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Buying financial freedom

Once a month I do a lap around my bank and brokerage accounts, manually downloading transaction statements and populating my desktop based personal finance software.

20+ years of experience helping clients to implement evidence-based decision making has taught me that a person’s ability to lie to themselves is boundless. Therefore I don’t place much value on budgeting, as without diligent execution a budget is an empty promise of hopes and dreams on the road to disappointment.

“a budget is an empty promise of hopes and dreams on the road to disappointment”

I do find keeping score of what actually happened is instructive.  This allows analysis of the facts. Credit card statements don’t lie.

My setup is simple.

Expenses

Outflows fall into one of five categories:

  • Needs
  • Housing
  • Investment Expenses
  • Tax
  • Wants
Snob Hill or Struggle Town

Snob Hill or Struggle Town? Housing size, location and price is a choice. Image credit: Namirob and pix027.

Needs covers the essentials, like groceries. Regardless of whether you reside on Snob Hill or in Struggle Town, there isn’t a huge variance in the cost of needs within a given locale.

Housing has its own category because for many people (me included) housing is their second biggest outflow after tax. Having a safe, warm, dry place to sleep at night is definitely a need… yet the location, size, and the price that we pay for that home is a discretionary choice.

Investment Expenses are those costs incurred while generating the income streams I did not need to be physically present to earn.

Tax is a, largely discretionary, expense that should be managed like any other. It is also the biggest outflow for many people. If it isn’t then you either need to invest more in yourself because you aren’t earning what you could be… or you deserve credit for managing your finances effectively.

Wants covers everything else: gifts, furnishings, holidays, mobile phone bills, eating out, and charitable donations.

Income

Inflows are split into two categories:

  • Income that requires my physical presence to earn

and

  • Income that does not.

Passive and active income are myths

Being a generally disagreeable fellow, I take issue with both the terms active and passive income.

There are times when investment properties can feel anything but passive, during maintenance issues or when refinancing for example.

Conversely, I have some clients who feel reassured enough by my presence that they pay me a retainer, even though they seldom call upon it.

Keeping score

Providing your combined inflows exceed your combined outflows then any combination can be considered winning.

If that isn’t the case for you then you are doing it wrong!

My definition of financial freedom is when the inflows not requiring my physical presence reliably covered the outflows. I comfortably passed this milestone before my 40th birthday.

What does “normal” look like?

I was curious what a “normal” expense split looked like. Which in turn led me to wonder what a “normal” income split would look like.

If I don’t know something I’m a big fan of asking somebody who does, so I asked the Office of National Statistics. They pointed out “normal” is subjectively based on perspective, but they could tell me what the “average” person did.

They had a fair point. Everyone thinks of themselves as being above average, yet enough people take out payday loans and watch reality television to make both compelling business models.

An “average” person does…

The first chart breaks down the weekly outgoings of the average London household.

Weekly household expenditure by category - London 2017

Weekly household expenditure by category – London 2017

It is alarming how little people save, particularly given the climate of low interest rates, low inflation, and full employment.

The second chart aggregates that spending into my five categories.

Weekly household expenditure by category grouping - London 2017

Weekly household expenditure by category grouping – London 2017

Housing and tax collectively account for almost half of gross earnings. Wants consumes nearly a third.

The third chart plots average UK inflows against average London outflows. Unfortunately, the ONS didn’t ask the right questions to allow the income side of things to be broken down by region.

Weekly household UK income and London expenditure by category - 2017

Weekly household UK income and London expenditure by category – 2017

The good news is the average person earns marginally more than they spend.

The bad news is that the curse of averages makes the inflow figures a bit of a nonsense. How many wage earners do you know who also earn self-employment income, private pension income, and government benefits?

Buying financial freedom

I found it helpful and motivating to set out my own expenditures in this manner.

It allowed me to plot business, dividend, interest and rental income alongside my household expenditures.

As those income streams grew I could chart my progress by doing the victory dance each time those income streams sustainably covered off another expenditure category.

It was a good feeling knowing I never again needed to worry about how I would pay the gas bill, or where the grocery money would come from.

In time all my bills were covered.

Eventually all my wants were similarly funded, buying financial freedom.

After that any additional earnings were icing on the cake… and there aren’t too many problems that can’t be solved with cake.

Next Steps

  • How do your expenditure and income breakdowns compare to the “average“?
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
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Individual Savings Account

A Stocks and Shares Individual Savings Account (ISA) is arguably the most powerful tool in the successful United Kingdom investor’s toolbox. It provides the a tax free engine that drives wealth creation.

Each year every adult resident of the United Kingdom can invest after-tax money up to a sizeable given annual limit, and any subsequent income or capital gains generated are completely tax-free.

There is also a variant of the marvellous investing device for children, that works the same as the adult accounts but with a lower annual limit.

This makes ISAs are one of the few tax breaks available to everyone that actually encourage saving and investment.

How do Stocks and Shares Individual Savings Account work?

Functionally an ISA is just a special type of tax advantaged brokerage account. Like any brokerage account, fees and charges vary markedly, and will have a big impact on your overall investment performance.

Monevator maintains a great brokerage fee comparison table. Always “trust, but verify” to ensure you find the best deal for your own circumstances.

Accessible on demand

Money invested in an ISA can be withdrawn without penalty at any time. There are no age limits or lock-ins like those associated with pension accounts.

Dip in and replenish… within the same tax year

Investors can withdraw funds from their ISA, and then subsequently replenish them again, providing both events occur within the same tax year, and the ISA account terms and conditions support this flexibility. Miss that year-end deadline however, and the future tax-protected status of the withdrawn amount is gone forever.

Utilise your annual allowance each year

ISA allowances are like health, beauty, mental acuity and fitness… basically one of those “use it or lose it” type of deals.

An additional allowance is allocated to each taxpayer each year, but prior year allowances lapse if they are not taken up.

Get rich… slowly

If you’d been taking full advantage of your annual ISA allowance since they were introduced, and investing in a low cost S&P500 total return tracker, then today you would be sitting on tax-free investments worth more than £3 million!

S&P500 Total Return Individual Savings Account Contribution

S&P500 Total ReturnStocks and Shares Individual Savings Account Contribution

Conclusion

You can’t change the past, but you can ensure that you make good use of the allowances available from today onwards. Providing you haven’t fallen into the debt trap,  and once your basic living cost needs are met, then from a financial perspective utilising a Stocks and Shares Individual Savings Account is most cases the best thing you can do with your after-tax money.

Next Steps

  • Use a comparison website to evaluate the best bank accounts for you.
  • Open the Stocks and Shares ISA most suited to your circumstance (you will need your proof of identityaddress, and tax identifier if you have one).
  • Periodically validate that the account you have remains the best deal for you.
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
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You have to live somewhere

After moving house 13 times in the last 20 years, this is what I know:

  • Moving sucks, and is expensive.
  • Clutter multiplies when we aren’t looking.
  • Stuff will break and get lost in transit.
  • Furniture that looked great in your old house likely won’t even fit in the new one.
  • Establishing internet connectivity is never as quick or seamless as the suppliers promise.

I will confess to once purchasing a property I was renting at the time, mostly to avoid moving!

Throughout that period, I have owned a portfolio of well-located investment properties. However the majority of the time I have chosen to rent where I lived. Renting provided a nicer standard of accommodation, with a shorter commute, than the equivalent mortgage payment could support.

I recently caught myself falling into the trap of unquestionably accepting that today reflects how they will always be. Some things don’t change, but these all do!

Negligible interest rates?

Low inflation?

Full employment?

Ever-rising property prices?

Booming stock market?

My being young, slim, able to run a sub-20 minute 5km… oh wait, that was a flashback to the days before I got old and started wearing my beer. Perhaps some things actually do change!

Being a cantankerous individual who usually challenges everything, this blind acceptance alarmed me. I decided to recalibrate what I considered “normal” by researching longer-term trends.

This exercise also caused me to challenge some of my own long-held beliefs. One of those was whether it really does make more sense to rent rather than own where I live?

Is it cheaper to buy or rent?

The first chart plots the current monthly buy versus rent cash flow position. Data sourced from Zoopla’s current average rental and purchase prices for my postcode, and a typical tracker mortgage from MoneySavingExpert’s comparison tables.

Monthly cashflow by property ownership option

Monthly cashflow by property ownership option

Conclusion: Today owning costs more than renting… in my postcode area.

End of discussion, right?

Isn’t rent supposed to be “dead money“?

Wait a second… isn’t renting “dead money”? Once the mortgage is paid off I would own a house!

This point requires an examination of opportunity cost. I could have paid the mortgage every month, or I could have paid the rent and invested any difference in the stock market.

Nobody knows what the future will hold, so instead let’s travel back in time the duration of a typical 25-year variable rate mortgage to evaluate what the outcomes would have been.

The life of a mortgage in pictures

This chart displays the composition of payments over the life of the mortgage. The recent period of record low-interest rates makes for an interesting picture.

Payment composition over the life of a 25 year mortgage

Payment composition over the life of a 25 year mortgage

Conclusion: Since the financial crisis mortgages have been almost “free”. Doh!

Next, we have the cumulative loan principal and interest over the duration of the mortgage. Owning occupying a property avoids spending on rent, though mortgage interest is still a considerable expense.

Cost of using a mortgage to purchase a property

Cost of using a mortgage to purchase a property

Conclusion: Over the duration of a mortgage the interest component certainly adds up.

This chart is an interesting one. When you purchase an asset you retain any capital growth it experiences. My postcode area has experienced a CAGR rate of 9.41% over the last 25 years, although the actual investment ride has been bumpier than the CAGR makes it sound.

Property equity accumulation breakdown over 25 year mortgage term

Property equity accumulation breakdown over 25 year mortgage term

Conclusion: By missing the property appreciation gravy train, renters like myself potentially left a lot of money on the table.

Renting is cheaper today, but will that always be so?

With the development of the homeowner equity position understood, we can compare the rent versus buy outcome.

25 years ago renting cost less than buying, just as it does today. That situation soon reversed, as rental prices increased over time.

Rents versus mortgage payments over the 25 year mortgage term

Rents versus mortgage payments over the 25 year mortgage term

Conclusion: Mortgage payments are anchored by the property purchase price. Property prices and rents both fluctuate in response to supply and demand.

The stock market must have outperformed property?

What would have happened if I had invested the surplus between rent and mortgage payments while it was cheaper to rent? The following chart displays the outcome of having purchased the S&P500 Total Return index.

Stock market investment performance over the 25 year mortgage term

Stock market investment performance over the 25 year mortgage term

Conclusion: The stock market performed strongly over the 25 year period, accruing a CAGR of 12.68%. However, contributions would have ceased once renting became more expensive than the mortgage payment.

Property ownership for the win

Would renting have proved to be a suboptimal choice over the last 25 years?

Buy versus rent: Accumulated equity after the 25 year mortgage term

Buy versus rent: Accumulated equity after the 25 year mortgage term

Conclusion: Absolutely, by more than one million pounds!

History doesn’t predict future performance

Will the outcome be the same over the next 25 years? Without a crystal ball, there is no way to tell.

During the accumulation phase of wealth management, building up equity rather than incurring expenses is vital. Whether that equity is accumulated in shares, investment properties, or owner-occupied real estate should be determined by the individual’s risk appetite and assessment of the investment landscape.

For most people housing is their second highest outgoing after taxation.

You have to live somewhere

The thing to remember is you have to live somewhere, and (unless you are freeloading off your parents) that residence is going to cost you something. That housing cost could be making money for someone else’s business, your landlord, or it could be accumulating equity for yourself.

Robert Kiyosaki is famous for stating owner-occupier property is not an asset, because it consumes rather than generates income. The charts here have demonstrated that well located real estate can generate significant wealth for the property owner, in a similar manner to a company or accumulation fund that chooses not to distribute dividends.

When combined with the careful application of leverage those returns can be magnified.

Do your own homework, as the prospects for any investment can vary considerably by locale and over time. Property is a long-term game, not least because moving sucks and you have to live somewhere!

Next Steps

  • Run the numbers on your own residence. Does it make more sense to rent or buy?
  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
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How to calculate a compound annual growth rate

Calculating an average rate of return over time provides a useful method of comparing the performance achieved by different firms or assets.

The formula to calculate a compound annual growth rate (CAGR) is:

[CAGR] = ( ( [Final Value] / [Inital Value] ) ^ ( 1 / ( [Ending Year] - [Starting Year] ) ) ) - 1

Key definitions

  • CAGR – Compound Annual Growth Rate
  • Ending Year – The final year of the period for which performance is being evaluated.
  • Final Value – The asset value at the conclusion of the evaluation period.
  • Initial Value – The asset value at the beginning of the evaluation period.
  • Starting Year – The initial year of the period for which performance is being evaluated.

What is a compound annual growth rate?

A compound annual growth rate ignores market volatility by providing a smoothed average return over a time period.

Why calculate a compound annual growth rate?

The compound annual growth rate provides a rough performance comparison method across firms. For example, how did the results of a group of fund managers or financial advisor compare over the last 5 years?

As with any statistic, using CAGR comes with health warnings. A compound annual growth rate provides a rear view mirror on what did happen but makes no attempt to project what may yet happen.

As an average the CAGR smooths away volatility, meaning the actual experience may have been a bumpier ride than the average makes it appear.

Always “trust, but verify” by being mindful of the context in which a CAGR is presented. A firm may boast of outperformance over the last 3 years, however their base may have been lower than their competitors after some dire results the year before the evaluation period.

Illustrative example

I want to calculate the 5-year compound annual growth rate of an investment property.

[CAGR] = ( ( [Final Value] / [Inital Value] ) ^ ( 1 / ( [Ending Year] - [Starting Year] ) ) ) - 1

[CAGR] = ( ( 684,000 / 492,500 ) ^ ( 1 / ( 2017 – 2012 ) ) ) – 1 = 6.79%

Next I want to compare that CAGR figure to the equivalent period return of the S&P500.

[CAGR] = ( ( 2,673.61 / 1,258.86 ) ^ ( 1 / ( 2017 - 2012 ) ) ) - 1 = 16.26%

Based upon these figures we can conclude that the compound annual growth rate of stock market outperformed the investment property over this period.

CAGR can tell a number of stories. Now consider the performance of the equity I contributed to the property, as opposed to the money borrowed from the bank.

[CAGR] = ( ( ( 684,000 – 443,250 ) / 49,250 ) ^ ( 1 / ( 2017 - 2012 ) ) ) - 1 = 37.35%

This time the property’s compound annual growth rate convincingly outperformed the stock market. When applied judiciously leverage can be a powerful growth accelerator. This highlights how important it is to understand the figures behind quoted CAGR values!

Next Steps

  • If you liked this post then please share it with your friends.
Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
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In the long run

My high school economics teacher used to defuse arguments with the saying “in the long run we are all dead”. He was quoting from John Maynard Keynes’ “A Tract on Monetary Reform”, which observed that the simplistic outlook held by Economists about an often uncertain world was about as helpful as the ancient Persian proverb “this too shall pass”.

Recently I’ve encountered numerous occasions where somebody said the current state of affairs is not “normal”,  and that over the longer term we should expect them to “revert to the mean”. They could have been talking about anything from interest rates, inflation, property prices, to cryptocurrencies.

What they really mean is they endorse Isaac Newton’s observation “what goes up must come down”… and they believe the inverse is also true.

what goes up must come down

For mine, “normal” is a subjective term that is very much defined by perspective and outlook of the observer. Usain Bolt and Stephen Hawking probably consider themselves to be normal (we all do)… they just find the rest of us wanting!

I decided to dig into the numbers, to figure out for myself whether there was anything to this talk of returning to “normal”, or if it was just a load of bollocks.

History of the world

In the long run we are all dead. Image credit: Lasse Vestergård.

758 years of inflation rates

First I looked at the annual inflation rates. Via the National Archives and the House of Parliament library, I found a research paper from the 1950s that tracked the annual price and wage inflation rates since the 1260s. I then extended the time series to today using figures from the Office of National Statistics.

750+ Years of United Kingdom Annual Price Inflation Rate

750+ Years of United Kingdom Annual Price Inflation Rate

There were some interesting results from analysing 758 years worth of data.

  • The average annual inflation rate was 1.53%.
  • The ride required to achieve that average was far from smooth, with annual swings of ±60%!
  • Deflation occurred in 44% of the periods.
  • Periods of 1970s style high inflation rates are not uncommon, though occur less frequently than they once did.
  • The recent extended period without much inflation rate volatility is unprecedented.

Conclusion: The often repeated 2% annual inflation rule of thumb holds true.

324 years of interest rates

Second I looked at official interest rates. The Bank of England once published data going back to 1694. While the original download is no longer available, the Guardian has republished a copy which I have extended using current Bank of England figures.

324+ Years of United Kingdom Interest Rates

324+ Years of United Kingdom Interest Rates

324 years of interest rate data told an interesting story.

  • The average interest rate was 4.71%.
  • Only 16% of the historical periods have experienced interest rates exceeding 5%.
  • The recent period of extremely low-interest rates is unprecedented.
  • The high-interest rates experienced during the 1970s and 1980s were also an anomaly.

Conclusion: The historical average interest rate is approximately 10x those experienced today. Ensure you stress test your debt servicing plans appropriately.

758 years of wage growth rates

Finally, I looked at annual wage growth rates. The research paper mentioned above had attempted to collate a time series looking at the weekly wages received by a “building craftsman”. I extended the series using Office of National Statistics annual wage growth figures, which resulted in the substitution of the average worker for a “building craftsman” from 1955 onwards.

750+ Years of United Kingdom Annual Wage Growth Rate

750+ Years of United Kingdom Annual Wage Growth Rate

The 758 years worth of data tells a story, though one that should be treated with caution as the time series contained several gaps, some of which were lengthy.

  • The average annual wage growth rate was 1.5%.
  • Historically wages do down as well as up, with declines in wages reported in 33% of periods.
  • Supply and demand play a huge role in setting wages. The effects of war, plague and famine plain to see.
  • The absence of annual wage declines since the 1950s is inconsistent with the preceding 700 years experience. This is most likely caused by the substation of average wages for those received in a specific vocation, rather than a structural change to the way the economy works!

Conclusion: Short-term wage growth is determined by supply and demand for skills, however over the long term it unsurprisingly parallels inflation.

In the long run?

In the long run both Newton and Keynes were right. With the benefit of distance and hindsight, all the daily volatility and noise smooths out into a nice understandable trend. The historical data examined here shows that when viewed in a 750 year context, the last 25 years have been an economic purple patch.

Next Steps

Disclaimer: I may receive a (very) small commission from any purchase you make via links on this website.
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