How To Start Investing Young

How to Start Investing Young

Disclaimer

One of the biggest indicators of your income bracket is, quite simply, your age. Up until retirement age your income is likely to increase. Income is also usually seen as the best way to increase your wealth. So the older you are, the more income you are likely to earn, the easier it will be to build your wealth. Correct? Not necessarily.

Let’s imagine you are 25 years old and you are earning a pretty average £25,000 per year. The number doesn’t really matter. If you save and invest £1000, what could this really be worth to you by the age you are 45? Here are some scenarios.

 
How to Start Investing Young
 

Imagine you want to invest in a fund which tracks the performance of the market. You can do this by investing in an index fund which basically owns all of the companies on a certain index in the correct proportion. A FTSE all-share index fund, for example, owns the shares included in the FTSE all-share index in the correct proportion.

If company A makes up 1.5% of the index, 1.5% of your fund portfolio should be made up of company A. Let’s say the market experiences pretty low returns over the next 20 years. At a rate of return of 2% per year, your £1000 would now be worth around £1485. At a more average rate of return, say 5%, the investment would be worth £2653. And at 8%, it would be worth £4660. 

Now let’s say you waited just one year and invested that same £1000 at 26 years old. What would that be worth at 45 and how would that one year delay affect your return. A 2% annual growth rate would turn that investment into £1456, 5% growth would equal £2526 and 8% growth would equal £4315. 

The difference between investing £1000 at 25 vs 26 could be worth anything between £30 and £350 based on different average annual growth rates. This is the beauty of compound interest. In the graph below, I have illustrated what a £1000 investment could be worth over 30 years based on different growth rates.

Investment Performance Differences

How to boost your returns

Dividend reinvestment

When you receive income from an investment, this is known as a dividend. You have the option of either taking it as income or reinvesting it. Here is where you run into the terms 'Price Return' and 'Total Return'. 'Price Return' refers to the return on an investment where dividends are ignored. In other words, the increase in the share price alone, the capital gain. 'Total Return' refers to the return you receive when dividends are reinvested over time. 

The graph below shows the 'Price' and 'Total Return' of the S&P 500 Index from June 1988 to August 2017. The S&P 500 index tracks the top 500 companies listed on the New York Stock Exchange (NYSE) by market cap, the market value of a company's equity. This is a good illustration of how dividend reinvestment can dramatically increase the value of your portfolio over time. 

S&P 500 TR vs Price

Low cost Passive investing

A passive investor is one that invests and forgets. If you don't have time or you are simply not interested in researching individual stocks (or you don't want to pay a financial advisor to do so for you) look into passive investment. The pinnacle of passive investment is the index fund. You decide which index/indices you want to track (eg. FTSE all-share, S&P 500) and you invest. This is not the same as a mutual fund. A mutual fund is run by a fund manager who picks stocks for you.

The ongoing costs associated with mutual funds (usually 1-2% per year) are substantially greater than index funds because it takes time/money/employees etc. to research/buy/sell stocks. In contrast, some index funds charge as little as 0.06% per year. Also, if you see articles on index funds and index ETFs, just be aware they are not exactly the same. I compared the two here.   

Tax Advantaged Accounts

An important aspect of investing long term is tax efficiency. You do not want to be paying tax unnecessarily on your investments. Luckily, there are a number of ways you can reduce your tax liability when it comes to investing. Some of the terms can be confusing so here are the answers to a few commonly asked questions. 

What is a Stocks and Shares ISA?

A stocks and shares ISA is effectively a tax-efficient wrapper around your investments. Your investments inside that wrapper can be altered as necessary. Every tax year (April to April), you have an ISA allowance. Currently, the 2018/19 ISA allowance is £20,000 and you are only allowed to open or contribute to one stocks and shares ISA per tax year. You can contribute any amount up to the allowance limit. 

Advantages:

No Capital Gains Tax (CGT) or income tax on income/dividends from your investments held in the ISA wrapper

Easy tax efficiency. You can contribute anything up to your annual allowance and don't have to worry about the tax implications if it grows to a substantial amount.

Disadvantages:

Anything contributed will be after-tax income. So you don't get any tax relief on the way in, just on the way out

Liable for inheritance tax 

Best Pick

Since my focus has been on low cost passive investing, I would recommend the Vanguard Stocks and Shares ISA. My article on the easiest form of passive income goes into more detail on why I chose this platform. 

What is a sipp? 

The Self-Invested Personal Pension (SIPP) is another tax efficient wrapper that grants you some tax relief on the way in (when you deposit), and some on the way out (income/withdrawal). Like an ISA you have control over your investments in a SIPP. You can qualify for up to 45% tax relief on the money you contribute and the annual limit for this tax relief is currently £40,000. You can access your pension pot from age 55 and there are a number of options you have when it comes to receiving income. 

Advantages:

Tax relief on the way in means your contributions are boosted. This means you have more money to invest which could potentially lead to greater returns than an ISA.

You can take up to 25% as a tax free lump sum after age 55. You then choose how your want to take your income on the other 75% (eg. cash, an annuity, flexi-access drawdown). 

Inheritance tax planning. Your contributions can increase your tax efficiency by reducing the value of your estate that you pass on to beneficiaries after death. 

Disadvantages:

You cannot usually access your pension pot until you turn 55.

You pay tax on most of the income from your pension. 

The lifetime allowance. If your pension pot is worth more than £1.03 million (18/19), you are subject to further tax on the savings above this limit. This depends on how you are paid. The rate is 55% if you take a lump sum payment and 25% if you take it a different way (eg. pension payment).

What is a Lifetime ISA?

A lifetime ISA (LISA) is specifically designed to help you save/invest for your first home or for when you turn 60. Since this article is related to long term investing, I will be focusing on the retirement advantages. You can contribute up to £4000 each tax year (April to April) from ages 18 to 50. The LISA must be opened before age 40. The government will add a 25% bonus on top of your annual contributions (therefore up to £1000 each tax year). This £4000 counts towards your annual ISA limit (£20,000 in 18/19). You can withdraw income/investments from your LISA when you turn 60.

Advantages:

Annual 25% bonus can boost your returns over the long term.

No income tax or Capital Gains Tax (CGT) to pay 

Disadvantages:

Liable for inheritance tax (unlike SIPPs)

Cannot access until age 60. 

Start Young

There are advantages and disadvantages to using all of the methods outlined above. You can decide on one or take advantage of the options you have and use all of them. You don't have to put all of your eggs in one basket when it comes to long term investing. 

The older you are, the more likely you are to be earning more money. But the younger you are, the more time you have for your money to grow. So if you’re earning less now than you expect to be earning in 5 years, remember this. A little bit now can be worth more than a little bit more in 5 years. I am all for greater transparency in the world of personal finance. Therefore, I have an article dedicated to the breakdown of my own investments here.

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