One financial rule your family can bank on
In the last ten years since the banking crisis a number of economic theories have been thrown into doubt. This has resulted in David Vines, a professor of Economics at Oxford, stating “as a result of the Global Financial Crisis we are no longer clear what macroeconomic theory should look like, or what to teach the next generation of students.” No wonder it has been called the dismal science.
As an example of this, we have seen central banks in effect printing money which the economic theories I was taught meant you should get an increase in inflation. Not happened so far. To show how skewed investors are thinking just now we also have nearly half of the Government Bonds issued in Europe trading at negative yields. Yes that’s right, buy a ten year German government bond and you are currently guaranteed to lose 0.4% a year for the privilege. Not only that, but the yield has been steadily falling for the last three months.
When I asked a fixed interest manager why anyone would buy this they said it was in the hope that they could sell it at an even lower yield in the future. They call this the “greater fool theory.” Maybe I am naïve but I would rather avoid being a lesser fool in the first place, plus I was taught that Government Bonds were designed to pay you for the privilege of lending them your money not the other way around.
Given this state of flux it is worth remembering economics is theory whereas maths is fact, and there is one rule that will never be broken but it does require patience to benefit from it fully. I am of course referring to Compound Returns. I am assuming at this stage some of you will stop reading and start searching for “cat plays piano” videos on You Tube instead. I have to admit it does not sound as though the remainder of this will be a riveting read but stick with it.
We all know the phrase “money makes money” and for long term investors it is absolutely true. I have been in this role for 25 years and in that time I have seen clients assets grow considerably. It is one of the most satisfying aspects of my job to help clients reach retirement with no financial worries. If you ask me for the key to achieving this I would say two things. Avoid debt other than a mortgage and get into the habit of investing as early as possible.
Question. What will give a higher return at age 65 – investing £2000 per year from age 19 for 9 years or investing £2000 per year from age 28 for 38 years? Go to the top of the class if you said 9 years from age 19. Assuming an 8% per annum return which is the historic return achieved by the UK stockmarket over the last 119 years (assuming 3% inflation), the 19 year old saver would have accumulated £502,380 at 65 whereas the 28 year old would have £475,882 even though they invested over four times as much as the teenager.
If you can afford to do so, this is one of the reasons I recommend pension plans for children. It is possible to save up to £3,600 a year into a pension from birth and the government also give basic rate tax relief on the contribution even though most toddlers don’t pay any tax. Contributions can be made by parents or grandparents.
If you did this from birth until they reached 18 using the same assumptions as above, on their 18th birthday they would have £145,606 in their pension plan. If no further contributions were made and they left it until age 65 their plan would have a value of £5,421,202. (Yes, the commas are in the right place). Taking into account the tax relief on the contributions this would have come at a cost of £51,840.
Now I appreciate very few families are able to do this but it does show the effect time has on returns. The added benefit of saving into a pension fund is that wee Johnny/Joanna can’t get their hands on it until at least age 55 (and that age is likely to increase) which means they can’t screw up the time factor which is crucial in the returns achieved.
So let’s leave the boffins to come up with the next economic “rule” and in the meantime stay patient and stick to maths facts to increase yours and your families’ wealth.