FI Building Blocks:
You have reached the final Building Block to Financial Independence. By now, you would have been introduced to some of the basic concepts of financial independence, maximising your income, increasing your savings rate and protecting your finances in an emergency. If you have skipped the rest of the Building Blocks, then I really recommend you go back to the beginning. All four blocks are fundamental to achieving FI early.
For me, being in a position to invest is probably the most rewarding part. You’ve done the hard work by increasing your income, cutting your expenses and saved for an emergency. If done consistently and diligently, your savings rate would be much higher than the national average (in 2016 UK: 7.1%, US: 5.4%). Now is the time to watch your money grow and actually see for yourself how you can get your money to work for you.
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.” – Robert G. Allen
FI Life Stages
To achieve financial independence, you need to look at it from two main life points (FI Life Stages):
- Period 1 – time period before pension starts paying out.
- Period 2 – time period after pension starts paying out.
To be FI, you need to be in a position where you have sufficient cashflow to cover your expenses during both periods using passive forms of income (income requiring no work, or very minimal work). If you have a pension pot saved up already, then naturally this places less pressure on you to secure other forms of passive income during Period 2.
You can develop a passive income stream using one or a combination of the following strategies:
- Invest enough money in the stock market so that you can live from the dividends and/or sell off your units (shares, stocks, funds, bonds, etc) slowly.
- Property investment to give you rental income.
- Develop a business and eventually hire workers to manage it all for you.
There will always be an element of risk when investing. Risk is the probability of sustaining a loss. The return you get on your investment is payment for the risk you were willing to accept. The riskier the asset, the higher the return you are likely to get. Equally, you are also more likely to lose it all. This is the risk and reward trade-off. When talking about risk, there are two components to consider. The first is your risk tolerance and the second is your risk capacity.
Risk tolerance is your emotional ability to continue the course during the booms years, and especially during the busts. It is how you cope with the ups and the downs of investing. I consider investments to be medium to long-term. For me, medium-term is 10 years and long-term is 20+ years. I don’t invest expecting a return in one year. Both the stock and property market has its cycles of highs and lows. Knowing and expecting a bust some point in the future helps to psychologically prepare for when it happens. The cycle is inevitable and it happens because of human behaviour. To understand why that is, I encourage you to watch the video by Ray Dalio – How the Economic Machine Works.
Understanding and recognising the cycle exists is much easier than knowing how you will react. When you actually see the value of your investment fall say 50% overnight, what would you do? Most novice investors would sell. This is natural human instincts. It is herd behaviour. People sell because they are worried they would end up with nothing at all. They are preserving what they have left and in their minds, it is about damage limitation. However, this is completely the wrong approach. Experienced investors would do the opposite. This is because they understand that the process is cyclical. The market will rise again, except this time they had bought more assets at bargain basement prices. The difficulty is no one knows how long each part of the cycle will last for. Prices could remain low for years. This is why I do not invest for the short term.
Your tolerance for risk will determine your ultimate investment portfolio. If you are risk adverse (someone who think they will lose sleep at night and sell at the slightest dip), then you should own relatively less volatile assets (assets that don’t fluctuate in price much). I personally buy and hold for both my stock market investments and my property investments. This means I have no intention of selling in the next 20 years.
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” – Warren Buffett
Risk capacity is your financial ability to survive an investment loss. Being able to tolerate a loss but not having the capacity (having enough money) will only result in financial ruin. A proper understanding of both tolerance and capacity are absolutely essential before you begin your investment journey.
So how does risk differ from volatility? It is really easy to conflate the two things and even I am guilty of sometimes using volatility as a proxy for risk. It’s much easier to grasp and explain risk that way, but it is not correct. Risk is the likelihood of you losing your investment. Volatility, on the other hand, is a measure of how often and how much the price or value varies over time. The more volatile an asset, the greater and more frequent the price swings in both directions. Just because an asset is highly volatile does not necessarily make it riskier than another asset. For example, you are more likely to lose out holding on to cash in the long term due to the effect of inflation eroding the real value of your money. Whereas, although investing in the stock market may be more volatile, you are less likely to lose money if you invest in the long term. So it is possible that over a multi-decade time horizon for cash is riskier than equities (stocks and shares). Any losses sustained are only on paper and not realised (become actual losses) until you sale.
The Art of Simplicity
Some of the best things in life are simple. Introducing complexity comes with it increased costs, time and stress. As a result, people in the FI community tend not to pick individual stocks to invest in. They may own some shares in individual companies, but this usually forms part of their ‘fun money’. This is money they have set aside to speculate and involves a higher risk. Even if they lose all their fun money, it would not make a difference to their financial position. It is money they can afford to lose. I am not saying that anyone who picks individual stocks ends up losing. What I am saying is that for the average person like you and me, we do not have the time, nor the knowledge to choose the right company and buy it at the right price. As a result, we should not risk placing all our hopes and future wealth purely on a stock picking strategy.
So what do you invest in, if not invest in individual company stocks? You invest in funds that track the performance of the world’s stock markets. It is like buying a tiny piece of every major company in the world. This way, unless it is Armageddon and the end of the world as we know it, the likelihood of your investment being worthless is as minimal as you can get it. That is, if you can cope with the volatility and not sell when the price drops. Even if the world was to end, the value of my investments would be the least of my worries. I should point out that it is possible for your investments to become worthless. This happens if you decide to put all your money into one single company (or a small group of companies) which all end up going bankrupt.
Funds which track the performance of the world’s stock market are called index tracker funds or passive funds. That’s because they aim to copy the performance of a particular index or indexes using predominately computer software and algorithms. You can buy them to track all types of indexes, not just world markets, but individual markets as well for instance. Active investments on the other hand use teams of people to actively manage the fund, using research, forecasting models and their own judgement to try and deliver higher than average returns. As a result, active investments are much more expensive compared to passive investments. My preference is, of course, passive investment strategies, not only because it is simple, but because it is cost-effective and provide value.
“There seems to be some perverse human characteristic that likes to make easy things difficult.” – Warren Buffett
Spread Your Money
When investing in the stock market through an index tracker fund which tracks the world markets, then you are engaging in diversification. It means you are reducing your risk by not putting all your eggs in one basket. In other words, the impact of one company going bankrupt or a country going through political turmoil won’t affect your financial position too badly. By using an index tracker fund, you can invest in hundreds of other companies and not rely on a handful to deliver. In addition, you are also investing in multiple markets around the world so that if one country is not doing well, it does not have a dramatic effect on your overall portfolio.
You could apply this same principle by investing in other things on top of the stock market, such as property, bonds or building your own business. This way, your wealth is not entirely reliant on one particular asset class. Now that I have mentioned bonds, it may benefit to briefly explain what they are. Bonds are like an IOU, a debt obligation. The return on bonds is generally much lower than stocks and shares because there is less risk. You can buy bonds issued by companies or by governments. The more stable and trustworthy a company or government, the safer your bond will be. The safer your bond, the lower the return. Remember the risk and reward trade-off I mentioned earlier. As people approach retirement, you would normally see them allocating a greater proportion of their wealth towards bonds. That is because the returns are much less volatile. They need the stability of not waking up the next day with 50% of their investments wiped out and having to return to work because they no longer have enough money. They do not have the luxury of time to wait for recovery phase of the cycle.
There are very successful investors out there who do not invest in index funds but spend their life and career picking stocks. For me, the average return I get from a passive index tracker fund is more than enough. The risk disproportionately increases when you start picking individual stocks if you do not know what you’re doing. Not everyone can be a Warren Buffet. Many have tried and failed, leaving themselves and their family in financial ruin.
I’ve mentioned this before. Compound interest can work for or against you. No matter what you decide to invest in, keeping the initial and ongoing costs to the minimum will ensure that you do not erode any future compound returns. By now you would understand that even half a percent of ongoing fees makes a huge difference once compounded over time. Even the opportunity cost of just a £100 one-off payment can be a lot. This is because that £100 could be invested and generate a return over time. I am not advocating doing everything on the cheap and disregarding everything else. That can actually be a false economy. What I am saying is to understand the real cost of your investment over time and decide on two things: 1) is the expected return sufficient to justify the cost; and 2) is there an alternative which would give me the same return but at a lower cost.
I use funds by Vanguard where I pay them fees of around 0.2% of my investment value. If you are in a company pension scheme where the benefits are not defined, then I would suggest you look into how your pension is invested. Are you paying high fees to active fund managers who try to beat the market? This is despite increasing evidence that over time, fund managers can do no better (or even worse) than significantly more cost-effective passive index funds. You are merely paying the high fees to fund their expensive golf memberships, private jets and country mansions.
Learn to invest by yourself if you want to do it cost-effectively. The first step is to decide what type of tax wrapper you want to use. A tax wrapper is what you use to shield your investments in order to minimise the tax you pay. The main options are a SIPP, ISA and LISA (you can read more about these in FI Building Block: Budget). The next step is to determine what funds you are interested in. This is because not all brokers will offer all funds. Once this is done, you then decide which platforms offer these funds. Platforms are basically online broker services which allow you to buy or sell shares and funds. There may be an annual management and/or dealing charges associated with using the platform. On top of that, there is the fee to own a particular fund, payable to the investment company. All these costs need to be considered and you need to shop around to find a fund and platform combination which suits you. Sometimes the platform charge may be higher because they offer a better service and an easier to use interface. If this is something you care about, then paying more might be worth it. Finally, remember that passive index tracker funds are the way to go. Don’t take my word for it though. One of the most respected and successful investors of our time is also an advocate of passive index investing:
“The trick is not to pick the right company, the trick is to essentially buy all the big companies and to do it consistently and to do it in a very, very low cost way” – Warren Buffett
PS. He is also a fan of Vanguard funds.
Review Your Investments
You need to review your investments at least once a year to see how they are performing. This is important for two things: 1) costs changes; 2) market changes. The first is self-explanatory. The platform you’re using may have increased their fees or the funds you are buying into are charging more. This could mean that it is beneficial to move your investments. Just make sure you incorporate any exit and set-up costs when working out if it financially makes sense.
The second element relates to rebalancing your portfolio of investments. The process of rebalancing involves buying or selling assets to get back to your preferred level of asset allocation. This is important to ensure that the overall desired risk of your portfolio has not changed. For example, imagine you had a 40/40/20 asset allocation, 40% stocks, 40% property and 20% bonds at the start of the year. By the end of the year, the value of stocks have increased and the value of properties have also increased. This will mean that the percentage value of the bonds proportion would fall because of the gains made in the stocks and properties you have invested in. Your new asset allocation could end being something like 45/45/10. As a result, your overall portfolio would be riskier than it was a year ago. You would need to either buy more bonds or sell some stocks or properties to bring your portfolio back to the original 40/40/20 allocation.
Timing the Market (Just Don’t)
Don’t try to time the market. This is when someone makes a decision to buy or sell based on trying to predict the future market price of an asset (such as stocks or property). In doing so, what that person is effectively saying is that they know something most people do not.
Now, lets say you have received an inheritance or have a large lump sum to invest. What do you do?
- Keep hold of it as cash and wait for a crash to buy?
- Invest a smaller fix amount on a monthly basis (also called Dollar / Pound Cost Average)?
- Do you invest the whole lump sum?
Option 1 – as Cashflow Cop believes that most investors are not experts, and even experts cannot predict the future (heck, they struggle to predict the weather a few hours in the future at times!), this is not a strategy I would recommend. Even Warren Buffet struggles to time the market. If you invest for the long term, even investing at the peak (no one really knows when that is) will still give you healthy returns. Time in the market is better than timing the market (I read that quote somewhere, but cannot find who first coined it).
Option 2 – this strategy is called Pound Cost Averaging. There are benefits and drawbacks to it. You can read more about it with a quick Google search (also search the term Dollar Cost Averaging). Investing a large sum of money all in one go requires you to overcome a psychological barrier: the fear that the price will drop soon and you could have bought it for cheaper. Pound Cost Averaging is when you split the lump sum up into say 6 or 12 equal amounts and invest on a monthly basis. The idea is that should the markets fall over the next few months, you have only invested a portion of your lump sum instead of all of it. However, it is important to note that your asset allocation is affected until all your lump sum is invested. That’s because you still hold a portion of that lump sum in cash (a safe asset but provides a poor return) whilst you drip feed the money into the market. As a result, your overall portfolio could be less risky and provide a poorer return until you’ve fully invested.
Option 3 – whilst Option 2 has its main benefit of overcoming a psychological barrier which could prevent you from investing in the first place, it is not the mathematically optimum strategy. That is because studies have shown that on a month by month basis, the market is more likely to go up than go down. As a result, the best financial decision here is to invest in a lump sum. Only hindsight will tell you if it was the wrong decision.
At the moment, I am an Option 2 type of person. Perhaps with time and more confidence, I would be more comfortable with Option 3. You need to decide for yourself which would suit you best.
- Know the two FI Life Stages.
- Developing a passive income stream.
- Understanding your risk tolerance and capacity.
- Keep things simple.
- Spread your money.
- Minimise costs.
- Investment reviews.
- Don’t time the market.
You’ve reached the end of the Building Blocks to FI. There are entire books dedicated to each and every single idea or technique I have briefly touched upon. The blocks are designed as an introduction to something I find very interesting because it has the potential to radically change how my family can live. Has the Building Blocks to FI help to explain how you too can achieve financial independence? If you have any feedback to help improve it so that others can get value from it, please let me know.
A final word from Warren:
“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.” – Warren Buffett
- Investing for Beginners by Monevator
- Why a Total World Equity Index Tracker is the Only Index Fund You Need by Lars Kroijer
- Valuations Matter – the dirty counterfactual to steady index investing by Simple Living Simerset
- You Don’t Have to Keep Up with the Joneses When it Comes to Investing by Financial Panther
- Smash the System by Sex Health Money Death
- What If You Know Nothing About Investing? by The Escape Artist
- How to Make Money in the Stock Market by Mr Money Mustache
- Lump Sum Investing Versus Drip-Feeding by Monevator
- Stock Series by jlcollinsnh