Invest for Security and Growth
Only once you have control of your cash-flow, insurances and control of your debts, which will be shrinking, can you think about what to do with your growing nest egg. The answer is to invest for security and growth.
One Month Emergency
From your 10% pay-yourself-first-money, find a decent high interest savings account and save up 1 month’s expenses. Once you have achieved the amount leave it in there and forget all about it. Only, (I repeat) only ever touch this if there is an emergency (boiler breaks down, roof leaks, medical care etc).
3-12 Month Contingency Fund
Once you have your emergency fund, then work out 3-12 month’s worth of expenses. Use the 10% pay-yourself-first-money to start putting the excess into a second high interest account. This account could be one with a notice period; It will offer higher interest in exchange for not being able to gain instant access to it. This money should only ever be touched if you lose your job and should cover you before any Income Protection Policy kicks in.
Invest for Growth
Once your emergency and contingency cash funds are full you can start to look for more ambitious investments. These investments will provide the growth you need to combat the effects of inflation. Yes, there are more risks to your money but you cannot afford to let your money (in real terms) wither away over time. A great way to invest is to use your regular 10% pay-yourself-first-money to buy Managed Funds. Managed funds can invest in Bonds, Stocks and Shares. There are thousands on the market and can be equity funds, Index trackers, Investment Trusts. The reason I suggest buying these is because of the phenomenon of Pound or Dollar Cost Averaging. It is next to impossible to time the stock market, so this is a way in which you can take advantage of fluctuating prices.
You will be setting up a regular Standing Order, for the same amount every month. The reason for this is that when the stock market or share price goes up you will be buying less ‘units’, but your previously bought shares will be worth more. When the stock market or share price goes down, the units are cheaper so you will be buying more. Instead of trying to time the market you will be, in effect, buying at an average price over the period of your investing. I would also advise that you do set up an automatic payment method, using your 10% Pay-Yourself-First-Money. You should also use a Tax efficient vehicle such as an ISA (UK).
Defined Contribution Pension schemes operate in the exact same way; If you have followed Step 2 Protecting Your Wealth and Income you will have your company pension in place. If your company does not provide one, or you are self-employed, there are Personal Pension schemes that will give you the same tax benefits. Consult your Independent Financial Adviser before investing.
Asset Allocation
As your assets increase in value, your next consideration is Asset Allocation. The theory behind this is that the proportion of your assets should be balanced, specific to your needs. What proportion your assets are in depends on your age and your attitude to risk.
Basically, the younger you are, the longer you have to grow your nest egg. Your focus should therefore be on growing your pot as much as you can. You can afford to allocate more of your assets to higher risk products that have higher returns, as you have longer to recover if and when the markets drop.
As you approach the age at which you will need to draw off your investments you will probably have a lot more to lose, so your focus should be on more secure investments. The three major assets classes are Cash, Bonds and Equity.
These examples are purely for illustration:
Under 45 age Cash – 30%, Bonds – 35%, Equity – 35%
Over 55 age Cash – 60%, Bonds – 15%, Equity – 15%
Cash
This is the safest asset but has the lowest return. Interest rates are currently very low and do not even keep pace with inflation. However your money is virtually safe; even in this day and age of financial chaos banks very rarely go bust. (They tend to get bailed out by Governments – another story for another book!). In the UK your cash deposit is also protected up to £85,000, at the time of writing.
Bonds
Bonds can be Government Bonds or Corporate Bonds. You are in effect lending money to the Government or Company and they in turn pay you interest in the form of a dividend at the end of the investment. These are also relatively safer investments. They are however long term and the returns are currently low.
Equity (Stocks and Shares)
These are the highest risk category of the three, but over the longer term, can give the highest returns.
So now you have an automatic system for investing your 10% Pay-Yourself-First-Money. Now it’s time to think about accelerating your push for Financial Independence, by increasing your income. The quickest way to get some more money is to sell your unwanted stuff. This will be the subject of our next chapter.