Right, investing and the markets.
The essential aim is to have your money make you money, ideally while you’re not watching and relaxing/sleeping/playing the ukulele.
Generally, humans are pretty good at innovating, working and striving to better their own lot and through our collective efforts, our technology and culture advance. Capitalism and ‘the market’ are the current bean counting efforts to try and lubricate and keep track of all that human effort and capital.
You can think of the stock market as a method of buying a small slice or slices of all of that effort and for your ownership each year you’ll receive a slice of all the inventions, effort and new advances in the form of some cash. Typically, over the past 100 or so years that amount of cash has been 7% of the amount you have invested each year, every year ongoing. This is generally referred to as the ‘market return’.
So what does this mean for me?
By investing in a stocks and shares ISA, you should receive around 7% tax free each year on average. The last few years have averaged between 10% and 21% but periodically these gains will be paired down by a recession where stock prices will drop, wiping out some of the large gains from other years, but the trend has historically always been up, to the tune of 7% over longer time periods.
The real magic of investing happens when your gains are reinvested to buy more shares meaning the next year you get 7% on your original amount + 7% from the year before. Over time that creates an exponential growth and loads of cash flow, this is known as compounding.
How powerful is this effect? Well the rule of 72 (link) states that you should double your money after inflation every 7.2 years with this rate of return.
Over very long periods of time, the ball of cash gets so large that you no longer need to exchange your time for money in the labour market and you can get on with your ukelele practice full time or whatever else takes your fancy. When investments are managed and passed from generation to generation, then suddenly all the very rich trust fund babies and Eton educated Tristan’s and Harriets I’ve seen in my respective lives in New York and London start to make more sense, given that sometimes it seems their parents don’t seem to have done too much labouring now or in the past…
So what should I do?
You want to invest in computer managed index funds, which simply buy the whole of a stock exchange or markets based on the size of the companies that make them up. This may seem dumb as in the case of the FTSE you have loads of mining stocks or oil stocks and you might think that I want those fancy tech stocks instead. The flaw in this thinking is that you don’t have the time to research and actively work out the best mix and there are huge investment houses/hedge funds that pay many people, many dollars to come up with a better plan than you, which will generally beat your plans unless you happen to be a skilled or lucky investor. I go into some more detail on why active investing is a zero-sum game elsewhere if you want to know more.
Active personal investing aside, why not put your money into the hands of a bank, investment fund or hedge fund manager? Well, turns out they like being massively paid, regardless of how well they do with your cash. Don’t forget that to be a better plan than index funds in the last few years they not only have to make you money, they will have to beat the 10%/21% return of the market in general over the past few years. Factor in that their fees are 10-20x higher than a computer blindly buying indexes in relation to their size and you find that index funds are the best bet. In a recent study, 98% of the time a low cost index fund such as Vanguard or Fidelity would beat all other investment funds/banks/houses when fees are factored in.
The final point is on diversification. Change is a constant part of the market and capitalism and the chance of some of this change being negative for the shares you have bought is called ‘risk’.
At various times the winds of change have brought once great companies to their knees while leaving their competitors relatively untouched, sometimes they will decimate entire sectors of the economy and sometimes whole countries will go backwards for decades at a time.
The best mathematical strategy to deal with these random risks is to buy as many different types of assets, companies and markets as possible and the easiest, cheapest way to do this is via a fund. A fund takes your money and buys many companies, such as the 100 biggest in the UK in the FTSE100 or 500 biggest in the US in the S&P500.
So in short, buy an All World or S&P index fund, inside a tax free wrapper, invest as much as you can on a regular basis and eventually the tide of cash means you can retire forever, or keep working or spend it on the equivalent amount of crack cocaine, the choice is yours!