Money Works For You
If you earn £100, what does that really mean? You now have the ability to buy something worth £100. True. But that’s not how I have perceived money for some time. When I was younger, I thought money was only worth it’s face value. So a £10 note could be traded for an item worth £10 or less. I was partly correct. But that’s not exactly how money works in the real world.
Money doesn’t just sit there doing nothing. This only occurs if it’s cash hidden under a mattress or if it sits in an account earning no interest. In either case, the value of that capital is being eroded by inflation. Most people know this, so they put their savings in a bank account that earns interest.
Making Your Money a Good Employee
How I Think About Money
When I was younger and discovered bank interest, it was a mental game changer. This was effectively income produced by already accrued capital. So it wasn’t that saving would allow me to buy an item or experience, it was that saving meant income, every year, continuously. This completely switched my savings mentality. I would be disappointed if my money wasn’t sitting in the best place to earn interest.
I would keep up to date with new accounts and if something better showed up, I would switch. I would even switch if the rate change was tiny. Why would I want to save in an account earning 1.75% interest when I could earn 1.78% interest somewhere else? I didn’t take the time or effort of switching into account. Mostly because I enjoyed it.
From Saving to Investing
Although this started with bank accounts it inevitably led to investments. I was originally a hesitant investor because I had this mental image of a day trader in my head. I imagined buying low and selling high in one day, potentially earning a lot and potentially losing everything. Watching countless hours of Warren Buffett, Jack Bogle and others on YouTube altered that image.
At the time (and still to this day) interest rates wouldn’t budge from their historic lows. Capital sitting in the bank was not just earning poor interest. It was earning such poor interest that it’s value could barely outpace inflation. In all my hours of research I came to the conclusion that index funds were the best option.
Index Fund Investing
I invested in 4 particular index funds in a stocks and shares ISA with Vanguard. Each fund tracks an index: The FTSE UK All-Share Index, which captures 98% of the UK market; The S&P Total Market Index which tracks the broad US equity market, including large, mid, small and micro-cap companies; The FTSE Global All-Cap Index which represents over 8000 stocks covering developed and developing markets; and the MSCI Emerging Markets Index which tracks large and mid-cap companies across emerging markets. These include China, India and Taiwan.
The Historic Annual Growth Rate
You can see the historic annual growth rate of each index below. Bear in mind past performance is no guarantee of future performance. Also, in this case, bear in mind the index launch date. The inception year of the FTSE UK All-Share index was 1962, so the data goes back over 50 years. The other three indices, S&P Total Market, FTSE Global and MSCI Emerging were launched in 2006, 2002 and 1998 respectively.
These index funds are also weighted differently in my portfolio. The FTSE All-Share fund and S&P Total Market fund make up 35% and 30% respectively. The FTSE Global fund and MSCI Emerging fund make up 30% and 5% respectively. This balance affects the total return of my investments. For example, the US market might perform well one year, increasing the value of the S&P Total Market fund which tracks the US market. In the same year, the UK market might increase in value but underperform. As both make up a similar proportion of my overall investment portfolio (35% and 30%), the overall growth rate would be somewhere between the two.
Every Pound Means Potential Income
If these funds were to continue growing at their previous rates, on average, my portfolio would grow by 8.84% per year. I worked this out by multiplying the growth rate of each index (eg. 7.87%) by the relative weight of that index in my portfolio (eg. 30%). If you add all of these percentages together, you get the average historic growth rate of the entire portfolio.
8.84% growth effectively means that an initial investment of £100 would produce £8.84 in income, every year, for life. This £8.84 includes growth (capital gains) and dividends. But it also imagines that you withdraw £8.84 (on average) every year from year one.
What would happen if you didn’t take any income for 10 years? Assuming 8.84% growth, the annual income (growth and dividends) would have grown to around £20.63 per year, on average. This, all from an initial investment of £100. It is this potential income, not the initial investment, that I care about. This mentality changes your whole outlook on money, saving and investing. Every pound is potential income, every year, for life.
What Does a Purchase Really Cost?
The development of this mentality didn’t just change my outlook on saving, it changed my outlook on spending. When a purchase doesn’t produce income and/or doesn’t appreciate in value, what does it really cost? It isn’t just the up front value. It is that plus any potential income which could be generated from that spent capital.
Below, I have taken the average cost of certain goods and services and then I have worked out how much income you would lose from making the purchase:
- Phone = £600 or £53/year in lost income
- TV = £200 or £17/year in lost income
- Theatre Ticket = £40 or £3.53/year in lost income
- Train Ticket = £20 or £1.76/year in lost income
- Film = £8 or £0.70/year in lost income
- Coffee = £2 or £0.17/year in lost income
think before you spend
This is not to say that we shouldn’t purchase goods and services. Money is there to be spent and the true value of something isn’t just limited to it’s price. But framing every purchase in this way can change your mentality, as it changed mine. Every time you pay with cash or plastic, you are costing yourself capital and long term income.
Interestingly, if you are paying interest on debt, you are ultra-aware of the extra cost. You are conscious of it every time a payment is made. If you generate extra money to pay off some of that debt you might see your interest payments drop and you know this has saved you in the long run. Potential growth and income is more obscure but should be perceived in the same way.
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