The Power of Saving & Investing

Many believe that the function of investing is to “get rich quickly’”, or to invest one time with the aim of obtaining an enormous pay-off. However, this couldn’t be further from the truth. For most professional investors, the true essence of investing is the accumulation of profits over time, benefiting from the impact of compound interest.

The Impact of Compound Interest

Lump Sum:

Let’s say a 35-year old has saved or been gifted £20,000. If they were to keep it in a bank account for 30 years, earning zero interest they would still have £20,000.

However, if they were to earn an annual 10% return from investments in this period, they would have:

£20,000 x 1.1³⁰ = £348,988

This is a truly extraordinary difference. But it’s important to remember, this is over a long period of time.

Consistent Saving:

The impact of compound interest can be illustrated in a different way.

Let’s say a 35-year old professional decides to save £1,000 per month for 30 years (360 months). If they put these savings into a zero interest bank account they would eventually have:

£1,000 x 360 = £360,000

However, if the individual saved £1,000 per month (£12,000 per year) and invested it with a 10% annual return, they would eventually have:

£12,000 { ((1+ 0.1)³⁰ – 1) / 0.1) } = £1,973,928

In this example, if an individual saved as little as £12,000 a year for 30 years and invested it, receiving an annual return of 10% per year, they would have just under £2 million, as opposed to only £360,000 if they had not. This illustrates the true essence of investing: not to get rich quickly, but to accumulate wealth and financial security over time.

Managing Retirement Income:

Another function of investing is to eventually generate an income from the accumulated wealth. Once an individual has amassed significant wealth, they may choose to adjust their investment portfolio to provide a consistent income. Building upon the previous example, an individual with £2 million may opt to invest in low-risk UK government bonds. As of the time of writing, UK 10-year government bonds offer an annual yield of just over 4%.

£2,000,000 x 4% = £80,000

This individual would be able to earn an annual income of £80,000 for the duration of the bond.

Mastering Your Cash Flow

How to Save:

After demonstrating the impact of compound interest, particularly in terms of consistent saving, it is now worth analysing how one can effectively enable themselves to save consistently.

Being a “master of cash flow” is a crucial aspect of household finance, yet it is also one of the most challenging. It entails a two-pronged concept: understanding the cost of sustaining your lifestyle and determining the amount you can consistently save and invest. Balancing these two aspects is arguably the most challenging part of personal finance.

Investing can become much more complicated and less effective if you continually need to liquidate investments for additional cash. Without discipline regarding cash flow, unforeseen life events may arise that necessitate dipping into investments you had intended to leave untouched for years. Unforeseen events are inevitable, so it may be prudent to allocate a portion of income for future emergencies as well as for investing.

In our consumerist society, many people believe that their “success” is measured by wealth, material possessions, and social status. Consequently, this leads people to exhaust a significant portion of their household income in order to display their “success” to friends, family, neighbours, and rivals. This often manifests as overspending, such as financing an expensive car, purchasing branded clothing, living in the most costly home possible, indulging in luxury holidays for social media, and engaging in heavy spending at restaurants and bars. However, this spending comes at a significant cost: financial freedom and stability. An investment portfolio is not overtly visible; as a result, it may not serve as a useful tool for individuals seeking to showcase their perceived success. Consequently, this discourages some people from building an investment portfolio.

The objective is to determine the costs required to sustain a lifestyle that fulfils your needs for happiness, adventure, and social satisfaction, while also identifying areas of overspending. Some individuals spend excessive amounts of money on consumption without considering alternative forms of entertainment, such as hobbies or engaging work projects.

Those who feel they are spending large sums of money solely for entertainment purposes may benefit from reflecting on potential alternatives to incorporate into their lives.

Once an individual has calculated the cost of maintaining their lifestyle, it can be helpful to automate deposits for investments and emergency funds, ideally scheduled for the day after regular payments, such as salary. For some individuals, if they do not see the extra money, they do not miss it.