Thinkpiece

01 Feb Thinkpiece

In this update:

• Lessons from History
• Compound me up

Welcome to this financial planning update. Here we share some views on various topical points relating to financial planning. This month we look at the impact of deferring financial planning decisions and the benefits of compounding returns over time. 

Lessons from History

 
With the speed at which one lives one’s life, it is understandable that if we’re not careful, certain things get put off. This is certainly true of one’s financial arrangements, even where one is clearly shown that taking action sooner rather than later is in one’s best interests.

And yet, a few hours a year invested into one’s financial planning can reap significant benefits.

Take for example somebody who delays contributing to their retirement pot.

You may delay, but time will not.

Benjamin Franklin

The cost of delay can have significant consequences as outlined in the table below. What this illustrates is the resulting values after contributing £100 per month to a tax-free savings pot for the periods shown.

Retirement at age 65, investment return 6% per annum, contribution of £100 per month.

Or, looking at this another way…

These figures and the investment returns shown are purely for illustrative purposes only and are not guaranteed. They do not take into account inflation. Do not proceed without obtaining independent financial advice.

The consequences of delay are clear for all to see. £100 per month is a modest investment contribution by today’s standards, and you can multiply the above numbers to get a sense of the cost of delay.

If one then took an average annual drawdown of 4%, then the difference between the potential levels of income at age 65 is considerable.

Of course, all of this requires the right foundation and a sound financial plan, and in conjunction with your trusted financial planner, needs to be set up correctly from the start.

Well begun is half done.

Aristotle

Of course, there are exceptions, but if you’re the sort of person who has been lured by the trappings of success, you have bought too much house and too much car on debt to present an image of achievement without the underlying financial fundamentals, you may not be able to find the surplus monthly sums needed in order to build up lump sums to provide yourself with a sufficient future income.

Ask yourself what’s important! For those who wish to operate in this way, that is up to them, but for me this is clearly a mistake.

Another key point with the effect of the cost of delay is how much you would need to contribute on the above basis at age 60 to achieve a pot of £275,599 at age 65.

The answer is…….£3,950.11 per month! Now, you might have £3,950.11 per month spare at age 60, but you might not, and you may even be talking about retiring then yourself, not working even harder to find the money to do the thing that you really ought to have done years ago.

I was very lucky to be taken aside at an early age and shown the benefits of saving and thriftiness and this has certainly not put me any further back. So don’t delay….. your future self will thank you for it.

Of course, this brings into question another key component of investment, and that is the compounding of returns.

Compound me up

 
When I was young, I was bought a small pocket calculator on my birthday to help me with my school studies. I can remember clearly my father saying to me to look at the effect of compounding by putting in a small number, say 2, and then pressing x x and then continually pressing the = button until the number grew exponentially.

I was always amazed at just how quickly the number grew, but didn’t at the time perhaps realise it’s significance. By the way, I still have the calculator…..

However, this obviously struck a chord with me and today I know that one ignores compounding in financial terms (compound interest), at one’s peril. This is one of the key tenets of any sound financial plan.

In Victorian times, the wealthy did not consider the interest that they earned on their investments, but the interest they earned on their interest! Wow!! They understood that compounding of returns is so very important in order to preserve one’s original capital and that if one spent all of their interest, they would not then allow that underlying capital to compound further. The Victorian wealthy clearly understood financial independence and the importance of ensuring that they didn’t draw more from their assets than was possible or sustainable.

Compound interest is the 8th wonder of the world.
He who understands it, earns it; he who doesn’t, pays it.

Albert Einstein

 
They were on the right side of the compound interest equation. Consider now the impact on a principal sum of £10,000 over various timeframes at different investment returns.

£10,000 compounded

Or, looking at this another way… 

These figures and the investment returns shown are purely for illustrative purposes only and are not guaranteed. They do not take into account inflation. Do not proceed without obtaining independent financial advice.

What these figures clearly show us is the significant impact that compounding can have if given enough time and enough return. Leaving our money in low earning arrangements is clearly detrimental if we are to build up lump sums for future years, or preserve our wealth in order to support our lifestyle now and in the future.

Now imagine the impact if that amount of money was a debt! Rates of some of the most widely-advertised high cost lenders can run into the hundreds and even thousands in terms of percentage rate charged! These lenders clearly understand compound interest!!

This also demonstrates the importance of having an appropriate emergency fund in place during such times where, if we did not, we would have no choice but to interrupt our investments during their all-essential compounding.

The first rule of compounding is to never interrupt it unnecessarily.

Charlie Munger

If one has a suitable level of cash held in an emergency fund, one can use this resource to address whatever emergency has occurred in one’s financial planning that could not have been anticipated, without disrupting your investment plan from continuing to do its work. This is another essential tenet of any sound financial plan.

Summary

• Understand the importance of contributing to your future.
• Beware the trappings of success.
• Throw plenty of time at your investments.
• Be mindful of compound interest both when investing and when borrowing money.

 
If you don’t have a plan for your money it will leave you.

 
If you’ve not yet put in place a sound financial plan and you’d like to know more, please feel free to contact us on 01626 305318 or via email here.

Best wishes from all at Stover Financial Planners!

The views expressed are not to be taken as financial advice. Professional advice should be sought before proceeding.