By Charles Carpenter, an investment adviser at Ravenscroft
WHEN it comes to your financial future, planning is one of the most important things you can do and is a crucial part of controlling your finances.
In this case, if you fail to plan, you may well be planning to fail. But why should you worry about creating a financial plan and how many of us have a plan in place?
Whether you are working towards a financial goal or looking to build a nest egg for your future, consistency is key, and time is certainly your ally. Investing periodically will allow you to take advantage of pound-cost averaging, which smooths the cost of investing over time. This, coupled with a medium- to long-term investment horizon, helps investments to weather any downturns in the market cycle.
While investing does incur more risk than holding cash, not investing also carries its own set of risks. Every year inflation erodes the purchasing power of cash and, with inflation prints hitting double digits last year, this risk needs to be managed. Furthermore, the total return on cash does not normally exceeds the given interest rate.
Starting your investment journey early, and being consistent, allows your earnings to compound. This means that income generated is reinvested alongside any regular contributions, ultimately leading to higher returns. For example, the total return for the FTSE 100 over the past ten years was +103% with dividends reinvested, which is an annualised return of 7%. Had these dividends not been reinvested, the total return for the same period would have been +31%, generating an annualised return of just 3.1%.
This principle applies even on a smaller scale. If you were to make an initial investment of £1,000 and monthly contributions of £100 over a ten-year period, assuming an annualised return of 7%, the total contributions would be £13,000 but, with the effect of compounding, the potential future value would be £18,546.
The longer the investment period, the more profound the effects of compounding, as demonstrated by the steepening curve on the graph below. If we increase the investment horizon from ten to 25 years, total contributions would be £31,000 with a potential future value of £81,326.
At the risk of using a cliché, Warren Buffet famously said that the stock market was a device to transfer money from the impatient to the patient. It is important to stay invested and ensure you have a sensible investment time horizon – often the longer the better.
This way, one can ride out the peaks and troughs. To put this into an example, during the same ten-year period cited above, the FTSE 100’s worst year had a total return of -8.73%, and the best year was +19%.
On the other hand, if you are already seasoned in your investment journey, it may be time to review your portfolio to maximise earnings and minimise costs. Over time, it is not uncommon for investors to have multiple portfolios across different brokers and managers. This can result in a mixed fee structure, multiple relationship managers, conflicting opinions and an overlap of exposure.
Larger portfolios may be susceptible to single-manager risk and, although it can often be more economical and convenient to consolidate your investments under a single manager, it is prudent to spread assets and employ a multi-manager approach.
It is also not uncommon for portfolios to shelter stocks that have constantly underperformed, and it is necessary to carry out regular housekeeping on your portfolio. While it is never ideal to crystalise a loss by selling a stock that is down, it is important to consider the cost of having capital tied up in a security that is routinely underperforming. Sometimes the best course of action is to cut your losses and switch to an investment with more upside potential.
Investing is a journey and while the objective is to enhance your wealth, it is equally important to manage risk. Different life events and milestones may cause you to reflect on your investment objectives and risk tolerance so it is important to periodically review your portfolio and ensure that there is no style drift (this is when a fund manager makes investments outside the fund’s stated investment objective), and that the portfolio construction continues to meet your current goals.
When planning for the future, a fundamental investment that is often overlooked is making regular contributions to a private pension fund. As populations are forecasted to plateau and contract, combined with an ageing demographic, a shrinking workforce and individuals living longer, it could become a personal responsibility to ensure private pensions are of a suitable value to cover retirement.
State pensions have historically been well covered by social security contributions, which have been maintained by a strong workforce. However, with increased government expenditure and a shrinking workforce, it may be a matter of time before reliance on state pensions becomes less viable. This means that pensions could well become a hot political topic and a brewing economic nightmare.
Governments have recognised that state pensions alone may not be sufficient to cover people through their retirement. Under the UK Pension Act 2008, employers must provide eligible workers with a regulated employer pension scheme, to which employees can choose to make additional contributions.
Maximising your private pension contributions also has tax benefits. Private pension contributions are deducted from your gross income, and tax is levied on the net amount, meaning your pension contributions are tax-free. Furthermore, increasing your personal contributions is a good way of ensuring that money is being set aside for the future, as it is automatically deducted from your salary. If it is not feasible to increase your private pension contributions, you can make contributions from as little as 1% of your salary and still benefit from employer contributions.
Another benefit of utilising your pension is that pension funds are typically managed by some of the largest asset managers in the world. As a customer, you will benefit from low ongoing charges and, based on your risk profile, gain access to investment funds that are expertly managed, regulated and have access to a wide catalogue of investments.
In the future, private pensions will become more important as state pensions come under increasing pressure. According to The Office of National Statistics, as of April 2021, 79% of employees in the UK participated in the workplace pension scheme. Despite this, almost a third of people in the UK do not expect to have any pension provision beyond the state pension when they retire and, with current full-rate pensions in the UK at £185.15 per week and £253.40 in Jersey, it wouldn’t be too farfetched to see individual pensions undergo stress testing to ensure they are adequate to support workers into their retirements.
When it comes to financial planning, it is key that you set out a feasible plan to control your finances, and not let your finances control you. Formulate a step-by-step approach to meet your life goals and oversee your income, expenses, and investments. While the future is uncertain, it is important to prepare.
Wealth can be created over time and, while it is often a slow process, it is possible to achieve your goals by planning accordingly. Financial planning and investing can often seem daunting but employing the help of a professional can enhance financial understanding and help guide you through your investment journey.