Category Archives: Financial Independence

Your Savings Rate: Why it is the most important metric in personal finance

euro notesA personal savings rate sounds like the most boring term in personal finance. It is something most people are not concerned about or have no idea what it is. However, I consider the savings rate as the single most important metric when dealing with finances.

Why it is important

Imagine that you are striving to achieve Financial Independence – a state in which you have assets generating income which exceeds your expenses. If you read this blog and follow the strategies, as a general rule you would need to have stock market investments which equate to at least 25 times your annual expenses. Such an asset base is huge and can take many years to build up.

As an example suppose your core monthly expenses are £1,000 and your monthly net income is £3,000. You would need an asset base of £300,000 to be Financially Independent (£1,000 x 12 x 25). At a healthy 50% savings rate (£18,000 per year) it would take 10 years to reach this goal as determined by the compound interest calculator below.

compound interest calculation example

300K accumulation at 50% savings rate

This calculation assumes a typical annual stock market return of 9.5%. As £300,000 is a lot of money it is easy to presume that the bulk of the amount would be raised due to investment returns. Surprisingly, this is far from true; compound interest, what Einstein called the eighth wonder of the world, only starts to kick in with a meaningful effect after a long time. Even this 10 year period is relatively short when thinking of investments.

Over 10 years the amount raised by savings would be £180,000, a proportion of 60%. If investment returns are less than 9.5% it would take a much larger proportion of savings to achieve the same goal within this time frame. It is entirely plausible for investment returns to be as low as 5%. At this rate the investor would need to save an astonishing £276,000, or 92% proportion, in the 10 years in order to achieve their goal.

Savings rate needed at 5% returns

Savings rate needed at 5% returns

These calculations prove that along with keeping investment costs low, avoiding debt and minimising taxes, a high savings rate is one of the sure ways to guarantee accumulation of reasonable amount of wealth.

Proportion of savings needed at a 9.5% return vs 5% return rate

Proportion of savings needed at a 9.5% return vs 5% return rate

You can not control or forecast investment returns but you can control how much you spend which directly impacts the savings rate.


Fascinating alternative scenario*

The above two investment return rates are very realistic. Just for fun, if we assume an overlay optimistic return rate of 20%, the size of nest egg generated would be truly astounding. I repeat that this is overly optimistic and would be in the world of the likes of Warren Buffett. Such a rate would result in a portfolio of nearly £600,000 over 10 years! This is very unlikely but to give yourself any chance at this the high savings rate would be key. The good old savings rate stops being boring here.

Portfolio value with very optimistic 20% savings rate

Portfolio value with very optimistic 20% savings rate


Calculating your Savings Rate

There are many ways out there for calculating a monthly savings rate. Here is my take on this. The savings rate has to be taken in context of net income which you can actually access rather than gross income. Therefore the savings rate would be the proportion of money which is put away in relation to the money which is actually made available. Savings rate = sum of savings / net income.

Sum of savings can include the following:

  • savings into cash accounts
  • investments in stocks and shares
  • personal pension contributions
  • employer pension contributions
  • government pension tax relief payments
  • income saved from other employment sources such as business proceeds

Regardless of which method you use, the key thing is to maintain a high rate. There is little point investing a tiny amount in even if you get exceptionally high returns. As this year has shown, market volatility is never far away. You can only control what you can and when opportunities arise it will be those who maintained high savings that will reap the benefits.

Interesting reading:

     

Why you should invest globally when aiming for financial independence

As the 2018 FIFA football World Cup heads to a thrilling climax it has reminded me of the importance of having a globally diversified investment portfolio. Not surprisingly, as in football or any other sport, investors tend to be very home biased by usually holding the majority of their investments in stocks which are based in their home country. This is often not the most optimum strategy and I will go over my reasoning for this here.

Key financial independence principles

Having financial independence requires that you own a collection of assets which are capable of providing you with passive income which is more than your expenses. Once you reach this stage working for money becomes optional as you will be free to do what you want with your time. Using principles explored on this site and others it can take a relatively long time (typically 8 to 15 years) to achieve this therefore it is paramount that the most optimum strategies are applied. The key principles include:

  • Spend less than you earn and invest the rest
  • Maintain a very high savings rate
  • Invest in low cost stock market index funds
  • Diversify your portfolio
  • Keep investing costs very low
  • Avoid trying to time the market

The power of diversification

The  principle I am focusing on is portfolio diversification. A common way to diversify is by constructing a portfolio composed of stocks and bonds. Bonds should only be included to reduce volatility and protect a portfolio’s value from market downturns for the short term. As a young person striving for financial independence I reduced my bond allocation to almost zero in-order to maximise investment returns. The few bonds I hold are within micro portfolios which may be deployed in the near future for short term goals such as buying a car or property.

As a UK based investor only 20% of my portfolio is made up of UK stocks. The rest consists of international holdings (approx. USA 35%, Europe 20%, Japan 15%, Pacific excluding Japan 10%). This proportion is roughly in line with the weightings of global GDPs (Gross Domestic Product) of these developed economic areas. GDP is a measure of the total value of goods and services produced by the region.

GDP list

Top Global GDPs. source – Wikipedia

With a global portfolio influenced by the above statistics, you can ensure that to a large degree you will benefit from any growth within these regions.

Currency risk – is it worth it

It is important to note that by investing outside you home country you will gain exposure to currency risk. If your currency gains relative to other currencies the portfolio will reduce accordingly and if your home currency loses value then your portfolio will increase in value. I experienced this personally in 2016 when my portfolio jumped by +20% after a drop in the pound sterling.

This is a double edged sword so you should try to get a balance by not overexposing yourself to one region. However, I believe that in the long run currencies in stable economies generally revert to a certain valuation and have low volatility. The benefits of diversification and our inability to predict the future outweigh this risk in my opinion.

Another side of the argument is that for investors in major economies such as the US or UK there is no need to invest internationally as the companies in the major indices (S&P 500 and FTSE 100) already do a lot of their business overseas. This is entirely true but it is not a guarantee that these investments will keep on performing as well as in the past. An interesting article on this is on Morningstar.

Like in this year’s football world cup, expected results are often far from the reality, with all the big teams (Spain, Argentina, Portugal, Brazil, Germany) crashing out unexpectedly. We simply don’t now where the next big gains will come from. It is best to globally diversify, tune out the noise and keep investing.

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Interesting reading:

     

40% Financial Independence – What it took to get here

Nearly halfway to financial independence. This is what I found out when I recently updated my financial metrics. The exact figure is 40.14% but this varies all the time as the stock market has its ups and downs. In this article I will reflect on my journey to get to this stage, what I have learnt and what may be in store in future.

The Calculation

I determined the figure by calculating my net worth and relating it to my yearly expenses using the 4% rule. This rule stipulates that you need to amass a diversified portfolio of 25 times your annual expenses in order to cover your expenses for decades. Real time updates of my progress are available on the goal progress page.

The Process

At the beginning, when I got my first job, I made a lot of financial mistakes like maintaining credit card debt without paying it off. Having debt is like carrying a huge weight on your back when you are trying to climb a mountain. At that stage, my net worth was negative, yes – less than zero. I did not care nor know about this as I was busy preoccupied with keeping up appearances and living large. To make things worse I took part in some substantial lifestyle inflation.

After three years, I had a lightbulb moment, learnt about financial independence and set about to improve my finances. By applying a number of strategies detailed in this book the trajectory in net worth was increasingly high. Key to this was understanding the differences between assets and liabilities. This has been critical. It has taken less than 6 years to get from broke to get to this point of 40% financial independence.

What does it mean

It is perfectly reasonable for anyone with an average income to achieve financial independence in ten to fifteen years. For these first few years, progress has seemed slow for me. This is to be expected, as can be seen on a compound interest calculator.

Frustrating as it is, it is important to stay focused and keep in the game; before you know it your portfolio will start behaving like a snowball, gathering speed and mass at an ever increasing pace. I have seen evidence of this in a number of personal finance metrics which I track regularly. An interesting metric is the quarterly net worth gain in the chart below.

My quarterly net worth gain

As you should view your investments as ownership in real businesses, as the CEO, it can be useful to review them every three months. As you can see, the compound effect is demonstrated by a general trend of increasing gains at every point.

The exception is a couple of major dips: first was a major expense for a car purchase in 2012 and secondly due to the recent volatility experienced in the global stock markets in 2018. It is not to  worry as even the best investors are affected by such dips as the second one too and it is often an opportunity to invest more. The following chart shows a change in Warren Buffett’s net worth, with a corresponding drop in the first half of 2018.

Warren Buffett net worth chart 2012 – 2018

The future

My plan for the future is to stay the course, sticking to the strategy and keep learning more. A couple of useful books I want to revisit are A Random walk On Wall Street and The Bogleheads Guide To Investing. These books fundamentally changed my though process for the better and are definitely worth buying.

If the compound effect continues at an exponential rate, what I achieved in the past six years will be achieved in the next three! By that stage there will be more life options available and more crucially the freedom to do what you want to do and when.

Useful Resources

     

The Number 1 secret of the rich

The Sunday Times Rich List 2018 had some fascinating insights. The list, released on 13th of May, shows that self made entrepreneurs now dominate the top of the list as opposed to old money did in previous times. This got me thinking; what are the people at the top doing to get and stay there?

Rich Dad Poor Dad – Leveraging the Philosophy

Although the list is very diverse in the ways that the fortunes were made, there are a number of common traits which are possessed by the successful. The wealthy tend to accumulate assets which generate income instead of liabilities which can drain your finances considerably.

This methodology is clearly defined in one of the great investing books; Rich Dad Poor Dad by Robert Kiyosaki. However, in this article, I look into exactly how the wealthy tilt this strategy and do things in ways that others don’t.

In the belief that appearing wealthy needs one to have flashy property such as cars, clothes or jewellery, people tend to spend most or all of their savings or use credit to acquire these. This is not effective and will only result in you looking wealthy but you will really not be.

A carpenter’s tools are vital to them

The main difference is that the wealthy build up their assets (tools) first and then, like a carpenter, use the proceeds of these assets to help obtain other properties which can be classified as liabilities. You should not assume that these individuals are wealthy because they may already own fancy property but that the properties are a side effect of having other income producing assets.

Using this approach, it is easy to see how it is a lot easier to accomplish financial objectives once you have amassed substantial assets. This is best shown by an example:

Imagine if you want to buy a car worth £10,000. A person with poor financial literacy would probably use a loan or car finance to make the purchase as quickly as possible. At a typical loan rate of over 5% a year, the total payment can be over £12,000 after a few years. If the person saves £500 a month it would have taken them 24 months to raise the full amount.

A smarter approach would be to save up front and then buy the car for cash. At the same £500 a month savings rate it would take 20 months to cover the £10,000. That is a full 4 months better of than the borrower. Look at it as 4 months of getting up early and going to work every morning, dealing with everything that comes with it, wasted. Time is our most valuable commodity and is finite.

This may seem impressive but there is an even more fascinating way to look at this by using the number 1 secret of the rich.

For the third approach, imagine that you are an employee and first build a portfolio worth £50,000 which can consist of income generating assets such as stocks or rental real estate. Assuming an annual return rate of 10%, after a single year the portfolio would have generated £5,000 of income. If you decide to purchase the vehicle at this point it would only take another £5,000 of your hard earned income.

If you were prepared to wait for 2 years, the portfolio would generate £12,000. Enough to cover the purchase without the need for any hard earned cash at all. For a 3 year period which is typical for a car loan as in the first scenario, a very large amount can be raised which can allow you to by a more premium car without much effort.

This is just a small example but the same line of thinking can be used every time you purchase liabilities such as cars and a house you leave in. This requires a lot of restraint and delayed gratification but you will reap the benefits before you know it. Spending it all without having built up a substantial asset base is like taking the tools away from a carpenter.