Over the course of this quarter we aim to help you understand why you might want to invest, where returns come from and the dangers you need to be looking out for. Part 1 covers the difference between saving and investing, and some ground rules to help guide you through the maze of money management.
Investing for investing’s sake doesn’t make an awful lot of sense to us here at Manse Capital. Money is, after all, a means to an end and without a purpose for that investing we really can’t begin to plot a course. In the simplest terms, this might be a longer term focus on retirement, a shorter term accumulation of funds to help your children/grandchildren through education or a particular item on your bucket list. The potential objectives are endless and every one of our clients has a different set of objectives. However, two of the significant factors in all these objectives play a massive part in how we construct a financial plan and an investment plan that supports it. Time and quantum (how much) help us use capital markets to achieve the returns needed to hit these goals.
Broadly speaking, and dependent upon a number of factors including your overall wealth and tolerance of risk, the time factor can be divided into two broad strands; 0-5 years and 5 years plus. Let’s call the first period ‘short term’ and try to understand the implications of what may or may not happen in this period. Short term money should almost always be invested in deposits that don’t carry any capital risk (the value of your initial investment actually falling), meaning that you have a pot from which you can draw short term expenses that wouldn’t normally be affordable out of income. These deposits may be used to supplement short term income in retirement or to plan a special holiday in 3 years’ time, where you sacrifice potential growth for security of knowing the cash is ‘there’ if you need it, without having to borrow from your longer term savings. As each investor circumstance is different, this ’5 year’ period can vary and be as low as 3 years. However, the important thing is that there isn’t any capital risk, the funds are accessible and you are not at the mercy of the short term volatility that is a given in ‘the markets’.
The BIG problem with these deposit based funds is that real returns (the return in excess of inflation) are hard to come by and the value of these funds will, in reality, lose against even a low inflationary backdrop (call this inflation risk). Over time this loss of wealth grows as a problem and means that in order to look towards generating expected returns in excess of inflation, you do need an alternative and this is where using ‘the markets’ comes in. More of what these are later in Part 2.
For the longer term (5 years plus, although again this will vary from case to case) and in order to avoid this inflation risk, investors need to accept a degree of risk in return for what, over time, will be a level of expected returns in excess of inflation. All Manse clients will at some stage have heard the expression ‘risk and return are related’ and time allows us a degree of certainty, in terms of levels of returns, that we cannot predict in the short term.
So in summary, your short term monies sit in deposit accounts and your longer term money is invested in ‘the market’. Short term security with a loss of value against inflation in the short term and longer term variations in returns but with greater certainty that the value of money will actually grow in relation to the cost of living.
Finally, on the subject of time, as you know it never stands still and as time moves on, our plans and objectives and circumstances continually evolve. The importance therefore of frequently reviewing your plan in light of these changes, cannot be underestimated. The one guarantee is that your day one financial plan will never remain ‘constant’.
One of the principle jobs of a financial planner is to help our clients quantify ‘how much’ and this may be something simple such as “I would like to help my children with a house deposit of £25,000 in 5 years’ time’” or a more complex question such as “if I wanted to retire in 18 years on an income of £50,000 per year and with £150,000 in the bank what would I need to sell my business for and how do I achieve this?’.“ The financial planning aspect of our role in helping our clients is the starting point in understanding the what/where/when/how much questions and then building in inflation and returns assumptions into a plan, which is then monitored on an ongoing basis. No two individuals are alike in terms of the ‘how much’ or the ‘when’ and this is where cashflow forecasting comes in. Understanding the inflows and outflows of capital and income in the short term and long term, and then building a plan that says ‘at an inflation rate of X and with an expected return of Y’ are where we add value. The answers that can then be provided could include a myriad of responses, along the lines of (numbers and dates are examples only):
- You will need a capital sum of £500,000 at age 60 in order to achieve your goals.
- You will need an annualised rate of growth of 6% pa on your invested funds in order to achieve your goals.
- You need to spend £15,000 less on an annual basis.
- You will need to sell your business for £1,000,000 in 2028.
- You will need to downsize by 25% at age 60.
Again the list is endless, but by understanding your goals we engineer a plan that uses both short term and long term saving and investing, to help you hit the ‘numbers’ you need in order to live the life you want.
In part 2 we look at how markets work based on decades of academic evidence, not the views of forecasters and speculators, and how a diversified portfolio can help add certainty to these expected returns and more on how risk and return are related.
Part 3 will conclude this series by explaining where returns come from, the importance of ‘cost’ in investing and the principle differences between the ‘evidence based’ approach to investing and the investment community who try (and usually fail) to beat ‘the market’.
Financial Planner & Director