13.72%

51.66%

Figure 7: Performance of a selection of managed funds. Source: Hargreaves Lansdown

There’s a further variation on managed funds that I’ll use in an example later on and those are hedge funds. These are higher risk and use a number of different investment strategies beyond just buying and selling shares. They can produce high returns but this higher risk means they’re mainly for wealthy investors with a minimum investment of high net worth.

Tracker funds

If funds are less risky than individual shares but cost more to invest in, is there a middle ground? Enter automated tracker funds. Every share sits in a market or index – for example, the Financial Times Stock Exchange (FTSE), which has an index of the top 100 UK shares (FTSE 100); or Standard and Poor’s (S&P 500), which lists the top 500 shares on all US markets. Automated tracker funds seek to replicate the market or index and therefore have low costs as they involve little human intervention (known as passive investing) and ongoing costs are fractions of a per cent against an actively managed fund, which could be 0.5–1.5%. As a general rule, the world’s economies are growing and therefore nearly all markets have increased in value, particularly when looked at over the long term. And although a tracker fund can never truly match the index (since it’s following or copying end of day positions), they track sufficiently closely, particularly the larger funds. Provided you’re investing for the long term, you can take advantage of low cost and growth with a tracker.

In 2008, Warren Buffett issued a challenge to the hedge fund industry, which in his view charged exorbitant fees that the funds’ performances couldn’t justify. One such hedge fund (Protégé Partners) took on the million-dollar bet and lost. Buffett’s contention was that, including fees, costs and expenses, an S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over ten years. While there’s a place for active fund management, there’s also a compelling case for passive tracker investing. It’s one that I’ve been drawn to over the years and now forms a significant part of our portfolio. They’re also easy to understand and don’t require a huge amount of knowledge to be able to select the suitable tracker, and we’ll use the S&P 500 as an example in later chapters.

To demonstrate this, compare the data in the Figure 8 for two trackers against the managed funds in Figure 7. Simply put, they cost less but deliver more. That’s why I like them.

Fund

Yield

Fees

2018/19

2019/20

2020/21

2021/22

2022/23

5 Year

UBS S&P 500 Index

1.23%

0.09%

6.09%

11.93%|

25.77%

2.62%

9.98%

68.57%

Fidelity Index World

1.61%

0.12%

4.69%

7.67%

23.41%

-2.51%

12.53%

52.60%

Figure 8: Performance of two index tracker funds. Source: Hargreaves Lansdown

There’s a variant called an exchange traded fund (EFT) that’s common in tracking an index and it works essentially the same as a regular fund except the way they’re structured normally means they’re a little cheaper, so many of my tracker investments are more correctly EFTs.

Gilts or bonds

These are effectively IOUs from governments or large institutions and used to borrow money. UK government bonds are known as gilts because, historically, the paper certificates issued had a gold edge; in the US, they’re called treasuries. On the basis that governments aren’t meant to go bankrupt, their yield is more stable than shares, whose price can be volatile. Here we come back to risk and the volatility of shares; it’s generally accepted that while share prices can be volatile, they can also produce a higher return, particularly when viewed against more stable gilts. Again, a common approach is that, early in your investment timeline, you’re encouraged to invest in equities (shares) as the overall gains smooth out any short-term losses. As you near retirement, many managed pensions will start switching from equities to gilts so that the risk of a short-term loss is reduced. The last thing you want the year before drawing your pension is for the value to drop by 10%, so in theory it’s not a bad strategy.

As we know, nothing is guaranteed and surprises can appear from anywhere. The astonishing events that unfolded after Boris Johnson left office in 2023 and Liz Truss and Kwasi Kwarteng announced their disastrous budget was a case in point. Economists weren’t convinced that the £45 billion of unfunded tax cuts would drive economic growth and pay for itself in the way the government believed. With inflation at a 40-year high, a rising risk of recession and higher borrowing costs, it was a big gamble at the wrong moment. International financial reaction was swift and damning. The pound fell to its lowest-ever level against the dollar, while gilt prices collapsed. Off the back of a very tentative recovery from Covid-19, this completely trashed the markets and unexpectedly shattered the value of all those ‘safe’ investments.

While a market collapse is clearly a crisis for those actively accessing their pension funds, for many of us, what goes down eventually comes back up and by the time you retire, this blip could well be forgotten. I say ‘could’ and want to unpick this a little more and demonstrate that for the average person, when it comes to investing, simple is best and you should be wary of many ‘financial experts’. Way back in 1990 when he was chancellor, Gordon Brown removed the option for pension funds to receive dividends free of tax. No regular voter on the street really noticed (nor cared); it generated huge sums for the Treasury but cost pension funds billions over the following years. But it wasn’t all bad news, because under the Labour government, companies were forced to declare the financial health of their pension funds, with many reporting that they couldn’t meet their liabilities (in other words, they didn’t have sufficient investments to pay out their employees’ guaranteed pensions). Around this time, British Telecom held the UK’s second-biggest pension fund and it was almost £8 billion in the red. In part, this led to the demise of the DB pension as BT couldn’t fund it themselves. To get round this problem, financial experts created an investment vehicle called a liability-driven investment or LDI. Without going into detail, these are leveraged tools to borrow against the assets within a pension fund. Notwithstanding that many pension assets are ‘safe’ bonds and the fact that the value of UK pension funds is somewhere in the region of £3 trillion, you start to see why the financial markets went into meltdown as bond prices collapsed.

I’m not going to side with one political party or another as in my view both have pursued flawed policies in their time. If I’m going to attribute any blame, it’s to the large financial institutions that are gambling with ever more complex financial tools in order to create a return. So when you’re at the stage where you’re reading an investment report or getting financial advice and someone suggests they have an investment that is ‘specially structured’ to generate impressive returns, I’d be extremely sceptical. I like to understand what I’m investing in and therefore prefer simple concepts.

The above section covers the core investment types and these will form the basis of your investment portfolio. Given the lack of guaranteed returns and other complexities, our own investment approach has been governed by simplicity, alongside investing for the long term. For the vast majority, investing in a basic tracker fund is going to be a sound decision. There are still choices to make in terms of which tracker or index to track but it’s a good baseline to start from.

Now we’ll delve into the mechanics of investing, some of which might seem minor but can have a huge influence on the returns you can achieve.

Reinvesting dividends and compound interest

Dividends can be viewed in the same way as interest on a savings account. You get an annual percentage return on whatever value you’ve invested. More important potentially than the actual percentage rate is what Einstein allegedly referred to as ‘the eighth wonder of the world’ – compound interest. In essence, it’s interest on interest and it has an astonishing effect over the long term.

Consider this scenario: you invested £10,000 in your ISA at age 20 and picked an index tracker that returned 4%. In the first year, you’d have an additional £400 (£10,400 in total). Assuming the same return the following year, you’d get 4% of £10,400, giving you an additional £16 on the £400 interest figure from the previous year, resulting in a total of £10,816. In 10 years, it would have grown to £14,802 and in 20 years, £21,911, more than double the original £10,000 invested, all from 4%. Let’s consider the FTSE 100, which has on average returned 12% over each of the past ten years. Plugging this into the above example, £10,000 invested would have grown to just over £33,000, less any platform and fund fees. This underlines the value of starting your investments, however small, as early as possible.

It’s worth taking a moment here to reflect on the interest element of your repayment mortgage discussed earlier. Paying interest on a loan follows similar maths to the interest paid on your savings but in reverse. If you buy into the idea of compound interest generating you a good return on savings, then I hope it explains why I prioritised reducing the mortgage balance and therefore interest paid to the bank.

Inflation

This refers to the general rise in the price of goods such that the purchasing power of the pound in your pocket buys less than it used to and is linked to the retail price index (the average change month on month in the price of goods and services purchased by most households in the UK). If the rate of inflation is higher than your investment returns then, overall, you’ve not made any progress. Although inflation hit a record high of 11.1% in October 2022, the rolling average over the past ten years is less than 3%, so while there’s short-term pain in your household budget, longer-term investments should be able to perform against inflation.