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What is saving and investment? If you wish, you can take advantage of the time factor and take some investment risk in the hope of enhancing your investment returns. If you choose to save instead of spend you give yourself flexibility and choice in the future. It can also provide a financial cushion for when things go wrong. How much should I save or invest?
Step 1. Spend less than you earn - Are going into debt or running out of money at the end of each month? If so then you are probably spending more than you are earning. It is just SO important to sort out a budget or 'spending plan' and ensure you have more coming in than you have going out. Once you have done that; 2. Pay off short-term or expensive debt - If you have outstanding balances on credit or store cards, HP on furniture or cars, an overdraft or personal loan, then use this money to pay them off first . This way you guarantee yourself a tax-free investment return of at least the amount of interest you are paying on these loans. (Debt is a major issue for many of us - Look out for future articles about this on fairfunds.co.uk). Once you have either paid them off or have a repayment programme in place; 3. Keep cash on which to live- It may not earn much interest but having funds in your bank account provides liquidity – you can pay bills or survive a lean month when your income falls or freezes. Whatever you normally spend in a month, we think that you should have at least that amount in an interest-bearing, current account at all times. When that is sorted; 4. “Warm cosy” (emergency) funds - Put money for emergencies in a separate interest-bearing account or Mini Cash ISA. How much is up to you but will depend on how much gives you a warm cosy feeling or peace of mind. We suggest around 3 months' spending, more if you are of nervous disposition. You will hopefully never have to use this – it’s for emergencies remember – just choose a high interest deposit account to park the money. When that is in place; 5. Think about next year - What’s going to cost you more money than you can afford from your normal spending? You don’t need to worry about a “rainy day” – you covered that in the previous step with the warm cosy funds. Maybe you would like a special holiday or to change the car, or to do some home improvements or put down a deposit to buy a house. Make a list. Put an amount beside each one and add them up. If you are a low risk person this should go into the same deposit account as the warm cosy funds. If you can take a higher risk then you can save into an Equity ISA, unit trust or OEIC. (More...) Having done that; 6. Think about the long term - If you have funds left over you can think about saving and investing for the longer term. When do you want to have financial independence (not needing income from a job or other people)? Would you like to pay off a mortgage, build up a fund for education costs, prepare to set up in business, or plan to give substantially to a charity? Again, the choice of investment vehicle depends upon the level of risk you wish to take. (More...) If you have planned for all of those things you can then; 7. Speculate - If you still have funds left over then you can invest more speculatively. Presumably if you lost the money with which you speculate then it wouldn’t matter because by going though steps 1 – 6 you have covered everything that does matter! Alternatively, you can give it away. In fact it may be very good tax planning to give it away but you should probably take professional advice first.
You may well be doing some of this already (if you have a pension scheme, an endowment or a repayment mortgage for example). However, the steps above should enable you to spot any gaps you may have missed.
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There are many kinds of investment risk – volatility risk, liquidity risk, income risk, capital risk, to name but a few – and there is no such thing as an investment which will give you high tax-free income, high tax-free capital growth, total accessibility at any time, all with no risk of loss. Above average investment potential almost always requires the acceptance of above average risk, but acceptance of above average risk certainly does not guarantee high returns. It may just lead you to above average losses! Broadly, you might be happy to accept different levels of risk for short term savings (e.g. your "warm cosy funds") where security of your savings is paramount and longer-term investments (e.g. for retirement) where you may be happy to accept some fluctuations in the capital value in the hope of achieving a better return. Different investment asset classes (cash, property, shares etc) have different risk characteristics. fairfunds advocates blending different asset classes in order to reduce the risk of a poorly performing asset class adversely affecting the performance of your investments. See our page on asset allocation. Also, watch out for future fairfunds articles on the subject of risk. |
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What can I expect to get back? Just as different investment asset classes have different risk characteristics, so they also have different return characteristics. We think that a sensible expectation for the real (above inflation) returns of different asset classes would be in the region of:
Thus, if inflation was approximately 3% per annum, you could expect to get total returns of:
It is often appropriate to blend different asset classes to maximise returns within your given tolerance for risk. Once again, see our page on asset allocation. |
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