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.
There’s an interesting argument relating to the value of debt in times of high inflation. Just as the buying power of your cash is eroded over time, if you maintain a debt (such as a mortgage) over the same period, the value of that debt may still be £100k but after inflation is taken into account in real terms it’s equivalent to a lower value. However, this is a little theoretical and I still subscribe to the approach of paying off your mortgage debt as quickly as possible, not least because it de-risks you from any further interest changes or remortgaging costs.
Pound cost averaging
This is an odd-sounding concept that essentially means it’s better to drip-feed an investment with smaller, regular amounts than a single lump sum. The calculations are a little messy but it’s easier to visualise graphically (see Figure 9). Take, for example, a share that’s valued at £10 in January. You buy 1,200, for an investment of £12,000. Over the next year, the share price varies between £13.25 and £7.50. Consider if you’d instead have invested £1,000 every month. The average share price over the 10 months is still £10 but buying in smaller, monthly investments has allowed you to buy 1,227 shares for your investment of £12,000, at an average share price of £9.78, or a discount of £0.22 per share.
Granted, if there were dividends due in the period, the first option would have yielded a higher dividend payout but the advantage of pound cost averaging is that it’s considerably easier to invest a smaller amount regularly than a lump sum and therefore the ability to buy more when the share price is lower contributes to outweighing a single lump sum investment. It also reduces the risk that you invest your lump sum at a high point in the market which then drops. We’d all like to buy at the lowest price but don’t know when that might be, so spreading the investment reduces the risk of inadvertently investing all your money at the top of the market.
Performance
Let’s take the S&P 500 as an example and look at overall growth and annual returns (see Figure 10, previous page). The S&P 500 is a benchmark of US stock performance and since its creation in 1957 it has returned an annual average of more than 11% through to 2021. Figure 10 shows those returns over the past 25 years, with only six years failing to make a positive return. Other than more often making a return than a loss, there’s no particular trend and this is where it’s advantageous to use pound cost averaging over an extended period to smooth performance and generate a reliable return rather than trying to pick a winning investment on any given day.
Given this trend in returns, it’s no surprise that, overall, the market has grown in tandem from an average closing price in 1995 of 541 to 4,097 in 2022. In other words, the combined financial size of those 500 US companies has grown dramatically over the past 27 years.
In the developed world, most economies and therefore stock market indices are growing over time. Clearly there are challenging times when economies shrink, either through political instability or a global shock such as Covid-19, but in the long term the trend is up. Although it’s not particularly ground breaking, this is key to my investment philosophy: I invest little and often over the long term. You don’t need to pay extra fees for someone to try to beat the market; just ride the market itself for a much lower cost. Compound interest shows the power of reinvesting returns but the real leverage comes when it’s applied over a longer period.
I’ll add one final comment – and again, it stems from a Warren Buffett quote, ‘Be fearful when others are greedy and greedy when others are fearful.’ When a stock is popular (or when there’s high demand and buyers are greedy for it) the stock price rises; however, the value of what you’re buying has reduced as you’re paying more for the same number of shares. When a stock is out of favour in the market and there’s less demand, the price falls. Providing the underlying business is still solid, you can pay a lower price for it and get better value.
The reason I highlight this is to reinforce the fact that even though shares, indices or a market can drop in value, it’s not always something to worry about. If anything, provided you believe in the underlying growth proposition of that company or economy over the long term, then you’re buying in at a lower price and getting better value for money, as in the pound cost averaging example. So while I’m not too concerned about a drop in the market and see it as a potential buying opportunity, beware of any company whose share price is falling because they are themselves failing. Every so often a business will fail, possibly because it hasn’t kept up with market trends or technology and the share price falls, making it look like a potential bargain against the previous year’s results. But if it’s a dead duck, it’s not good value. Examples include HMV and Kodak, companies that completely failed to keep pace with technology. At its height in 1994, Kodak was worth $20 billion but it ignored the potential of digital cameras (despite inventing them) and sales fell off a cliff from $14 billion to $2 billion, with the company falling into bankruptcy in 2012. Cheap doesn’t always mean good value.
The time to be more concerned about a market dip is if you have to sell, or liquidate, your investments and end up selling at a potential loss – but there are strategies to manage that as you reach retirement. However, if you’re an investor in your thirties and not looking to retire for the next 30 years or so, I’d advise you to ride it out and it will bounce back. It probably won’t be a surprise that I look at my investments on a daily basis and, yes, I get a little grumpy if I see they have gone down – but I don’t panic, as I’ve learned over the past decade or so that what goes down does come up again and when that happens, I’m happy!
To prove that this isn’t all theoretical, I’m sharing an extract from my personal tracker from pre-Covid-19 days, over two years. The investment value includes our pensions and ISAs. There are some caveats to this graph (Figure 12, below) in that I was still employed during 2020 and contributing to my pension, though we were incrementally adding to ISAs and had started drawing down from Lou’s pension in 2021, so it’s not as pure a picture as the S&P 500 example but it shows similar trends. Yes, it was a shock to see more than £100k wiped off at the start of Covid-19 but it has recovered well and I believe it still has a way to go.
Figure 12: Personal investment performance 2020 to 2022
Duplication
When I started working and enrolled in my first company pension, I received a piece of advice that sparked my investment journey. There used to be a second part to the State Pension that was known as the State Earnings Related Pension Scheme (SERPS) but you could opt out of it and invest the money elsewhere. I wouldn’t have done this but two of my school friends were taking a gap year while working for Norwich Union (now Aviva) and the company suggested this to them. If you opted out, you needed a private pension to pay the SERPS money into and I arrogantly thought that I might be better off managing my own money than leaving it to the government, so I gave it a go. This started off my personal pension (now SIPP) and the opportunity to pick investments. I was like a kid in a sweet shop; I jumped at almost every tip I read and invested in all sorts of oddball funds and shares. However, over time, I saw which investments were doing well and which ones tanked but still didn’t have much of a strategy, even though I thought it was performing OK. This became the backbone of my pension and as I moved on from each job, I transferred the old company pension into my SIPP until it was a reasonable size. Because of this, I began to worry that I might not really know what I was doing, so I sought investment advice from a popular investment company. As part of this, they reviewed my portfolio performance and discussed the option of moving the management of my pension over to them. I was proud of my progress and the pot I’d amassed but felt rather deflated about the summary of my portfolio as ‘rather eclectic’ and found that it hadn’t performed that well against several benchmarks. Nonetheless, I learned some important lessons from the review, the main ones being about duplication, dilution and trading costs. For the record, I took the discussion as valuable free advice and didn’t transfer my pension. It’s worth remembering that just because you’re talking to a salesperson, you don’t have to buy; if during the process you decide it’s not right for you, you can always say no.
I invested in many different funds and one piece of analysis I received suggested breaking down the full list of underlying shares. This showed that some shares were held in several different funds, particularly the large global technology stocks. A large holding of a particular share wasn’t a problem but holding shares in different funds was. For example, you might hold 1,000 Microsoft shares in two different funds but because of their different investment strategies, you might find one selling 100 shares one day while the other bought 100. At the end of the day, you still had the same number of shares but you’d been charged two dealing costs. This is another reason why investing in a single tracker is sensible, as it avoids this problem.
