Where’s the snowball – why you’d better save if you want to FIRE

You don’t have to travel far into most personal finance sites before you find the obligatory compound interest post.  Even I did one back in 2012 where I was so bold as to call it The Miracle of Compound Interest.

In brief Compound Interest, sometimes also called the snowball effect, is at its most basic just interest on interest.  A trivial example.  Let’s say you have £1 and can get an investment return of 10% per annum (those were the days).  Choose that option and after a year you’d have £1.10 which is your £1 plus ‘interest’ of £0.10.  If you reinvest that for another year you’d have £1.21 which is your £1, last years interest of £0.10, this years interest of £0.10 on your £1 but also £0.01 which is interest on your £0.10 interest from last year.  Interest on interest...

So that’s the lovely theory but as someone who is now Financially Independent and so has been there, done that, got the t-shirt, what’s my view on it.  I’d now say care is needed.  Let me demonstrate with three simple examples.  Let’s go back in time to the end of 2007 where I’m going to give each of our punters seed capital of £50,000, I’m going to assume a real (after inflation) return of 4.1% (what I’ve achieved on my portfolio of trackers after expenses) and I’m going to assume their each looking for wealth of £800,000 (which is not far off what I thought I needed back then although inflation since has ensured I now need 2 commas) before packing in the day job.  From here their journeys will vary:

• TheRIT will crack on with working hard, focus on quality of life and so annually squirrel away £58,728 per annum (which is the average annual savings I’ve achieved since I’ve been on my FIRE journey, equating to a post tax Savings Rate of 82.4%) earning a real return of 4.1% per annum (my actual real annualised return thus far).  I know that will include inflation adjusted savings but please give me a little slack here as it’s not important to the point I’m trying to make today so won’t bother with inflation adjusting.
• MrAverage will also crack on with working hard but instead focuses on standard of living.  This means he can only save 5.1% of post tax earnings which has been deliberately chosen as it’s the current UK household saving ratio according to the ONS.  Like TheRIT, MrAverage achieves a real return of 4.1%.
• MissInvestingSuperstar follows in the footsteps of MrAverage but boy does she know her stuff when it comes to picking winners.  So much so that every year that she invests she manages double the return of the others and so achieves a real 8.2% per annum.  Ask yourself how many people actually achieve that and would you be prepared to back yourself to achieve that with severe disappointment many years hence if you don’t?

Click to enlarge, My after tax Savings Rate over the long term has been 82.4% 

Every little 0.01% helps

Today’s post title will possibly make High Yield Portfolio (HYP) advocates think I'm about to talk about Tesco’s (Ticker: TSCO) Friday action which included a 75% cut in the half-year dividend to 1.16p and a share price fall of 6.6%.  I'm not though because my own HYP contains alternate Sainsbury’s so I'm not (yet) affected plus there is already plenty of good blog coverage on the topic.

Instead I want to cover an important announcement that could with time save passive index investors a lot of money but which for some reason gained no MSM press inches that I'm aware of.  I don’t know why but the cynic in me thinks it could possibly be because the company that made the announcement doesn't advertise heavily and that is what much of the news is today – thinly veiled advertisements.  It was however picked up by the very astute non vested interest Monevator team.  Some Vanguard UK and Irish Domiciled Index Mutual Fund’s, ETF’s and LifeStrategy Fund’s have had their investment charges lowered.

Personally this affects me in the following ways:

• I hold a lot of the Vanguard FTSE UK Equity Index Fund in my Youinvest SIPP.  Ongoing Charges on that fund from Monday reduce from 0.15% to 0.08%.
• I hold the Vanguard S&P 500 UCITS ETF in my TD Direct NISA.  Ongoing Charges on that ETF will reduce from 0.09% to 0.07%.
• I also hold the Vanguard FTSE Developed Europe UCITS ETF in my TD Direct NISA.  Ongoing Charges on that ETF will reduce from 0.15% to 0.12%.

The Buck Stops Here

Some might think this post a little cynical however I've found that it sometimes pays to be a little cynical so here goes.  Businesses and their marketing machines have few goals on their mind.  One of those is to remove as many pounds and pence from your pocket as legally possible.  Ideally they then get to do this more than once.  They then try and get you not to notice how many notes and coins you’re counting out by bringing other businesses into the game that can help you to pay the original business in one electronic form or another.  They certainly don’t assess whether the purchase will benefit you or your family’s life.  It’s nothing personal.  It’s simply maximising the revenue.

Once those businesses have completely emptied your pocket worry not.  That’s because another business will come along who will provide you with a product of one type or another that will allow those previous businesses to remove pounds and pence that aren't even yet in your pocket.  They also don’t assess whether the purchase will benefit you or your family’s life and are again simply looking to maximise the revenue.  It’s nothing personal.  It’s simply maximising the revenue.

You might even work for one of those businesses.  Again, they are not interested in whether the salary paid brings benefit to your family’s life or if you need additional State support simply to exist.  They are simply trying to pay you and all your colleagues the least amount possible that will prevent empty desks either in the form of people leaving and/or new people not joining.  If this should occur then some other business will maximise the revenue at their cost.  It’s nothing personal.  It’s simply maximising the revenue and profit.

It’s Just a Cup of Coffee – More on Compound Interest

To enable me to regularly save around 60% of my earnings I follow three philosophies within my life. 

Firstly live well within my means.  A simple example that has a big impact is the decision to currently rent for a number of reasons including this and this.  Given that my rental is not my forever home I make some compromises and live in a property that is significantly more modest than what I can afford.  This decision then compounds as by choosing to live in a smaller property heating, lighting and Council Tax bills are also a fraction of what they would be were I to have that larger property.  This adds up to significant savings which are then invested.

Secondly I have opted out of consumerism, do not value image and am not swayed by advertising.  In fact I find that I no longer even notice advertising.  Instead I buy only what I need and when buying I spend the minimum that will give me the quality I desire.  This means I have not purchased an Apple iPad as my old laptop is more than sufficient and still working well even though the battery no longer holds charge.  It also means I do not have an expensive iPhone on an expensive monthly contract as I have decided that I don’t need instant internet gratification at any time of the day or night.  Instead I choose to access the internet as much as I like for a lot less than £10 per month whenever I am at home.  It also means that when I go shopping I buy the cheapest grocery items that will meet my quality needs.  If I want to cook myself a Full English Breakfast on a Sunday morning I’m not too proud to use Tesco Everyday Value Baked Beans at £0.26 for a 420g can versus the nicely marketed Heinz Baked Beans at £0.70 for a slightly smaller 415g can.  All of that frees up yet more cash.

The Miracle of Compound Interest

The saying goes that “money doesn’t buy happiness”.  I firmly agree with this however I think the saying is also a little misleading and should be extended to say “money doesn’t buy you happiness but without a certain amount it’s going to be very difficult to be happy”.  Thankfully, I am not in the situation where I am heavily indebted or worse am heavily indebted and require the booming pay day loan industry to get by.  I can only imagine the pressure and stress that a life like that would put on both an individual and their family.

It is for this reason that I believe a basic level of personal finance should be taught at school.  What good is English, Mathematics, Sciences and the Arts if the earnings potential that those skills bring cannot be harnessed and maximised.  Within the personal finance module it would be compulsory to teach the miracle of Compound Interest.  I can’t help but feel that we would have less indebted people today in the UK if only more people understood how Compound Interest worked.  The sad thing also is that at its most basic form Compound Interest is such a simple concept.  It is nothing more than if you have an initial balance of money which has interest added to that balance, then provided you don’t withdraw that interest, from that moment on that added interest also earns interest.  It is nothing more and nothing less than that.