Saving money and investing it somewhere is more important to becoming financially independent than having the perfect investment strategy.
Investing is still important, but increasing the amount of your income which you keep is going to make the biggest difference to your financial independence.
Increasing your savings from £100 a month to £150 a month will increase your pot a lot more than getting a 7% return instead of a 4% return in the first 10 years.
Saving money? But isn’t investing the most important thing?!
Cash is a terrible asset in 2021. If you remember from my post on best emergency fund savings accounts, you’re doing well to get 0.5% nominal interest, which is a negative 1.5% real return against the UK’s target rate of inflation. So, not cool.
The only real way to beat inflation in 2021 is to put your money to work. You pretty much need to invest. But, investing is scary.
I take lots of risks with my investments to boost my returns, but I’ve had a 30% investment balance drop happen to me and it turned out I was quite comfortable with it. Just because I’ve done something, doesn’t mean that you should!
If stock market doom would terrify you, you could always invest in bonds as well as shares to reduce your risk and give you some peace of mind. I don’t rate bonds, but I guess for cautious investors they have their place.
The important point I want to make in this post is that you don’t have to be a super-high-risk mega-investor to achieve financial independence. It doesn’t work that way. Fortunately, if you’re just disciplined with your money and commit to paying yourself first, you’re just as likely to succeed in your financial independence campaign as a high-risk investor who has the expensive tastes.
Saving money, spending money and savings rate
I’ve written before about why a penny saved is better than a penny earned. If you’re short on time, I’d recommend reading at least the summary table at the end of that post to see how saving a penny each week and investing it makes a big difference to your wealth.
The important point is that consistently saving a bit of your income allows you to drop your budget, lower your target amount that you need to live on your assets forever (i.e. retire) and means that you can put more money into the asset pot – i.e. that bit you’ve just saved.
I’d like to say that this idea was entirely mine, but it isn’t. I mean, it’s completely logical, but I believe that Mr Money Moustache inspired me on this one. He’s a Canadian-born US financial independence blogger of significant fame, but a lot of his assumptions kind of work here in the UK too.
Savings rate
A lot of financial independence bloggers will talk about something called savings rate. That’s basically the percentage of your pay that you don’t spend each month and that – instead – buys assets and so on.
If you look at the Mr Money Moustache post on it, his assessment is that if you want to retire in 10 years in the lifestyle that you’re in, you need to be saving a little over 64% of your take-home pay.
Remember though: this is take home pay (net pay). If you’re earning £30,000 per year, your take home pay (assuming no student loans) is £24,064. That’s without pension contributions, too. If you want to check out your take-home pay, there’s an awesome tool on Money Saving Expert that allows you to calculate where your pay goes before you get it.
On no, I’ll never achieve that!
Before you panic and despair about your savings rates, there are a couple of things that you should consider as a UK financial independence campaigner that give us a big advantage compared to our US peers:
- Employers pay into pensions, and we don’t pay tax on our pension contributions. That 3% gross boost from your employer? That counts towards your savings rate. Also, when you pay into a SIPP, the UK government refunds the 25% (or 40%) tax back – so that £100 you pay in is actually £125 (or £140). If you pay into your workplace pension using salary sacrifice as a basic rate taxpayer, you get £100 of investments but it only costs you £68.
- ISAs are tax protected. When we sell ETFs for profit later, long after we’re financially independent, we don’t pay capital gains tax. If we switch to a dividend and income portfolio, that income tax free. Nice!
For homeowners, there’s also the possibility of downsizing your home later. We’re toying with the idea of selling our house entirely to run away to sea on a liveaboard boat, but you don’t need to be as extreme. Simply moving to a cheaper area or going from a 4-bed to a 2-bed home when the kids have moved out might be enough for you to hit financial independence sooner than you’d think, turning those mortgage payments into savings for that dream life.
Sale of primary residences is also capital gains tax exempt in the UK.
Spending money
One other thing: your life might actually get cheaper when you achieve financial independence.
This is an idea I lovingly stole from Vicki Robin’s book: Your Money or Your Life. Ask yourself: will you really need a car when you’re no longer commuting to work, if you can just rent one when needed? Maybe, maybe not – but you won’t need two.
Are you really going to buy work clothes if you don’t work?
How often are you likely to buy a coffee from Costabucks when you can get all the sleep you need?
You might find (as I have) that your cost of living drops when you don’t need to work for money unless you really want to.
Objection! I don’t want to live like a pauper!
Usually at this point in any conversation about financial independence, someone in the room starts making comments about not wanting to waste their lives being poor.
That’s part of the reason why I put my ideas down in a blog: people really don’t want to hear that there’s an alternative to working for the man until you snuff it. It’s like financial independence is an affront to all that they hold dear. Here’s a post from the centre-right journal The Spectator that tells me I should be miserable doing what I’m doing. [I’m not, thank you very much!]
You don’t have to live on rice and beans forever in an unlit hole in the ground. That would be depressing. There’s definitely a balance to be had between super-saving and just being smart with your money. The point is that you should get rid of stuff that doesn’t actually make you any happier and save money that way, or optimise what you decide to spend.
There’s a really good academic article by Dunn, Gilbert and Wilson (2011) called If Money Doesn’t Make You Happy, Then You Probably Aren’t Spending It Right. The authors summarise a lot of academic research that I’ll cover in a separate post, but the key bit for this post on savings is that spending lots of money on expensive stuff won’t make you any happier than cheaper things that you also enjoy.
If we follow this logic (and the extensive research that they reference), we can still be happy by switching out owning fast cars and going on luxury spa breaks for bike rides around the New Forest and a nice bubble bath with wine and choccy. We won’t be any less happy for having cheaper hobbies, but we’ll definitely save more money and achieve financial independence a lot faster!
I’ve written a post on a similar theme about how we became accidental minimalists, if you’re interested.
A perfect investment plan vs. a “good enough” investment plan
I’m a big fan of diversification across asset classes, within asset classes and across geographies. It’s important to me that I generally make returns on my assets and that I don’t lose too much.
Although I have in the past invested in startups which might all return nothing, I haven’t gone all-in on a single high-risk asset class and I expect some solid returns to counteract significant losses. I’m trying for quite a short financial independence timeline until I hit CoastFI, so I’ve taken risks that may or may not play out so that I can achieve the timeline.
If you’re flexible on timings or can wait a bit longer, you don’t need to take the same risks!
An all-equity global portfolio might net you a nominal return of 9% averaged annually over 10 years. If you account for inflation, that might be a 7% real return on your money – so far, so good.
A lower-risk portfolio with a bigger weighting in gilts/ bonds might only get a nominal return of 6% averaged annually over 10 years, with a 4% estimated real return annually. Clearly, that’s lower, but how bad is it?
Crunching the numbers
Below is a cheeky table to compare some real rates of return over 10 and 20 years. I haven’t put in 30 years, because in my case I’d basically have missed an “early” CoastFI window and might as well have just put more into pensions and spent the rest of my money like a normal person.
| Portfolio scenario | Value in 10 years | Value in 20 years |
|---|---|---|
| £1,000 averaging 7% annual real return | £1,967 | £3,870 |
| £1,000 averaging 6% annual real return | £1,791 | £3,207 |
| £1,000 averaging 5% annual real return | £1,629 | £2,653 |
| £1,000 averaging 4% annual real return | £1,480 | £2,191 |
| £1,000 averaging 3% annual real return | £1,343 | £1,806 |
| £1,000 averaging 2% annual real return | £1,219 | £1,486 |
| £1,000 averaging 1% annual real return | £1,105 | £1,220 |
| £1,000 in cash savings at 0.5% nominal interest | £860 | £739 |
Nice numbers, but what does this all mean?!
OK, so we can clearly see that over 20 years a 7% real return is going to beat the snot out of a 4% real return.
Suprises = zero.
We can also see that not making a real return is pretty much catastrophic and it’s a really good argument for not leaving your money in a savings account. If you’re not investing in at least something, you’re playing the game of life on the insanity difficulty setting and you really don’t need to.
What’s important though is that an imperfect portfolio that only gets 4% return isn’t twice as bad over 20 years as the dream scenario of 7% real return. Over 30 years, different story – but in the short term, a more conservative portfolio balance or one that you just “like” isn’t necessarily going to scupper your chances of financial independence, you’ll just need to put more in.
There’s an argument that following COVID, returns may be a lot lower. This makes the savings rate increasingly important.
That’s where savings rates come back out to play.
Saving money and making money is a better use of your time than picking the perfect portfolio
Here’s the killer bit that’s going to earn me howls of abuse from financial independence afficionados: you’re better off increasing your savings rate than fretting about having the optimum portfolio balance.
Don’t get me wrong: having a good bunch of assets to grow your wealth is important. You should definitely pick a good mix of assets to grow your money. You should expect a decent real return from your assets and you shouldn’t start stashing your cash under the mattress and praying.
What you shouldn’t do though is try to over-optimise a portfolio to squeeze out that last 0.5%.
Sure, 1% difference will clearly be noticeable over 20 or more years – look at the table and tell me otherwise – but it’s not going to be the deciding factor between you achieving financial independence and never being financially free.
The key thing is that you need to put as much as you can in the assets pot first, then consider optimising. It’s about priorities.
How much does saving money compensate for a weaker portfolio?
I’ve taken the data from the table earlier and worked out how much extra cash you’d need in the pot at the start of the time period to compensate for poorer performance. The base case is our 7% real return, and all the others are based on that.
| Portfolio growth | How much you need at the start to match 7% in 10 years (£1,967) | How much you need at the start to match 7% in 20 years (£3,870) |
|---|---|---|
| 7% annual return | £1,000 | £1,000 |
| 6% annual return | £1,099 | £1,207 |
| 5% annual return | £1,208 | £1,459 |
| 4% annual return | £1,329 | £1,766 |
| 3% annual return | £1,464 | £2,143 |
| 2% annual return | £1,614 | £2,605 |
| 1% annual return | £1,781 | £3,172 |
| Cash savings at 0.5% nominal annual interest | £2,288 | £5,236 |
These numbers look big. Maths is scary! However, if you remember back to why a penny saved is better than a penny earned, you’ll happily note that we can also reduce out financial independence target number by a factor of 25 times the value of the saving.
So, if we save £10 extra per year, we can knock £250 from our target.
Saving money is disproportionately weighted in financial independence planning.
What this means is that for every £10 per £1,000 you save – i.e. 1% increase in savings you make from your budget and therefore financial independence number – you can afford your portfolio to have a 1% smaller returns over 20 years.
But… what do we do with this information?!
This is huge news. It means that there is an absolute priority order for how you should approach your financial independence campaign:
- Make a budget.
- Cut out the stuff that’s just unnecessary.
- Optimise your expenses to save money on stuff that you have to buy (as opposed to stuff that genuinely matters to you).
- Invest as soon as you can into a reasonable portfolio – not necessarily “the best” portfolio.
- Re-optimise targets, savings and budgets as you adapt to your new strategy.
- Optimise your portfolio of assets.
How I’m using this in my financial independence campaign
To start with, I used a robo-investor while I got to grips with how I was going to approach my financial independence campaign. I have since transferred it to suit myself, but the numbers suggest that there’s absolutely nothing wrong with a robo-investor that gives you decent enough returns. You don’t need to worry about optimising fees until you have made saving money your best talent.
Working through this has also taught me that the measures like giving up the car and eating a few veggie meals has given me a huge advantage in my financial independence campaign. The cost savings, funnelled back into assets, is going to make this process significantly easier. I’m not any less happy for it, either.
Finally, I’ll admit to overpaying our mortgage a bit instead of being a hardcore all-in-ETFs financial independence investor.
Our interest rate is over 2% (might be 2.38% off the top of my head), and I had initially been discouraged by having discovered investing after we’d started overpaying, but I now know that the £200-ish we’d cut from our spending to overpay the debt isn’t actually too bad: we’ve learned to live on less, reduced our target number and we’re still getting a (slightly) positive real return. We’re planning to stop overpaying soon anyway but it’s good to know that the savings were more important than the missed opportunity for the last 4 years.
We’re also talking about downsizing or – radically – moving onto a boat in the future, which means that we’ll actually benefit from the capital growth in the house. This also means that our overpayments on the mortgage and possibly even the capital payments themselves are part of our savings rate.
