I’ll start this post with the end thought in mind. If there’s anything that you take away from this post, then please let it be this: Your saving rate is the single most important aspect of achieving early retirement. In other words, the amount of money which you put into your retirement plan is far more important than both the asset that you place it into, and the returns which that asset may generate.
We’re constantly told by various sources that we should save anywhere from 10 to 30% of our income. Some publications go so far as to say that we should be putting away half (!) of all of our income. This figure is often out of reach for those of us who work a single job on a full-time basis, so what can we do to “catch up” and start to reap the rewards of passive income?
To begin with, let’s presume that you’re already contributing to a workplace pension scheme, and if you’re not doing this then there are numerous resources online which advise you exactly why you should be doing this. For the sake of this article, I won’t go into those reasons, and will write about this matter in a later post. For now, this post will focus on you beginning your own personal savings plans, and to do this you have to start, anywhere. Just begin, and open an online account with any broker. Here in the UK the biggest, and often most recommended broker is Hargreaves Lansdown, however this past summer saw the introduction of Vanguard, and that means one thing: lower fees! I’d thoroughly recommend using either of these services as they both offer something different, and both have positive and negative points which can be weighed up and traded off against each other. You may even find that in time, you wish to pursue both of these options, and that’s perfectly fine too. Just be sure not to mix-up your ISA allowances, as that can land you in hot water with HMRC (Her Majesty’s Revenues & Customs).
So once you have an online brokerage account open, what should you do next? This is where the savings rate becomes important, but what becomes even more vital is simply saving something and doing it on a regular basis. Try to put away just £100 on a monthly basis, and you may be surprised at just how quickly this adds up. Put this money into an index fund (Vanguard is an excellent option for this) and you’ll notice that your total balance rises all the more. However, when you’re starting out on your investment journey you’ll notice that the initial savings amount that you put away will be of far greater importance than that which you can accumulate through compounding.
Unfortunately, we are now part of an environment whereby the majority of people expect instant returns and successes, and an ever decreasing amount of people have the ability to look beyond the short-medium term. A study back in 2014 by British-based website This is Money found that 56% of British people have less than £1,000 in savings. Should you be able to stash away this £1,000 at a rate of just £100 per month then obvious maths says that in less than a year you’d have achieved your goal. Not only this, but should you invest this money into a cheap index fund, then you’ll see this amount start to grow even quicker, due to the power of compounding. To illustrate this point, let’s use the figure of £100 tucked away at the end of each month, and this amount is deducted automatically from your bank before being deposited straight into your Vanguard account and invested into a FTSE All-Share index fund. At the end of your first 12 month period, you’d have invested £1,200, however by using a conservative compounding return of 6% your total balance would rise to over £1,233. That’s £33 that you’ve earned for FREE for very little effort on your part. Let’s now fast forward to the following 12 month period and presume that you again invest £100 per month. You would now be starting on £1,233 and will have invested enough money to end the year having increased your balance to £2,430. However, the total account balance following the second year would be over £2,543, meaning that in the second year your compounding return would be over £110! You can quickly see that this is far greater than the amount of interest earned on your investment during the first year, and yes you guessed it, this will increase even more during the third year and so on.
To some, these investment returns may appear minimal; after all we are talking about 12 month periods in the above examples. Any large increases in your net worth which accumulate through compounding interest will not be felt until you reach a critical mass of savings. When starting out it’s vital to focus more on the amount which you are saving together with the frequency of those deposits, than on any advantage that compounding may bring. Be aware of this, and do not get disheartened. We all have to begin our financial marathon somewhere and what’s important is that you have now commenced your journey and your compounding returns will mean that all things being equal*, you will have more money at this same stage next month/year.
- Save as much as you can on a regular basis,
- Invest that money into a low-cost index fund,
*Investments can fall as well as rise, and therefore you should be both familiar and comfortable with the relevant risks associated with investing.