institution you are fairly guaranteed to get your money back unless this sort of thing happens
If zombies are on the loose then you may not get your savings back. In most other cases you will…
Investing is hard to define, but you tend to know it when you see it -
- there’s an element of risk, often of total losses. Stock market investing is relatively benign there – total losses can happen but aren’t that common!
- once you have invested, the value of your investment will be volatile
- some investments are one-way only. Education, both university and those school fees spring to mind. You may not get a 2:1 or the child may be genuinely dim-witted, negating the value of your education investment. The gear you get to fulfil the order may not have more than scrap value if the order doesn’t get placed.
- You need to save much more than the annual income you derive from the investment portfolio – typically 20 times. The return for that stupendous over-saving is you can sit on your backside and not go to work for the income
So why on earth do people invest, then. Are they out of their heads?
It’s because studies show that if everything goes right a well-diversified investment portfolio beats cash in the log run. You look at the graph in this and go “holy crap, I’m putting my money with the hare and not the tortoise”
There are quite a few ifs in that previous paragraph. Most people have to screw up a bit before they learn the essentials of investing. I’d go as far as to say if you are diversified enough it doesn’t matter that much what you invest in, as long as you don’t fiddle and churn. Diversification also applies in time. Most people enter the stock market over decades as they save into their pension for retirement, but come out of the market all of a sudden when they buy an annuity. They could use some temporal diversification, perhaps shifting a percentage of their equity portfolio into cash savings over the last five years before retirement, to head off being slaughtered in a stock market crash just before they retire.
When should you invest, and when to save?
Save if your time horizon is short
If your need is within five years, then save. Unless you’re comfortable with the risk of losing half your savings at the end in a stock market crash because you think the chance of having more is worth it. Most people hate losses more than they like gains, so this is a bad move for humans.
save if your target is low
If your goal is less than about £10,000 even if it’s 20 years off there’s a case for saving, too. There’s a value in certainty. Yes with investment the rate of appreciation has historically been greater, which means you need to save less to reach your goal. There’s not enough difference between saving £500 a year and saving £300 a year to my mind to make taking the rollercoaster ride of investment worthwhile, plus there are fixed costs associated with investing which eat into your potential gains at the low end. There is a shedload of learning you have to do for investing too, because if you don’t understand the volatility you risk being panicked out of the market at the low-water mark. That is the time to lean in, not run out
invest if you have a long-term sizable goal
If your sizable need is twenty years off, then you should consider investing. Children’s university fees would be a candidate if you start when they are born. The total amount is about £50,000 at the time of writing – as a parent you do not have to save up the opportunity cost part 2.
Two things make this a better candidate for investing. The total amount is worthwhile, and for most people the difference between saving £2,000 a year in a cash ISA and saving £1600 a year in a S&S ISA would make a material difference to their standard of living. I used a real rate of return of about 4% for the S&S ISA and 2% real for cash to come up with those figures. People tell me you can get a 1-2% real rate of return on cash for the long term. If I were saving for this I would personally assign a 0% rate of return on cash, which favours the investing route even more.
The other advantage of university saving is that the volatility is more acceptable due to the spread out nature of the expense. Say your child is coming up to 13, whereupon you switch from investing in a S&S ISA at £1600 a year to saving (at the higher £2000 p.a. rate) in a cash ISA. The rationale behind the switch is the volatility of the stock market is such that you need to be in it for more than 5 years to have a good chance of breaking even. Your child will enter university in five years from now, because they go to university at 18. So you are guaranteed have £10,000 cash towards it, even if the stocks fall. Say your stock market investments turn out to be effectively worth £33,661 3. The stock market then has a hissy fit just before your child goes to university and halves the value of your S&S ISA to £15000.
£25,000 is still enough to make a major dent in your child’s university costs. Plus if you have done your homework, you will observe that you may as well stay in the market – the cash will address the first year of fees. Say your child entered university in Jan 2009 4, which was the most recent low-water mark for the FTSE all-share. That loss would have softened by the next year. University fees are incurred over three years, so they are a good match for a mixed investing/savings approach.
If the market crash happens earlier, as is likely at least once in the first 13 years then your investment buys more stocks, and is a cause for celebration, not gloom
invest for retirement
Retirement is always a candidate for investing. You can expect to be retired for at least as long as you are at work, so unless you can consistently and steadily save half your pay you need the extra that investing can give you. Plus your retirement costs are incurred over a long period of time if you use drawdown, though many people buy an annuity which is a fixed one-off purchase which is a bad match for the characteristics of investing.
Unfortunately you need to understand why you choose investing over saving. The risk and volatility of investing is gut-wrenching at the beginning, because you are poorly diversified in time and in stocks if you buy individual shares, and still poorly diversified in time if you buy index-trackers as people say you should (the index-trackers take care of equity diversification right off the bat).
Most people should save first, then invest
Investing is an old man’s game for your average Brit IMO. In the first part of your working life, money is particularly tight, and the only investment people make is with their pension if any, and their house in some cases, assuming they actually repay the mortgage 5. Because of these two implicit investments, most people get along fine by ignoring investing, and sticking with saving until middle age.
If you want to retire early, however, you have to engage with investment. One tough issue with investment is you can only invest ~11k p.a in a tax-sheltered ISA which buys you about £500 worth of tax-free income each year, so it takes an individual about 10 years to buy £5000 worth of tax-free income. You can do a little bit better than that because you compound the income in the accumulation stage, but it’s still seriously rate-limited. You can invest outside an ISA, and for basic rate taxpayers the issues of non-sheltering aren’t apparent in the early stages.
You have to invest a lot of money to make investing worthwhile
I’m going to stick my neck out and say investing needs at least £20,000 to make it worthwhile. Before you start, you must not owe any money, other than perhaps a mortgage. No ifs, no buts 6. You don’t have to find that all at once, indeed investing a lump like that all in one go has hazards of its own.
What I mean is that when you’ve stopped contributing, the total invested should be £20,000 or more in today’s real terms, even if it your plan takes you 20 years to get there. All too often on Moneysaving Expert forums I see people say I want to invest £500, or even £5000. It’s not going to shift the needle on the dial, and if you can’t find more, there’s a case to be made that the volatility in the stock market is going to deprive you of sleep at times. Save it, and chase the best interest rate you can get. Often that is to be had by paying down loans As I said earlier, before you even think about investing, clear your debts.
Sorry. Investing is not for the poor. Widows and orphans should probably stick with saving, and it works better for them because they don’t pay tax on their savings interest, though that is cold comfort at the paltry savings rates on offer at the moment.
Why do I say you need at least £20,000? Because there is a long, steep and harsh learning curve associated with investing, it needs you to both understand the principles and also to address the enemy within, which easily takes fright at the rollercoaster ride of the fluctuating capital value. Get this wrong and you will lose money and sleep. Some of that 20k will be invested in yourself, in learning what not to do
Invest like you are never going to spend the capital
Unless you’re saving for a defined expense like those university fees, aim to spend the income from your investments, not the capital. It’s terribly hard to get a stable handle on the real value of invested capital. If you don’t know the real value of what you have, how can you determine how much of it you can spend without running it down?
This is the issue that people who keep a chart of their net worth fall into – if a lot of your net worth is in investments then there’s a lot of noise on that signal due to market sentiment. It’s irrelevant, high-roller. In Quicken, I represent my ISA capital as the inflation-adjusted amount of money I have put into the account. When I look at TD Investing’s listing of my ISA it’s a lot higher. All that is telling me is that the world has gone a litttle bit mad and is irrationally exuberant about equity valuation. It won’t last. I’m not going to spend that money. I focus on the income from it, which I can spend (and is usually about 4-5% of the amount I’ve put in).
Unfortunately you still have to engage with and understand the investing process. Most of the issues with investing you try and get right when you buy, then the less you do the better. However, over long periods things like rebalancing are relevant to keeping things on track.
It’s Not Fair
Life isn’t fair, and the Cosmopolitan myth that you can Have It All is toxic. Having one thing usually means foregoing something else. Investing isn’t right for many people. Note that this isn’t purely an issue of what you earn. I earned over the national average wage, but not stupendously more. What I didn’t do was spend as much as most. I have had fewer holidays over my working life than most people. I’ve never been to Ibiza or seen a Spanish beach 7.
This weekend a couple I worked with jetted off to go on a jaunt in Eastern Europe culminating in a road trip to Venice. I’ve dead chuffed for them, and I think it’s fantastic. But on the other hand he gets to spend forty four weeks of the year in the office, and when the boss says jump, he has to jump, and he has to pay homage to The Performance Management System, whereas I don’t have either problem any more. His choice is right for him, and mine is right for me.
So if you can’t find that 20k over 20 years, you probably get to spend more over those twenty years, and if that’s what matters to you then great. There’s nothing that great about investing – other than when you sign off your job at the end of the term, you clock out for good.
Investing, or saving? Know the difference – it matters. The siren song of Investing can come dear, particularly if your goal or your temperament is more suited to Saving. If you have any debts or you spend more than 80% of your take-home pay Investing is probably not for you. Emergencies, such as being made redundant, tend to happen more when the economy is bad and the stock market is down, and if you are spending a high proportion of your take-home pay you may not have enough buffer to avoid having to liquidate your investments into a down market. In which case you’d usually have been better off saving.
Many people are drawn to investing by the pound signs on the upside. They need to look at the sharks and the piranhas circling under the water as well as the tropical island and the yachts above the waterline. It’s that evil combination of increased probablity of personally experiencing economic hard times with stock market lows that makes investing hazardous for people of working age if they can get their hands on what they’ve invested. This is the rationale for tax-favoured pension investment, where you can’t get your sweaty mitts on the money until you are 55. The Government incites you to invest in pensions with the tax benefit, and then denies you the opportunity to get your hands on the loot during your working life. It’s for your own good
- some people might regard this as investment; I did when I was doing it. ↩
- there are strong arguments to be made that a gift of 50k will make more difference to your child’s future as a deposit for a house rather than paying university fees up front, but that’s not the point of this discussion ↩
- I used this compound interest calculator to simulate the real return on adding £1600 per year till the child is 13, compounding at 4%, stopping contributions for five years but still compounding at 4% ↩
- I know children enter university in October. For this hypothetical example I’m using the most pessimistic point in the FTAS index, which happened in January ↩
- BTLers are a different case where repaying the mortgage comes at the expense of expanding the estate. Presumably if you are a halfway competent BTL landlord, you retain your mortgages and expand your estate. Paying your mortgage off is for the little people like me who are buying the house they live in ↩
- in years to come, erstwhile students on the new-style ‘graduate tax’ version of student loans will be an exception to this, particularly if their investing is done in a pension ↩
- I hate hot weather, beaches and sun, so it’s no great hardship ↩