Own the world?! Some mistake, surely? After all, we’re only here to reach Financial Independence! We’ve no business trying to own the world, right? Wrong! Two words for you: index funds. If you don’t know what I’m on about, this post is for you. Bear with me, and I promise all will be clear.
But first, let’s talk about the basics of investing in the stock market. When it comes to investing, a lot of people are scared. At best, stocks are often viewed as a socially acceptable cousin of gambling.
That’s quite understandable. Just like putting it all on black in roulette, shares in a single company can leave you with double or nothing in a short space of time. Just ask anyone who bought Enron shares in the late 1990s. All of this makes the stock market seem a real emotional roller-coaster.
Let’s be honest. Investing is risky, and it will never feel 100% comfortable. But we’re about to learn a strategy to smooth out the roller-coaster. To do so, let’s go back to kindergarten. We were all taught this proverb as kids:
Don’t put all your eggs in one basket.
I’m sure most of us follow that advice without even thinking about it a lot of the time. When we look for work, most of us submit many applications rather than just putting in one and crossing our fingers. It turns out “don’t put all your eggs in one basket” is pretty sound investing advice too.
Whilst individual shares can be exceptionally volatile, big groups of shares across large numbers of companies tend to be less so. Why? Because when one company goes down, another will probably go up, balancing things out.
Here’s where “owning the world” comes in. If we could just own a bit of every company in the world, we’d be insulated from the fortunes of any single company, or even country. Instead, we’d just take a slice of the overall pie of global growth. Obviously there are times when the global economy as a whole takes a dip. On the other hand, if the whole global economy ever goes the way of Enron we’ll be too busy worrying about other stuff in the armageddon to even notice.
I hope we can agree that owning the world is a solid theory. But in practice it sounds like a lot of hard work, doesn’t it? Can you imagine how long it would take to buy shares across the whole world? Here’s the lucky bit: someone already did it for us. We can invest in a whole bunch of shares – getting the benefit of global diversification – through vehicles known as global index funds.
We’ve got options on specifics. The biggest game in town for index funds is Vanguard. Even Warren Buffett – the most famous stock investor in history – wants his wife to put their wealth in Vanguard funds when he dies. I’m not here to sell any particular option. If it’s good enough for Warren Buffett, though, it’s certainly good enough for me!
What are your main concerns about investing? Have you already started? Would you consider global index funds?
It’s a fact: even as many millenials resign themselves to a life of renting, most of us are still obsessed with dreams of bricks and mortar. In many parts of the world, millenials have grown up with house prices that only ever seem to go in one direction: up. This feeds into a general idea that home ownership is a golden goose, and many of us feel a pressure to hurry – bordering on panic – in order to get on the “property ladder” before it’s too late.
In our enthusiasm, though, we forget that buying a house is a massive financial decision. For most of us, it’s the biggest purchase we’ll ever make. So it’s surprising that the question of whether or not it’s even a good idea to buy a house is often considered less than where to go on holiday next year.
The best way to approach such a big decision is to go in armed with the facts. Understanding the possible pitfalls will help you approach home ownership with maturity, wisdom and good sense. You will be able to look back in 20 years and look back on the decisions you made without regret. Here are some thoughts to get you started:
1. Affordability. A mortgage is a type of “secured” loan. This means that if you stop paying, the bank has a claim on your house. It doesn’t take a long memory to know that this threat has teeth. Psychologically, you should consider a mortgaged property as being owned by the bank.
2. Interest rates. At the time of writing, interest rates are really low. The Bank of England base rate, for example, is close to zero. In the 1980s, though, it was more like 10-15%. Over in the States, the fed funds rate similarly reached a high of 20 points in 1979 and 1980. Could you afford your mortgage repayments doubling or trebling?
3. Opportunity cost. My dad always told me that rent is money down the drain. That’s only half true. To illustrate the point, we’re going to imagine being already pretty well off. You might rent a $200,000 property for $10,000 per year which you could have bought outright. If you buy it, you save $10,000. If you don’t, you might put that money into an investment which yields 7% – $14,000. You just won $4000 per year by skipping home ownership. Of course, we’re not factoring in leverage (see below) or the tax implications and stability of that return.
4. Leverage. Property can be a powerful investment due to leverage – you can put in e.g. 20% and borrow the rest. The ordinary citizen is gonna find it hard to get a similar financing arrangement on their stock portfolio. If the value of the property goes up, you keep 100% of that additional value. Just don’t forget that this cuts both ways. Property can go down in value too, eroding all of your equity and more, and you still have to pay the mortgage.
5. Stamp duty. Some countries – like the UK – have a government tax on transferring land or property. This can go up to a hefty 12% for the most expensive properties, so can be a significant added cost of home ownership.
6. Conveyancing. Most UK buyers will use a solicitor or conveyancer to conduct searches on a property they want to buy (e.g. to check ownership or flood risk), and then to exchange contracts and complete on the property. This doesn’t scale with the cost of the property, so could easily add 1% to the cost of buying a cheaper property.
7. Survey. A full structural survey can cost hundreds. Whilst cheaper options are available, bear in mind that buying a house is a huge financial decision for most people. Weigh up other factors like the age of the house, and whether you’re in a position to cope with a large unexpected maintenance bill, to decide what the most appropriate option is here.
9. Mortgage early repayment costs. This one is important for us Financial Independence types. We might be in a position to pay back our mortgages faster than most. However, typically the charges range from 1–5% of the value of the early repayment. Consider looking for a mortgage with no early repayment charge if this is a path you’re looking to take.
10. Moving costs. Are you moving far? Don’t forget that you need to get your stuff from A to B. If you don’t plan this right you could be hit with significant costs, especially if you’re moving long distance.
11. Property taxes. This is really specific to where you live. An average American household spends a couple of thousand on property taxes on their home. Council tax in the UK goes to local councils to pay for services like bin collection, but households end up paying a similar amount.
12. Maintenance. Upkeeping your home can be a significant expense – one that you don’t need to pay in most countries if you’re renting. 1% of the home’s value per year is a common rule of thumb, though you will want to consider other factors like age, climate/weather and who’s living there.
13. Leasehold/Ground rent. In some parts of the UK and US, home ownership is not always quite as simple as owning outright. Especially some parts of England and Wales, and on apartments, “leasehold” is common. This means that instead of buying a property, you are buying a long-term lease on it. You do have all sorts of rights, and a level of security not usually associated with being a tenant. In the case of leasehold houses you should also be able to buy the “freehold” (~complete ownership). That process can be expensive, though. You also have an ongoing cost – ground rent – to use the land the property is built on. Be doubly cautious when buying a relatively newly built house. The leashold agreement can leave you with spiralling costs, and a house that is difficult to resell.
15. Anchoring effect. Some of us like roots, some of us like wings, some of us a bit of both. Our 20s and 30s can be a great time to indulge our wanderlust or explore living in new places before deciding where to put down roots. Whilst it’s never too late or too hard to make a change, the costs of home ownership we just covered will make you think twice about packing your bags overnight and moving somewhere new.
What do you think? Is home ownership worth it? Does it increase or decrease your freedom? Is it necessary for Financial Independence?
Disclaimer: This post is not investment advice – details are use merely to illustrate a general investment principle.
I don’t use the word miracle lightly, but tell me: does turning $10,000 into $452,593 without putting in a single extra dime not sound like a miracle? Well hang onto your hats, because one powerful phenomenon can make this miracle a reality: compound interest. Let’s do a bit of maths:
Captain Thrifty starts with $10,000. He puts it into a fund which tracks the S&P 500 (don’t worry about it if you haven’t heard of this – it’s basically just a vehicle to invest in all of the biggest US companies at the same time). Captain Thrifty gets a 10% return (historical records show the average annual return for the S&P 500 since it began in 1928 is approximately 10%) = $1000. His $10,000 is now $11,000.
Captain Thrifty gets another 10% return = $1100 (10% of $11,000 rather than the 10% of $10,000 he got in Year 2). His $11,000 is now $12,100.
So far, so pedestrian. Lets have a look what happens over the rest of a 40 year working lifetime, though, at that 10% return:
Year 10 $25,937
Year 20 $67,275
Year 30 $174,494
Year 40 $452,593
Putting in no more money, that initial investment has grown more than 45x over. Sound exciting? Damn right it does. You’ll notice a few things:
Time is the magic ingredient. Compound interest starts off slow and unsexy, but by Year 40 that original $10,000 generates over $41,000 in a single year!
Winners start early. Because time is so important to harnessing the power of compound interest, the earlier you start, the more heavy lifting it can do for you.
Before we all get too excited, though, there are a few important things to be aware of:
Inflation. The calculations above don’t take account of inflation. You may have 45x the nominal value of your starting sum, but that doesn’t mean it’s worth 45x that sum in today’s money. Generally speaking, we’d expect everything to be much more expensive in 40 years’ time, so your money won’t go as far. Accounting for inflation, the S&P 500 has returned around 7% per year. At 7%, $10,000 in todays money would become $149,745. Still not shabby!
Returns. The 10% figure is based on historical returns. However, it’s very debateable whether or not similar returns are likely for the next 100 years. The return you get will affect the final outcome massively.
Volatility. Returns are not consistent in real life. This massively affects the final outcome. Take this example. Two annual returns of 10% each make for an average annual return of 10%. So does -10%/+30% or -20%/+40%. Should end up with the same result then…nope!:
$10,000 -> +10% = $11,000 -> +10% = $12,100
$10,000 -> -10% = $9,000 -> +30% = $11,700
$10,000 -> -20% = $8,000 -> +40% = $11,200
The long and short of it is that we can’t go too crazy with our figues, but still let’s be honest – compound interest is a powerful tool towards Financial Independence. If you’re a young reader, especially, time is on your side. Get that snowball rolling and it just might surprise you. And even if you’re a little older, don’t worry. This can still help you. After all:
The best time to plant a tree was 20 years ago. The second best time is now. – Chinese Proverb
What’s the most powerful financial concept you know? Do you like to crunch the numbers or play everything by ear?