In my last article I introduced you to The Investment Framework. This is a framework that you can use to guide your investment decisions. It will eliminate your fear and show you where to invest. How to avoid losing money. And how to invest. Where you can put small sums of savings that will grow (faster than inflation). And if you have a family, how you can ensure they have a secure financial future.
How do you even get started?
If it is the first time that you have seen this framework, it may seem overwhelming. There is a lot there. You may not even know how to begin at step one. Or maybe you feel that you don’t have enough money to make it worthwhile.
… You don’t need any money today to get started…
Well I have two things to say about that. You don’t need any money today to get started. You just need a way to get some money. And what I usually find is that people have more money than they think. More on that later.
Presumably, you have a job. This job will have cash-flow. A salary. The first thing to look at here is what percentage of your income you can devote to investing. If you have (for example) a salary of $100,000 then maybe you can save 10% a year. That’s $10,000 that you are investing every year. That will get you to around $600,000 in 25 years depending on the return that you receive.
OK that probably isn’t enough to retire on but it’s a start.
What if you don’t have the money to invest?
What if you cannot afford to save 10% of your income? In that case I suggest that you start looking at reducing your expenses. There are experts in this field who can help with this. Does this mean that you cannot begin investing now? No, it does not.
I mentioned that you may have more money than you think. The first thing to look at is the benefits that you get from your job. Specifically pension benefits. I previously worked at a company that gave me 10% of my salary as a contribution to a pension fund of my choice. This may be the case for you. Or your company will give you a matching contribution.
Can you pick the investments you want?
The next thing to find out is if you can change the investment allocation. In other words, is your pension Defined Benefit or Defined Contribution? If it is a defined benefit plan you will not be able to affect the contributions. In this case, you take note of how much the benefit is worth when you retire. Then you know how much extra money you will need to retire comfortably. If you don’t need any more money you can begin looking at other goals. Other goals might include paying for school for the kids. Or buying them their first cars. Or providing money to a charity that is important to you.
If it is a defined contribution plan then this effectively means that you can decide how much you want to contribute. Usually there is a matching contribution from your employer. Sometimes the employer will contribute whether you do or not. It’s worth your while to contribute because usually you can use pre-tax dollars. As we will see in later articles, taxes can have a significant impact on your final portfolio.
The advantage of defined contribution
But there is another interesting thing about defined contribution plans. The advantage (if you know what you are doing) is that you can decide how it is invested. Your employer has nothing to do with it. So, you can allocate your investments however you want. When you consider this in light of the Investment Framework you will quickly realize how powerful this can be.
The sad thing is, most people I have worked with never max these defined contribution plans out. They ignore them or set up a completely separate private pension. They pay in to these private pensions with post-tax dollars.
Don’t ignore these plans!
And they ignore the company defined contribution plan. They let the pension plan provider decide how to invest their money. And so, they pay extra fees to the provider to put their money in a plan that is probably not appropriate for them. Probably it’s earning lower returns than they could otherwise get on their own. Don’t be one of these guys!
Change your mindset!
Another preparatory step you need to take (most likely) is to change your mindset. I have spoken in the past about adopting a goals-driven mindset. Many of us are present focused. We spend all of our income as we get it. Or before we get it! I have definitely been guilty of this in the past. This needs to change in order for you to get the most out of your investments.
Now some of you are already very good at saving money. This is an attribute that I admire. Personally, I have struggled with this in the past. Until the global financial crisis it was very common for bankers to receive bonuses at the end of the year. What I used to do was go into debt during the year. I had a good time going out to eat or buying expensive clothes. Or having expensive holidays. And then, at the end of the year I would pay off all of the debts with my bonus.
This was a terrible decision and not good behavior. I should have lived within my means and invested the bonus. If I had I would be much better off now. Because after the crisis began and banks were (rightly) held responsible bonuses were cancelled. This meant that when I eventually lost my job I had far less money to live on. I coped but not as well as I might have liked. And I wound up taking an awful job so I could pay my rent.
Focus on your goals…
Hopefully nothing like this will happen to you. But this is one way that you could be forced to change your mindset. Better to change it yourself before you run into problems. One way to do this is to focus on your goals. Ask yourself “why”? Why is this goal important to you? And list out all of the goals that you have. And settle on the most important one.
For most of us, the most important goal is providing for our retirement. Whatever your goal or goals are, be clear that this is the reason why you are investing. Some people have no goals and don’t know why they are investing. One of my clients found himself bouncing between investments. Doing FX trading here and buying jewelry there. He had no direction. And he found himself blowing the proceeds. Because he had no goal it was impossible for him to move towards it. He was getting nowhere.
Once I explained to him the importance of goals he was able to create a plan. He now knew where to invest. And every day he moves closer to his goal.
How do you calculate a return?
The next thing that you need to understand is how to calculate a return. The return on your investment. You probably understand this as the interest rate on your savings. A savings account is basically a loan from you to the bank. As a result, you earn simple interest return. But there is a concept known as total return. Total return is your interest (or income) return plus the capital return. Capital return is basically the increase in value of the underlying asset.
Income vs capital returns.
So, for example, imagine you buy a dividend paying stock. The dividend is basically your share of the income generated by the company whose stock you own. Consider Cisco Systems, the high-tech hardware company. At the time of writing they were paying a dividend of $0.33 per share per quarter. The share price at the time of writing was $42.85. Therefore, this stock has an income return or dividend yield of (($0.33*4)/$42.85) 3.1%. This is analogous to the interest rate on your savings account.
However, we must also consider the price change. So, the Cisco Systems stock price on May 31, 2017 was $31.53. One year later it was $42.85. That’s an increase in price of $11.32 or a 36% capital return ($11.32/$31.53). Not bad compared to the negative return on a savings account.
So, to get the total return for the year you would have to add the years worth of dividends to the price increase and divide it by the original stock price. Four quarters of dividends are ($0.33 * 4) $1.32. $1.32 plus $11.32 is $12.64. Thus, the total return is 40%. Even better.
Beware of individual stocks.
Now I don’t necessarily suggest you go out and start buying individual stocks. A 40% return probably looks really good. But as I have mentioned before, stocks are very volatile. The stock price can easily go down by more than 40%. Even double or triple this percentage. The point of this exercise was to help you understand the concept of total return.
If you decide that buying individual stocks is for you, remember that you need to truly understand the company. This is a full-time job. It is essentially what I do all day every day. It can be very lucrative. But you need to know what you are doing. This is how Warren Buffet made his money.
What about real estate?
Those of you interested in direct real estate investment really need to understand this concept. Many people buy a house with the intention of renting it. What I find is that most of these people really have no idea if they are making a positive return. This is after accounting for all of your time and costs. In some cases, you might be better investing in a Real Estate Investment Trust (REIT).
Total return in a direct real estate investment is composed of both the rental income and the capital appreciation of the property. As you know, houses tend to go up in price over time. But also, many REITs and real estate funds have both a dividend yield and a capital return.
This return calculation only works for one year…
For most people, investing your money in an index fund is the best way to go. An index fund is a fund that contains of all the stocks in a particular stock market index, like the S&P 500.
However, keep in mind here that this example is only a one-year simple return. When you start introducing more periods (say the 25 years or so to retirement) then calculating a return becomes much more complicated. This is because of the compounding effect of interest. Otherwise known as interest on interest. This assumes that you reinvest your interest.
What is the required return?
In this case, you need to know the required return. The required return is the return that you need to make on average to achieve your goal. Suppose that your goal is to accumulate $3m by the time you retire in 30 years. You have $400,000 saved already. You can afford to contribute $15,000 per year. How can you calculate your required return without using complex math?
The best way to calculate the required return is to do what I do. Use a financial calculator or a spreadsheet (like Microsoft Excel). If you are not experienced with using the formulas in Excel then really the best thing is to either buy a financial calculator or use one of the free ones online. I actually use all three tools depending on what I am doing.
In my experience the best financial calculators are made by Hewlett Packard or Texas Instruments. Personally, I prefer the Texas Instruments calculator because I think it is more intuitive. But whichever way you go, you will need to understand some concepts.
The online calculator…
For now, I am going to assume that you’ll use the online calculator.
This picture shows you the Finance Calculator from Calculator.net. You can see that I have entered in the amounts I mentioned earlier (i.e. if you need a $3m retirement portfolio). As you can see in the results (on the right side), it indicates that your required return is 5.393%. In my opinion, this is achievable and is relatively conservative.
And in this case, you have a clearly defined goal. You know how much to contribute. And based on the required return you can begin deciding where to invest.
What do all those terms mean?
The terms in the calculator might be a bit confusing however. By way of explanation:
- FV (Future Value): this is the amount that you need to meet your goal in the future. Here for example, it is your $3m retirement portfolio.
- N (# of periods): This is the number of years until you need to meet your goal. In this case, 30 years.
- Start Principal: This is the savings you have accumulated so far = $400,000
- PMT (Annuity Payment): This is your annual contribution of $15,000. PMT means “payment”. I recommend that you keep to annual amounts to keep things simple. If you go monthly, you will have to adjust the periods and interest rate. It can get confusing.
- I suggest you use “PMT made at the… end of each compound period”. It makes sense since you will accumulate the $15,000 over the course of the year. Also, you cover any starting contributions in your original savings of $400,000
What else can you do with it?
The below section indicates how you can change the calculator to determine other results.
For example, lets suppose that you have the following:
- $400,000 in savings
- You know that you can contribute $15,000 per year
- And you are reasonably sure that you can earn a return of 6.5% on average every year.
And you want to know how much your retirement portfolio will be.
Well then you just select “FV” and enter in the above information:
In the results you now see that your expected Future Value (or retirement portfolio) is now $3.9m. So, you can see that it is pretty easy to play around with this calculator to determine different results. You can do the same with a handheld financial calculator or an Excel spreadsheet.
You’re ready to start investing your money!
You are now ready to take the first step in using the Investment Framework to realize your investing goals! Specifically, you now know the following:
- You can begin investing today no matter how much money you have
- Look to your employer to find additional sources of money (pensions)
- You may need a mindset shift to adopt the Goals-Driven Mindset
- Now you understand the concept of return
- Also, you know how to calculate your required return
- You are ready to begin investing!
In my next article I’ll go more into the “how-tos”. In other words, how to invest for your specific situation. I’ll work through a specific investment of how the Investment Framework can be applied.
Until then, if you have any questions, reach out to me. Tell me a little about yourself and we’ll see if I can help.
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