Money shapes our lives.

We spend 80,000 hours working to earn money.

We spend many more spending it or simply worrying about it.

Everyone needs financial literacy to get through life.

Yet we are not taught the basics of how to handle money.

There are three simple, (not easy, but simple) steps to build wealth:

  1. Spend less than you earn
  2. Avoid debt
  3. Invest the rest

Wealth

Wealth gives you freedom to take risks.

If you can take risks, you can:

  • Change jobs
  • Demand better pay from your boss
  • Pursue work that makes you happy
  • Take time between jobs to organise your life

Taking these risks will improve your life and increase your income.

More Wealth means more Freedom

More Freedom means more Chances

More Chances means more Income

More Income means more Wealth

More Chances makes a Happier Life

Spend Less Than You Earn

If you spend more than you earn, you're spiralling towards bankruptcy.

If you spend exactly what you earn, then you'll be a slave to your job forever.

If you spend less than you earn, you can build wealth.

There are two ways to spend less than you earn:

  1. Earn more (without spending more)
  2. Spend less (without earning less)

"A penny saved is better than a penny earned" - A financially literate grandmother

Cutting spending is more effective and is often easier than increasing earnings.

For the median UK earner, because of tax:

  • Earning an extra £1 per year, increases their wealth by 84p per year
  • Saving an extra £1 per year, increases their wealth by £1 per year

Spending less also makes what you have go further.

In terms of financial freedom, halving your spending is the same as doubling your earnings.

I recommend Mr Money Moustache's Blog if you're interesting in spending less.

He is challenging, funny and extremely effective at cutting spending.

Avoid Debt

It is pointless saving or investing if you have debt.

Debt is incredibly powerful.

It will wipe out the value of any savings or investments you have.

It will prevent you from ever gaining any wealth.

Debt uses the same principles that powers investments, but instead of working for you it works against you.

The average interest for UK credit card debt is 19%

The average interest for UK savings accounts is 1.2%

The expected returns for investing in the market is ~7%

The difference in growth is exceptional.

The graph below shows what happens to £1000 worth of debt, savings and investment, left untouched for 20 years.

Once you have no debt, start saving.

To avoid debt it is important to have an emergency cash fund.

As a rule of thumb: have enough cash to cover a few month's expenditure.

If you need to spend money, always use savings. Never take on debt.

If you have no savings and have to take on debt, pay it off ASAP.

Use your surplus cash to relentlessly pay off debt.

Start with the highest interest loans.

Student loans and mortgages are special cases

In the UK student loans are more similar to a graduate tax than debt

Mortgages are leveraged investments

Invest The Rest

The government has many schemes to encourage saving and investing.

In my experience it often does the opposite.

To safely invest, you need to understand:

  • Types of accounts with their:
    • Eligibility rules
    • Deposit rules
    • Withdrawal rules
    • Tax implications
    • Various charges
  • Types of investments with their:
    • Volatility
    • Diversification
    • Liquidity
    • Potential for growth

You then need to choose your investment platforms and sift through platform specific funds etc.

People either make a jab with partial knowledge or give up trying.

Below is my overview of these points and my broad-brush advice. See the disclaimer.

Types of Investment Accounts

When it comes to types of accounts it makes sense to:

  1. Maximise your employer pension contribution (this requires a minimum investment from you)
  2. Max out a Lifetime ISA, if you're eligible and will buy a house or stay invested until you're 60
  3. Open a Stocks and Shares ISA and invest up to £16k-20k per year
  4. If you still have spare cash (lucky you!) invest in a standard investment account

When choosing which accounts to use, you must trade-off between potential growth and flexibility.

Pension

Most people are unable to withdraw from their pension account until they are at least 55 years old. This makes it the least flexible investment account.

Pensions enable the highest returns because:

  1. Your pension gets invested before income tax
  2. By law, your employer must pay you more if you save in your pension

The money you would have paid as income tax earns interest while invested. You will get to keep this interest.

You will have to pay income tax when withdrawing from your pension. But if you have no or little other income when you withdraw, you will get to take advantage of your tax free personal allowance.

If you save 5% of your pre-tax income in your pension, then you employer must pay you an additional 3% of your salary, which goes straight into your pension.

This is the minimum, many employers are more generous and will give you an even bigger pay rise.

The graph below shows the difference in your return on investment if you invest:

  1. In your pension with employer contributions
  2. In your pension without employer contributions (e.g. after maxing out your employer's offer)
  3. In an ISA with your extra take home pay (what would have went into your pension)
Assumptions This assumes all investments have an identical return of 7% per year.
The values used for the plot are based on the median UK salary of £15.38 per hour and the median UK working hours of 37 hours per week.
Other incomes within the same tax bracket should have equivalent differences.
This assumes the earner has an employer who contributes the minimum required by law to their employee's pension.
This means a contribution equal to the value of 3% of the employee's pre-tax salary, excluding the first £6250 of earnings.
As required to trigger the minimum employer contribution, the employee is assumed to contribute 5% of their pre-tax salary, excluding the first £6250 of earnings.
The calculations take into account income tax and national insurance, assuming the employee's salary is their only income.

If you earn the UK median salary, and you decide to save nothing in your pension you will have an extra £934 per year in your pocket.

If you take advantage of the 5% employee, 3% employer incentive you will get £1868 per year in your pension.

Lifetime ISA

A LISA is a government scheme to encourage investment and first time home buying.

It is more accessible than a pension but also has lots of rules around eligibility, deposits and withdrawals.

You cannot open a LISA if you're younger than 18 or older than 39.

You should definitely invest in a Lifetime ISA if you plan to buy your first home (which you should only do for lifestyle reasons).

It also makes sense if you have maxed out your employer pension contribution and plan to keep this money invested until you're 60.

You pay into a LISA with your after tax income.

You can contribute up to £4k per year until you're 50 years old. (But you must open an account before you're 40).

The government adds 25% to your investment. If you're a basic rate tax payer, this is equivalent to a refund on your income tax.

In this case it will perform the same as an employee only pension contribution.

Explanation If you have £100 before income tax and pay the basic rate of 20% you will receive £80.
If you invest this £80 in a LISA the government will add 25%, bringing your account balance to £100.

You can withdraw from this account fee free if:

  • You're over 60
  • You're a first time home buyer using this money towards a deposit

You can withdraw money at any time for any other reason, but you will pay a fee.

The fee is usually equivalent to losing ~6% of your investment.

Explanation If you invest £80 in a LISA the government will add 25%, bringing your account balance to £100.
If you withdraw money without meeting the criteria, you will have to pay a 25% charge, leaving you with £75.
This is 93.75% of the original £80.

Investing in a LISA and withdrawing fee free is much better than investing in a normal ISA.

Investing in a normal ISA is marginally better than a LISA with fees.

Investing in a LISA and withdrawing with fees is much better than not investing.

So don't let the fees put you off too much!

ISA

You can invest up to £20k per year in an ISA.

Any investments in a Lifetime ISA count towards this total, so if you max out your LISA, you can invest up to £16k in a normal ISA.

Standard Investment Account

In a standard investment account you may have to pay taxes on the interest you earn.

You may pay tax every year based on the increase in value.

You may have to pay capital gains tax when you withdraw your cash.

ISAs are preferable so that taxes aren't a concern.

Types of Investment

You can invest in:

  • Company stock - you own a percentage of a company
  • Bonds - you own the debt of governments or companies
  • Property
  • Commodities - you own natural resources like gold, oil or grain

Each of these has its own:

  • Volatility
  • Liquidity
  • Potential for growth
  • Minimum investment

An investment is volatile if its price changes dramatically over short periods of time.

An investment is liquid if you can easily turn it into cash.

Company Stock

  • Volatily: High
  • Liquidity: High
  • Potential for growth: High
  • Minimum investment: Low

Bonds

  • Volatily: Low
  • Liquidity: Medium
  • Potential for growth: Low
  • Minimum investment: Low

Property

  • Volatily: Low
  • Liquidity: Very Low
  • Potential for growth: Medium
  • Minimum investment: Very High

Commodities

  • Volatily: Low
  • Liquidity: Medium
  • Potential for growth: Low
  • Minimum investment: Medium

Single Investments vs Investment Funds

You could invest in a single company, bond, house or commodity, but

Investing in a single asset is very high risk.

Diversification is how you protect yourself against unpredictable changes that affect single types of assets.

Don't put all your eggs in one basket.

You can actively pick many individual investments that sound promising to you.

Don't do this. To have a chance you would need to dedicate your career to it.

Even then, over a 10+ year period you will do worse than if you just spread your investment across the market.

There is a reason Warren Buffet is famous. He is one of the only people who has successfully beat the market. Almost everyone else lost, while working hard for the privilege.

Don't try to beat the market. Join it.

The solution is investment funds.

They spread your money across many individual assets.

You can choose funds with different scopes for different types of assets; such as different sectors of the economy, different countries, different lengths of investment etc.

If you want to maximise diversity you can spread your investment across all publicly traded companies and bonds.

Active funds have paid professionals regularly changing what they invest your money in.

Passive index funds spread your investment proportionally across your investment class, representing the full market.

Passive index funds beat active funds and have much lower fees.

They should be your investing bread and butter.

Passive vs Active In any given year 80% of actively managed funds do worse than their index.

A Vanguard study showed that over a 15 year timespan 45% of actively managed funds failed, another 37% did worse than their index, with only 18% outperforming it.

Over a 30 year timespan 99.4% of actively managed funds failed or underperformed their index.

Financial Independence

When you work you give up your time in exchange for money.

When you save and invest, you give up what you could buy now in exchange for financial security.

As shown earlier, the power of compound interest is what makes this deal attractive.

Every bit of wealth gains you more autonomy, and if you save and invest enough, you can become completely financially independent.

This means you have enough wealth that the interest it earns covers your cost of living.

It means you can no longer be forced to work out of necessity.

It means you can focus on what's important to you. Whether that's your family, your hobbies or even continuing a career, but on your own terms.

This is true "F*** You" money.

The rule of thumb for calculating FU money, is to multiply your cost of living by 25.

Explanation The authors of the "Trinity Study" investigated what percentage of their assets a retiree could withdraw every year for 30 years, without becoming bankrupt.
Looking at the data for 30 years retirements spanning the years 1925-1995 they found this value fluctuated between 4% and 8.5%.
If your wealth equals 25 times your cost of living, then withdrawing 4% of your wealth will cover your expenditure.
Note: If you landed on a lucky year and could safely withdraw 8.5% of your wealth, then you only need 11.76 times your expenditure, not 25 times, but you wouldn't know this until the years had passed.

Lets take an example of Jill. Jill earns the UK average of £15.38 per hour and works the UK average of 37 hours per week.

She has been good at controlling her expenditure, and spends what would be her take home pay if she earned minimum wage.

This means savings of ~£10k per year and cost of living of ~£14.6k a year, for a savings rate of ~40%.

The average working life in the EU is 36 years.

If Jill didn't invest she could only reach FU money as she retired.

But thanks to investing Jill has many choices.

  • She could carry on working the same job and retire with £1.6 million instead of £370k
  • She could enjoy retirement a whole 18 years earlier than planned
  • She could work for only 10 years then switch to part time work

Her investments give her opportunities to control her life.

How To Build Wealth

  1. Spend less than you earn
  2. Avoid debt
  3. Invest the rest

Investment guidelines:

  • Invest in passive index funds
  • For highest growth choose stocks
  • For highest diversification choose a global fund
  • To balance growth and liquidity fill your accounts in this order:
    • Pension
    • LISA
    • ISA
    • Standard Investment Account

If you get even part way through this list you're well on your way to growing your:

  • Wealth
  • Freedom
  • Chances
  • Income
  • Happiness

Inequality

I believe the lack of financial education is a huge driver of inequality in our society.

The wealthy are taught about money; through family and friends.

The wealthless are left to hash it out on their own.

People are driven to buy a single house through the folklore that surrounds them.

And the opportunity cost is huge.

People spend years uninvested saving up the huge deposit required; even though this is less effective, riskier and less accessible than investing in an index fund.

The steps for building wealth highlight why inequality is accelerating:

  • Spending less than you earn is easiest for those on high incomes
  • Avoiding debt is easiest for the wealthy
  • Effectively investing the rest requires financial knowledge

But with the right knowledge, it is possible for anyone to do all three.

Disclaimer

I am not a financial advisor. Please assess your own financial situation and carry out your own research / seek professional financial advice as required.

Though keep in mind that financial advisors are unlikely to have your best interests at heart.