Welcome back reader.
Now we’re launching into my favourite topic – Investing! There’s one key reason why investing is close to my heart: it’s the art of getting your money to make money.
The first key thing to understand is that you won’t get rich from your salary alone. No one, outside the highest paid 0.1% in the country (CEOs/footballers/celebrities) are rich from only their annual salary. Fighting for the next promotion to get a raise is important, but arguably more important is taking what you currently have in savings and making it work for you.
Not convinced? Take a look at the below chart (US data, apologies, they’re just better at tracking stats that us, however the point holds in the UK regardless). Taking GDP per capital as a proxy for economic growth (the stock market in aggregate should ultimately equal GDP growth + inflation so this is reasonable), you can see how pathetically the growth in wages has fared vs the growth in GDP. Between 1980-2015, real GDP has grown by almost 80%, real earnings have grown by less than 5% after inflation. No contest.
However, these two sources of wealth are not mutually exclusive, they are complementary. After all, the mission statement of FI is to accrue enough wealth through labour (and the judicious application of such wealth) that the market will provide all the income you need for the rest of your life.
Before we move on, lets unpack that a little, because it’s a more revolutionary idea than it initially seems. For almost all of human history, man has had to work to gain enough food to eat, to create shelter, or to earn enough money for both. What modern financial markets offer, is an escape from this cycle. Rather than you having to work, you can put your money to work! The best thing is that your money doesn’t need holidays, it doesn’t need to sleep, it will work for you 24 hours a day every day. You couldn’t ask for a more reliable employee!
The scale of the gains from this relationship is also often misunderstood. People often think of their savings as a simple addition-based amount. In other words, if I have £1,000 now and save £1,000 every year for the next nine years, I’ll have £10,000. Sure, but this is missing out on what Einstein called a wonder of the world: compound interest! Now imagine that you read this blog (well, not hard to imagine if you’re reading those words, but stick with me!). Instead of just putting the money in a savings account with a tiny interest rate, let’s say you invest it and earn a 5% return a year (a reasonable return to expect from historical standards). How much money do you have at the end of 9 years? £12,577.89! You’ve made 25% more although you’ve saved the same amount! The first £1,000 you saved has been busy working hard for you for the full nine years, the second £1,000 for eight years and so on.
But we’re not done, this is where the magic comes in, the first £1,000 doesn’t just increase, the increased amounts also contribute to your total cash pile. After one year, your £1,000 is worth £1,050 (5% up). This £1,050 then earns 5%, resulting in £1,102.5. The £1,102.5 then earns 5%, netting you £1,158. Over time, this seriously adds up. If you kept saving £1,000 per month for another 11 years (20 years total), you would have £21,000 in a savings account. Or, if you invested it, you would have £35,719.25! This is a massive difference. If these amounts aren’t wowing you, how about we assume initial savings of £20K and the same £1K per month saving habit?
If you just put it in a cash savings account which earned 0% after inflation (which isn’t even possible right now, almost all savings accounts available at the moment earn a negative return), then you would have £40,000 after 20 years. If you invested it, you would have £86,131.91! More that twice what you would have otherwise earned!
You can keep making the numbers bigger, but the key thing to remember here is its all about time. The longer you can keep money in the market the more you make. This is why its key to start saving early. I made the mistake of pretty much spending everything I earned through my 20s. Sure, some of it was spent on awesome things (travels, dinners with friends, amazing experiences) but an awful lot was spent on complete bullshit (expensive foods or drink I didn’t appreciate, pointless conveniences, expensive clothes I didn’t need or wear). If I had saved that, I would be worth much more now and be yet another step closer to FI.
It comes back down to a choice. £50 saved doesn’t feel like it will take you much closer to FI. But if you’re looking to reach freedom at 45, £50 will become £104 if saved at 30, £133 if saved at 25 and £169.32 if saved at 20. You stack those savings up and you’re getting to big numbers very quickly.
The other way that I like to think about it is this. Lets assume you have a very decent job earning £25 an hour. If you save £50 at 20, you’re saving yourself 2 hours of work now, but almost 7 hours of work at 45. That’s a fully working day for many people. I’m not saying you need to live like a monk, you should enjoy life while you can. I just want you to ask yourself the question: what would you rather have, £50 to spend now, or one day less of work in your life?