Saving is rather like trying to lose weight; it takes effort and willpower, and is entirely up to you. People often ask me how much of their annual income they should save. I tell them 30%, and then they will be fine in those latter years and will have a little extra for unexpected expenses. The response is invariably “that’s impossible”. I remind them that saving is about adjusting lifestyle now so that you are not forced to do so at some time in the future.
When investing, rather like losing weight, there is a simple set of rules that will work over time; or there is the typical approach of chasing the next exciting fad or fashion and chopping and changing from one investment to another, and the outcome will be arbitrary.
A simple set of rules for investing is to ask three questions about the potential investment, and if the answer to any one of them is “no”, then don’t do it. These questions can be equated to the salary or income that you live off, bearing in mind that someday the income from your investments will fund your lifestyle.
1. Is this investment likely to pay me income every year? In the future you will need to live off this income so it’s useful to know how much the investment is producing now.
2. Is this income payment likely to be the same or ideally increasing every year? Again to live off this income it should ideally be keeping up with inflation.
3. Is the income yield high enough? When investing money, you are essentially buying an income stream, ideally growing into perpetuity. The key is not to pay too much for the income stream. An acceptable income yield usually relates to the rate at which you expect the income to grow.
If you follow these simple rules, there will be no surprises and your investment outcome will be predictable.
You should have a purpose or objective when investing. This objective must be measurable in order to monitor progress, which is usually referred to as a benchmark. All too often an investor’s objective is superior returns, to outperform a benchmark like an index, or to be in the best performing unit trust. The expectation from superior returns is that “I will be alright in my retirement years”. All too often this is not the case; not enough has been saved. This suggests that the original objective and benchmark was not appropriate.
A useful objective when investing is to ensure that the income produced by your investments at a chosen date in the future will be able to fund your lifestyle. The benchmark would be the cost of your lifestyle. In summary, saving is about adjusting your lifestyle now so that you are not forced to do so in the future, and investing is about ensuring that your investments produce enough income to fund your lifestyle in the future.
There are two obvious realities. The first is that your future lifestyle will need funding. Very few people work until they drop. The second is determining exactly how you are going to do this. Don’t fall into the typical traps of optimism and denial; knowing that you are not saving enough, but hoping that the markets will miraculously produce returns that will resolve this, or of course, what so many people do, merely ignore the problem.
Investment planning can be reduced to two words – income replacement. Wouldn’t it be ideal to reach age sixty and know that your investments are producing enough income to fund your lifestyle? This doesn’t mean you have to stop work, it simply means that you have choice, and will not be plagued by financial anxiety. This is an absolute mind-set where your objective is an investment portfolio that produces enough income to fund the cost of your lifestyle. It’s about you and you alone, and has no bearing on the lifestyle of others.
If you choose investments in companies that produce reliable growing income, then it is relatively easy to arithmetically determine how much income you will earn from those investments at a point in the future. Adjusting for inflation enables you to compare the future level of your investment income with the cost of your lifestyle now. Knowing this will enable you to adjust your lifestyle now, save more, and ensure that you are able to fund your latter years with the income from your investment portfolio. Surely that’s a sensible objective measured against an appropriate benchmark, the cost of your lifestyle.
By Simon Pearce CEO Marriott Asset Management