Should you ever use a financial advisor?

financial advisor behind a computer

There’s a lot of criticism in the FIRE community when it comes to taking advice from financial advisors. I’m here to address the main concerns:

1) Financial advisors will still get paid even if your portfolio loses money. They don’t care about what investment performance is achieved.

Wrong. Of course, financial advisors care about their clients and their wellbeing. Advising clients is a long term business and not about shafting somebody to make a quick buck.

Yes, most advisors charge say 0.5%-1% to manage a client’s portfolio. Yes, that ongoing adviser charge is payable even when your portfolio has lost money. However, if financial advisors lose money in your portfolio, it doesn’t mean they haven’t done their job to justify their ongoing advisor fees. Quite often, the portfolio an advisor looks after suffers significantly smaller losses than a portfolio picked by clients themselves. I’ve seen it many times myself as clients like to have the majority of their wealth managed by professionals but leave a small pot of “play money”, which is typically invested in the latest hottest stocks with very little diversification.

The “play money” can go through wild swings and at times look like a fantastic investment in comparison to the advised portfolio. However, we’re not comparing apples with apples here if the advised portfolio is significantly less risky (has less in equities) and the “play money” pot is 100% invested in shares.

Advisors are interested in growing their client’s portfolio because if the portfolio grows, so will their fees because their 0.5%-1% fee is applied to a bigger portfolio.

Competition is another driver which necessitates the requirement to grow a portfolio. There are many attempts by competitors to steal a client’s portfolio. Somebody might offer a better track record or lower charges, or an improved service when looking at the client’s monies. Clients also speak with friends and family and can be influenced by them when moving monies around. Advisors know this and that’s why they do what they can to grow clients’ assets and keep them happy.

2) “I can do it myself. I am better off keeping my costs low and as an advisor is an additional expense, I should avoid it.

Do you do your own plumbing? What about your accounting? Do you know how to fix your car’s engine? Would you extract your partner’s wisdom teeth?

It’s hard to know everything and there’s a reason we have specialisms out there. They all charge a fee for their service – why should you not want to pay for a service you receive from an advisor? If you don’t want the service, you don’t have to sign up to it.

computer screen with market charts

The fact is most people know nothing about investing and the financial markets. They would much rather have somebody else look at their portfolio than deal with it themselves. If you are a busy entrepreneur or a mother of three young children, you don’t have the time, inclination or interest to research the ins and outs of building an investment portfolio – you just want it to be sorted and not worry about it. Financial advisor help with that.

A financial advisor is also your investment coach. Every time there is a wobble in the stock market, they get a massive increase in calls from scared clients. People call their advisors and ask what’s being done to prevent losses or demand that everything is sold to cash right this very instant as it’s their expletive money! Selling during a market correction is, of course, a very bad idea as people would unlikely be able to benefit from a market recovery. Often sellers would lock in a permanent loss of capital, miss a big part of the recovery and get back in at higher prices. An advisor would explain this to a client and advise them to stay cool and carry on. Ask yourself, is it worth paying somebody 1% a year and risk missing out on 10%-20% of investment gains because you felt better staying in cash? I’ve seen clients who gave up on the stock market after the 2008 crash and have held nothing but cash since – a good advisor would have helped them achieve much better returns than cash ever could.

If you know how to invest and are comfortable making investment decisions, then more power to you. You do not need an advisor to look after your portfolio. However, there are other things you might be able to benefit from such as tax planning, estate planning and protection (insurance) planning. For example, do you know what’s going to happen to your FIRE strategy and your family if you’re unable to work due to a serious illness (cancer or heart attack) or your partner dies? Do you have a will, if not, do you know what will happen with your money on your death? Do you know what a lasting power of attorney is? Do you know how much inheritance tax your family will pay when you’re gone? Should you take all of your pension tax-free cash now in one go or in stages? What should you do with the £321,472.89 transfer value of your defined benefit pension? Oh, you’re divorcing – do you think lawyers and judges have a good understanding of financial assets to ensure how to split the marital assets in a fair way? Do you think you need advice?

investment growth on a screen

3) Many people think that an advisor just invests your money.

Financial advisors do a lot more than just invest client’s money. They work out the best way to reduce taxes by using different tax allowances, tax exemptions and make changes when the regulatory environment changes.

The best examples are in the pensions world. There have been massive changes in the UK pension legislation and these can have a huge impact on somebody’s finances. For example, not having your children nominated as death beneficiaries on a pension could mean that a big tax charge is payable when your children inherit the pension. No, this is not an inheritance tax charge, it’s income tax. If you die after age 75 (and most people will) with monies in your pension and your child (or any other pension beneficiary) takes the inherited pension money as a lump sum paid into their bank account, it would be fully taxed as income. How would you feel if you inherited a £500K pension and had to pay £200K+ to the taxman? You could have kept it all in an inherited pension account, if you had used a good financial advisor. This isn’t common knowledge and the average person on the street has no idea how these things work. Would you be OK paying somebody a relatively small fee to avoid paying many thousands of tax down the road?

Advisors add value, just like a dentist, a mechanic or school teacher. If they didn’t, they would be, quite rightly, out of business.

4) Advisors are all a bunch of sleazy salesmen.

Yes, financial advisors sell products but their main value is in providing the service of financial advice and they charge for it. It used to be the Wild Wild West in the UK as anybody could call themselves a financial advisor and start flogging financial products, which paid them the biggest commission. This is no longer possible. Commission payments have been largely outlawed (only possible with insurance products) by the regulators. Client protections have been improved and advisors can be held responsible for mis-selling any products.

The main thing advisors sell is advice – the products are just a tool to achieve the clients’ objectives. It’s common to agree on the fees with clients in advance so that they know what becomes payable and when. There’s no smoke and mirrors anymore. Charging has become much more transparent and people know where their fees go.

A good advisor will not sell you something you don’t need.

The first meeting with an advisor is almost always free of charge or at the advisor’s cost. It’s an opportunity to discuss your situation with the advisor to see if there are any opportunities to start a mutually beneficial relationship. The advisor won’t give you any advice in that meeting but it might be worth having a discussion to see if there’s something obvious you should be doing. This could be as simple as checking with your employer if you’re maximising your pension contribution matching arrangement.

Summary

People need advice. I think they will make significantly better decisions if they take advice from financial advisors. Even if you don’t value their investment advice, there is so much more you can benefit from using an advisor. As mentioned above, the first meeting (often) doesn’t cost anything and if you don’t like what they have to offer don’t go ahead with it. Shop around. You can always disagree or ignore advisors and continue going your own way.

When you think about it, among other things, financial advisors help people retire and pull the trigger to stop working, which is exactly what FIRE does. Maybe they’re not so bad after all.

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How to build a strong foundation for financial independence when you’re at the beginning of your career?

The maths of financial independence is simple: build a portfolio of 25x of your annual expenditure and you’re done. So, if you spend £20,000 p.a. then you will need a nest egg of £500,000 in an investment portfolio. Each £1 of annual expenditure increases the size of your retirement portfolio by £25 – this makes it important to know what your expenditure is.

Here’s what I would tell myself if I was 10 years younger (i.e. 22) and just starting out:

1) Earn more money

FIRE is definitely easier to achieve for people who are on higher incomes than it is for minimum wage workers. That’s how the world works. However, financial independence can be achieved on all incomes.

Your first job is likely to pay low wages. Your focus needs to be on improving your career prospects – as this will lead to the biggest return on investment you could make. Forget investing in the stock market, forget bitcoin, forget P2P. You need to earn more and you need to aim high!

Your best investment to make is in your education and skills, skills, skills. You need to develop skills, which can increase your salary. This might mean taking industry exams and passing additional professional qualifications. You should be happy to pay for these qualifications/exams/study-materials etc as they will have a direct impact on your income. I think the future is bright for anything to do with technology, programming and AI – you might want to consider to reinvent yourself and change careers completely.

About 6 years ago, when I came to the UK, I had zero industry knowledge or qualifications in the financial planning sector. I started as a receptionist in a small Independent Financial Advisor (IFA) office and was earning circa £15,000 p.a. After investing c£2,000 on exams to acquire new qualifications and a job change I was making £30,000 p.a. two years later.

It cost me £2,000 to increase my salary by £15,000. That is a fantastic return on investment! You can’t expect that from the stock market. I didn’t stop there as I aimed higher and have managed to substantially increase my salary over the next couple of years to just over £50,000 p.a. This, in Central London, is relatively comfortable but far from luxurious.

You can do it too. In fact, you can do far better than me as I feel that after hitting my £50K salary I’ve become complacent and stopped learning and hustling – I’ve only taken two exams in the last three years and failed both.

It makes sense to allow an amount for education and skill development in your monthly budget. It could be £50 or £100 per month set aside for online courses, learning to program or to host impactful PowerPoint presentations etc – the world is your oyster.

Also, think about joining clubs that can help you develop professional skills – this could potentially be the cheapest option to start with.

woman with shopping bags

2) Don’t overspend

The biggest thing you can do is fight lifestyle inflation. Avoid the temptation to increase your spending every time you get a raise or a bonus. Fight the temptation for as long as you can. You should aim to spend the same amount as you always have. You don’t need to buy expensive junk, clothes or toys. Try the supermarket branded items and see if they taste any different from the more expensive alternatives. Stop buying expensive clothes when there are budget options.

people on a crowded train

Transportation is insanely expensive in the UK and you need to minimize these costs. I have colleagues who pay £5,000 p.a. for the privilege of riding a crowded train for an hour twice a day to get to work and back home. Not only are they £5,000 out of pocket but they also spend circa 8.8 hours a week commuting (254 working days p.a. minus 25 days of annual leave means 229 working days where people commute for 2 hours – 2 x 229 = 458 hours p.a. = 8.8 hours p.w.). That time and money could be used in a way to obtain further skills and knowledge, which could massively increase earning prospects.

Depending on your job, you could look into how many days per week you could work remotely from home. You should also consider walking or cycling to work as these are the cheapest ways to get around. I’ve been walking to work for the majority of the last 6 years. I used to drive a lot when I was backpacking in Australia. Since 2014 I’ve driven exactly on two occasions. Now I am somewhat scared of getting behind the wheel as it’s been so long.

Don’t spend too much on haircuts. I have a friend who went to get a haircut in a fancy part of London. They made him comfortable, offered coffee and snacks and cut his hair. Then they billed him £120. Wowzer! He never went back to that salon.

The most I’ve ever paid for a haircut is £35, which is mad when I think about it. Now I get it cut for £10 and it looks exactly the same.

There are many other areas where you can reduce your costs. You get the point – don’t spend more than you need to. However, don’t forget to enjoy your life and your youth – you will never get it back. You are allowed to treat yourself. Invest in experiences!

I mean I backpacked in Australia. It was a horrendous decision financially, but a fantastic one in terms of experiences, stories and adventures. Go have some fun!

two people cooking

3) Learn to cook

I challenge you to buy a cookbook and make every single recipe in it. What do you have to lose? You will learn to make (hopefully) tasty food and get to eat it. It’s also a great project you could do with your partner or housemates. Some recipes will turn out great, others will be a disaster, however, you will improve with time. You will also discover a few things which work for you and will continue to make the dishes over and over again. I am no master chef, but I am able to make the world’s best waffles, pancakes and tofu nuggets.

Cooking at home is much cheaper than eating out at cafes/restaurants and you will be able to take lunch to work. These savings will add up.

4) Avoid bad debt

There’s good debt and there’s bad debt. An example of good debt is a mortgage for your home or a loan to expand business operations. Bad debt includes credit card debt, hire purchase agreements and payday loans.

Student debt can end up in either category – you need to weigh up the cost of a university degree with the future employment prospects. For example, I think it’s OK to spend say £30K on a degree and fund it with loans if you can realistically earn £50K+ p.a. a few years from graduating. Don’t spend big money on a Mickey Mouse degree. Racking up a load of debt and not having a viable career is a sure way to the poorhouse.

I’m fortunate that I don’t have any debt and didn’t have to pay any tuition fees at university (I had to keep my grades above a certain threshold to qualify for “free” education). In all fairness, I don’t think I have ever needed to use my academic degree knowledge at work… five years of study and two degrees which I didn’t care for. I’m glad it didn’t cost me any money but I will never get my five years of youth back.

piggybank

5) Save your money

Now that you’re earning nicely and have more coming in than going out each month, you can start to save some money. First of all, you need to build up an emergency fund of at least 3 months’ worth of living expenditure. Then build up a cash reserve for upcoming big-ticket items. I have linked to my previous posts about these two topics.

Set up standing orders to automatically transfer money into your savings on a recurring schedule. Many finance gurus call this paying yourself first. You will quickly get used to living on what remains in your bank account. This will help you stay on track and keep saving on auto-pilot.

6) Start investing

Albert Einstein reportedly said “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Investing is all about compound investment growth i.e. growth on previously achieved growth and repeat.

Saving is a long term game. It’s a marathon, not a sprint. The younger you are when you start investing the more years of compound growth you achieve. I wish I started investing earlier – I would be in a much better position financially. Circa ten years ago was when we got out of the previous financial crisis and it would have been such a good time to start my investment journey.

Consider investing in passive index funds (trackers) to keep your costs low. Don’t do anything fancier than that, unless you have too much money. Stay away from stock options, futures contracts, CFDs etc. It’s possible to trade anything successfully, but if you’re just starting out, do not attempt trading anything other than passive index funds. Keep learning and reading about investing – things will get easier.

As always, this article is not financial advice. Your capital is at risk when you make investments – you can end up with less than you started with. Seek financial advice if you don’t know what to do in your circumstances.

Now go get cracking!

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Let’s put the 4% safe withdrawal rate to the test

I’m sure you have all heard about the 4% rule. This is something which always comes up in FIRE blogs. So naturally, I will discuss it a little bit as well.

The 4% rule refers to the amount (plus annual inflation) you can safely withdraw from your investment portfolio without ever running out of money. This figure is from a famous financial study by William Bengen. It’s best to explain the 4% concept with an example. Let’s say you need to safely withdraw £20,000 from your portfolio to cover your annual living expenditure. Based on the Bengen 4% rule, you need a portfolio of £500,000 (£20,000 / 4% or £20,000 x 25) to do so to avoid running out of money in your lifetime (although the study only looked at 30 years of making these withdrawals if I remember correctly but you could be relying on these withdrawals for much longer). This is why they say that once you have saved up a 25 X multiple of your annual expenditure, then you’re done – you have achieved FIRE.

I think it would be interesting to look at the 4% rule in practice and do a little backtest. Let’s say we start with a portfolio of £500,000 fully invested in the S&P 500 in January 1985. Please note a bit less than 3 years later the market crashed by circa 21% (in October 1987).

Let’s assume that we withdraw £5,000 each quarter plus inflation (this works out to be £20,000 p.a. i.e. 4% from the starting figure of £500,000). What would that actually look like over the following 35 years?

The following chart shows the impact of these withdrawals:

As you can see the chart continues to increase in value over time even though we are withdrawing at least £20,000 each and every year. It’s not the smoothest ride out there but the initial £500,000 becomes circa £4.25m by the end of the backtest (this is in inflation-adjusted terms). Therefore, we keep getting richer over time. The worst year for this strategy was a 37% loss and worst drawdown was 51%. However, overall we got a fantastic result and this should give you a massive confidence boost when it comes to the 4% rule.

S&P 500 backtest with 4% withdrawal rule

I deliberately kept the backtest very simple. We were always fully invested in the S&P 500 without any allocation to any other asset classes (no fixed interest, or gold or emerging markets etc). If I was at work, I’d call that a very aggressive investment portfolio, which is not for the fainthearted… but why make it more complicated? Why mess with it if it works?

The problem is that people find it difficult to stay invested when their portfolio loses 20%, 30% or 50%. How much can your portfolio go down in value until you say that it doesn’t work any longer? The pain can get so bad, that investors sell at or close to the bottom and miss out on the recovery because they have lost faith in the stock market. Sometimes the best thing (and also the hardest thing) to do is to sit on your hands and do exactly nothing. There’s no need to check the value of your portfolio every single day or even multiple times a day as I used to do. Now I aim to only look at my monies once a month – I’ve only succeeded in a handful of months so far but I’m still learning…

The main thing to remember is to stick to your plan. In the example portfolio above, the plan was very simple: stay invested for the rest of your life and make no further investment decisions and only withdraw £5,000 plus inflation each quarter. This would have worked so well if you were able to actually implement the simple plan or strategy as intended.

You can always choose to make life more complicated and aim to reduce the ups and downs (i.e. the volatility) in your portfolio. Let’s now test a 60% shares (S&P 500) and 40% fixed interest (bonds) portfolio where we rebalance the allocation annually. Again, we start with £500,000 and withdraw £5,000 each quarter. This is what the 60:40 portfolio (red line) would look like compared to having it all invested in shares (blue line). Please note, the charts start from January 1987 (not January 1985).

S&P 500 VS 60:40 portfolio with 4% withdrawal rule

You can see that the 60:40 portfolio ends up with circa £1.5 million in today’s money. We were able to maintain the quarterly withdrawals of £5,000 plus inflation and continued to increase our wealth. The ride was much smoother this time around as the maximum drawdown was 31% and the worst year lost 20% – this makes it much more palatable to continue staying on course and sticking to the plan. However, we ended up with less at the end of the test compared to the strategy where we were fully invested in the S&P 500 (blue line).

You can argue this both ways. You could say that it should only matter what you end up with i.e. try to maximise how much you have at the very end. Alternatively, you can argue that it’s absolutely pointless to invest in a strategy, which could be the best over the long term but is not one an investor could actually follow as the ups and downs are far too scary – imagine going from £2m all the way down to £1 million in less than a year and continue to keep a smile on your face. It’s difficult, very very difficult.

The major caveat with all of the above is, of course, that past performance is not an indicator of future returns. You can end up with less than what you started with. This post should not be treated as a source of financial advice.

It doesn’t matter whether you start with a £500,000 portfolio or £100,000 portfolio. The concept and results remain the same, it’s only the scale of things which changes. The 4% rule has worked really well over the last 30 or so years. The only impact I can think of is the increased performance drag due to transaction costs on the smaller portfolio. Another thing to remember is that taxes were assumed to be zero in my backtest – but this can successfully be engineered in the UK with the use of different tax wrappers (e.g. ISA, GIA, pension, investment bond) and strategic withdrawals where you make use of your available tax allowances (stay tuned for a post on this in the future).

There’s a lot of talk and debate about the safe withdrawal rate being something different in today’s markets because interest rates are low and bond yields have changed etc. The reality is that nobody knows what the future is going to look like. I think 4% is a good starting point and the two tests show that historically things would have been OK. I wish the dataset had more price points and I could extend the backtests maybe to 50 or even 100 years. Even better if I could use the UK stock market in the backtest. Now that would be powerful! However, 30+ years of US market performance data will have to do. If I figure out how to add in the UK stock market I will do a post about it in the future.

The way I see it is that even if the market tanks the day you retire, you have a range of options available to you for extra income. I mean you could go back to work, do a side-hustle or move to a lower cost-of-living area. There’s plenty you can do to survive the tough times. On a similar note, I remember reading the Escape Artist’s excellent blog post about going into Monk Mode where he discussed the benefits of doing so. Go check it out! His blog is pretty good.

As is often the case, it doesn’t need to be all or nothing. You could decide to be an aggressive investor until say age 55 and then move on to the 60:40 strategy. This approach could provide you with more investment growth during the years when you still have potential to earn a salary (in case markets tank and things get scary) and reduce the volatility in your later years so that you can have more peace of mind. This is something I’m thinking about doing. I’m happy to take investment risk now when I’m young and gainfully employed and then will gradually de-risk my portfolio as I get older and protecting my nest egg becomes more of a priority. By the way this is exactly what “lifestyling” or “target dated” investment funds do – I wouldn’t be surprised if you have these in your work pension today (they are the popular choice for default investments for auto-enrolment pension schemes).

I hope this article has provided you with some food for thought and given some courage to plan for the 4% withdrawals in the future. The stock market might look relatively grim right now but in the long run, it will probably recover. Stay on course and stick to your investment plan. You can do this!

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Everything you need to know about having a short term capital reserve

Now that you know the importance of having an emergency fund, we can move on to talking about your upcoming big-ticket purchases. Remember, you need to have your emergency fund sorted out first!

car keys

Most of us have some kind of an idea of what we want to spend our money on. Every now and then we like to treat ourselves and buy something more expensive – it could be the latest smartphone, a new Vitamix blender or a new car. Other times it could be some repair work on your home or home renovations. These expenses need to be budgeted for and appropriate savings set aside. As mentioned earlier, you should not dip into your emergency fund for this kind of spending money or more formally for this kind of capital expenditure.

I think most people tend to “wing it” when it comes to budgeting. This can work for some but it isn’t always the best route as you might overlook one expense by paying for another one and can run into trouble later. This post will tell you what you need to keep in mind to effectively manage your upcoming big-ticket expenses.

What do you mean by short-term expenditure?
A good rule of thumb is to think ahead of the next 3-5 years and think about what upcoming expenses are on the horizon. Going any longer than that will make your estimates less accurate and therefore less useful. However, we can get a relatively good idea of what the future holds for us in the next few years. This could be an upcoming dream holiday, saving for a mortgage deposit or a new car purchase.

Short term can mean less than 3 years and also for more than 5 years. It depends on what you have planned for the future and where you are in your life. For example, a young couple might be thinking about buying their first home but their parents would be thinking about repairing the roof or building an extension.

How much should you set aside for your short-term capital expenditure?
This is an impossible question to answer as everybody has different upcoming expenses. Simply work out what things will cost over the next couple of years and add it all up. Simples.

Should you borrow?
In short, no. I’m anti-debt, especially against consumer debt. If you need to borrow money to buy a smartphone, then you shouldn’t be buying that smartphone. You can’t afford it. Stay away from debt wherever you can and consider alternatives such as buying second hand or opting for cheaper goods and services.

Where should you keep your short term capital expenditure?
One option would be to simply keep it in cash, similar to your emergency cash. However, the key distinction here is that you know when the big-ticket expense will happen. You also have some control over the expense as you may decide to delay it, bring it forward or cancel altogether.

Because of that added control, you can now think about using safe short term investments for this type of expenditure. If you have a £10,000 expense coming up in one year’s time, then you could put £10,000 into various bank accounts to earn some interest. You can even decide to lock the money away for 6 or 12 months or even longer to earn better interest.

banks

There are many banks and building societies who are more than happy to take your money and pay you a bit of interest. There’s no point in recommending a particular bank’s account as the offers keep changing all the time. Make sure to check a particular account’s terms and conditions as quite often they’re something like “earn 5% interest on up to £2,000 of your savings”. You might need to open a few accounts with several banks to maximise your interest. This is not for everybody – especially not for people who hate opening accounts and can’t be bothered. I know my girlfriend would rather earn zero interest or even pay for the privilege of having her money held in an account if it would prevent her from having to fill in a form which asks for her address details covering at least the last 3 years (speaking from experience here).

person holding coins

I’m sure you’ve noticed that interest rates are very low right now. The Bank of England lowered its interest rate to 0.1% and the Federal Reserve (in the US) lowered it to 0.25% only a few weeks ago. Inflation is at 1.7% and 1.5% in the UK and US respectively right now. You might think that keeping money in cash will guarantee a loss in real terms as you are unlikely to beat inflation with your cash savings. This is very true and I think it’s unlikely to change any time soon. However, this does not mean that they do not have a place.

Investing your money in the markets will introduce risk to your capital and you can end up with less than you started with. This is especially the case over the short term. To be clear, when I say short term I mean anything below 5 years. There will be a post in the future shining some more light on this but the gist of it is that the longer you’re invested the lower the probability of suffering a capital loss. This is because markets have an upward slope as they tend to go up over time.

One option is to consider using a savings platform. These are essentially cash management platforms, where you create one account (a hub account), deposit your money and then select various bank accounts to deposit your money into. The benefit is that you only open one account with the platform and then pick the various bank products you wish to split the money form your main hub account. This removes the need to fill in forms to open new accounts with new banks and building societies. You will also have an easy overview of where all your money is held and how much interest you are earning. Bigger savers will also benefit from added security as UK deposits are FSCS protected up to £85,000 per bank, building society or credit union – you can increase this by spreading your savings over several institutions.

The only downside is that these savings platforms charge for their services. This tends to be 0.25% p.a. or similar on anything held on the platform. So, you should expect to earn slightly lower interest than going directly to the providers with your savings.

Taking the above into account, if you choose to invest some money which you need in say two years’ time, then you might actually end up with less than you have today. There’s no need to risk your hard-earned cash like this.

You can also look at the savings products offered by NS&I for your short term investments. These are backed by the UK government and its printing presses. Therefore, your money will be as safe as the UK government.

To be clear you should not invest money in the stock market where you intend to access it within the next five years. Also, avoid any peer-to-peer (P2P) investments as it can take ages to get your money out of these platforms (speaking from experience).

Interestingly, I heard of a creative/unusual way of earning more interest on your money. This example is from Sweden where the local central bank i.e. Riksbank has kept interest rates at zero or below (yep negative) for the last five years. However, it is possible to overpay your taxes in Sweden and earn a minimum of 0.56% p.a. interest on these payments. This has resulted in massive overpayments and a budget surplus a few years ago. They changed the rules and now Swedes don’t earn any interest on their overpayments and many received refunds.

That example is not an attempt to encourage you to think outside the box to increase your interest. There’s plenty of scams out there. If it sounds too good to be true, then it’s probably a scam. For example, anybody who offers to take your money in exchange for a guaranteed 10% annual return, is full of it. Stay away!

Summary
I hope the above has convinced you to keep your short term capital expenditure in cash or low-risk cash investments. You now understand why it’s important to keep this money separate from your emergency cash and why it should be in safe investments. I have shared some of my ideas on how to invest your short term money and what kind of investments to avoid. Go ahead and check out some of my ideas (Google is your friend).

TLDR
Short-term capital expenditure includes your future big-ticket expenses which will happen within the next 5 years. You have control over this type of expenditure and that’s why you can choose to invest in safe cash investments to cover it (as you will be able to access your money when or before you actually need it).

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You need an emergency fund – this is an emergency!

Why do you even need an emergency cash reserve?
Things will always break down. In fact, some things are designed so that after a certain amount of use they will break down and you need to buy a replacement. Wikipedia defines this as follows: planned obsolescence in industrial design and economics is a policy of planning or designing a product with an artificially limited useful life so that it becomes obsolete (i.e., unfashionable, or no longer functional) after a certain period of time. The rationale behind this strategy is to generate long-term sales volume by reducing the time between repeat purchases (referred to as “shortening the replacement cycle”). It is the deliberate shortening of a lifespan of a product to force consumers to purchase replacements.

tap

Look, your car will malfunction, your boiler will stop working and at some point, you or your partner will lose their job. If you don’t have some cash set aside, then you will have a big problem once something like this happens. These events can be expensive, stressful and a massive pain in the backside.

Fixing your car or replacing your boiler might cost £1,500 and finding a job could mean months of unemployment and many interviews until new gainful employment is found.

Things can get even worse (sorry). In the broken car scenario, you still need to get to work. If you’re unable to get to work, then your earnings are likely to reduce, which creates additional financial hardship. You’re also unable to pick up the kids from school and need to ask a friend or relative for help. You might have to take a taxi or an Uber to work instead and this is a new unwelcome expense.

If your boiler breaks down and you have no warm water, then you can’t enjoy your morning showers any more. Imagine you suddenly had to take cold showers until your next paycheck. I tested having a cold shower the other day and survived, but it was unpleasant. Now, throw in some children into the cold water situation and you will see how important it is to get the boiler fixed as soon as possible.

If something similar has happened to you, then you’ll know that it’s difficult to go on with your life as you normally would if you don’t have any cash set aside for the what-ifs of life. Having a pot of money tucked away for emergencies provides you with additional peace of mind knowing that you will be financially OK if something were to break down or you lost your job or something similar.

There are other benefits – for example, having set aside 6-12 months’ worth of your normal expenditure, will provide you with a “financial runway”. You will feel more at ease if you hear rumours that they might start making people redundant at work. Having some savings set aside might also give you enough confidence to start out on a new business venture because if it fails, you will have enough money to sustain yourself throughout a lengthy job search. That new business might be your ticket to happiness and financial security.

Ask yourself, how much “job security” do you really have? Most people have a 30 day notice period at work. What about sickness? How long will you get paid your full salary if you can’t go to work for a few weeks? Is statutory sick pay going to be enough? How safe do you feel? Do you already live payday to payday?

An emergency fund is also important for people in situations where they end up in abusive relationships. It’s difficult to leave and start your life again somewhere safe if you have no money to your name. I’m not an expert in this area and don’t know about all the things you need to consider before leaving an abusive partner. However, I’m sure money would help with that.

There are occasions when you need to suddenly drop everything and travel somewhere. I hope it never happens to you, but you could need to travel for a funeral because of a death in your family. You might need to buy an expensive flight or train ticket on short notice. There might also be accommodation costs and potentially a reduction in your earnings as you’re away to be with your family. That would be a difficult time for obvious reasons and adding money worries would only make things worse. It doesn’t have to be like this.

As you can see there’s plenty of scenarios where having an emergency fund is the solution. It’s not the only solution, but it’s the best in my opinion. You could probably borrow some money or use your credit card etc but these could create further problems if you’re unable to service the debts. It’s a slippery slope and I’d steer clear from that path. The emergency fund is a much better solution as it doesn’t have any big downsides.

There are a few things you should consider before you start an emergency fund. This post will tell you what you need to know to make sure you build up an emergency reserve so that you are in a good position when things don’t go as planned.

bank notes

So, what do you need to keep in mind before starting to save for an emergency fund?
First of all, if you’re already struggling with debt, have maxed out all your credit cards and owe money to your friendly neighbourhood loan shark, then this post isn’t for you (but I’m glad you’re reading it). You’ve got bigger fish to fry and should not be thinking about having an emergency fund. You need to prioritise paying off your debts. Seek debt counselling from a reputable charity if need be. Godspeed.

If your financial situation is better and you are OK with paying all of your bills and have some extra money each month, then you are in a good position to start saving. It’s important to realise that you need to dig your well before you’re thirsty. This means that you have to plan before the emergency happens. If things are good at work and you’re healthy etc then now is the best time for you to start building an emergency cash reserve.

How much do you need to save for emergencies?
There are many numbers thrown around on the internet and everybody will give you a different figure. It’s quite subjective but 3-12 months’ worth of your normal expenditure should do it. So, if you spend £2,000 per month, you should aim to save up at least £6,000 for your emergency fund. If this sounds too hard, then you could look at what your essential outgoings are and cut out all the excess. Say it’s £1,500 per month. In that case, you would need a cash reserve of at least £4,500.

If saving up 3 months’ worth of expenditure is too difficult, then aim to save as much as you can. One month’s expenses saved up is better than nothing. It’s important to start the saving habit.

The upper end of 12 months is also subjective. You could opt for more if you wish and this is a personal decision based on how much safety you want to have in life. I think you need to be a bit wealthier than the average Joe to have more than 12 months’ worth of cash set aside for emergencies.

It’s important not to treat your cash reserve as a miscellaneous savings pot. You should not dip into this pot to fund your holiday, buy a new electronic gadget or spend it on booze and cigarettes. This is important and you will be very glad you have this money set aside when you need it. The purpose of this money is to have insurance. That’s how all insurance works – you buy it precisely because you don’t want to ever have to use or need the sum assured.

Where should you keep your emergency cash reserve?
Simply put: in the safest place you can think of. If you don’t trust the banks, keep it under your pillow. If you think somebody will find it under your pillow and run away with it, then keep it in the bank. If you’re worried about both of these then diversify.

The main criteria to look for are ease of access and safety. I mean, don’t lock it away for 12 months to earn 1% of interest on it. Remember, this is money you need to have access to at a moments notice. This is an emergency!

You could open a second bank account to keep these monies separate from all your spending money. One option is to consider opening an account with NS&I as well because they are backed by the UK government. I’ve created a short video below about the different products available on NS&I.

NS&I is essentially a way for you to lend to the government and earn some interest in the process. Your bank might go bust but the government is quite unlikely to go bust (especially here in the UK as the government can simply print more pound sterlings left, right and centre). Therefore, your monies in NS&I will be very safe. You could choose from several products such as Premium Bonds for example. Have a browse on their website. A lot of people like having Premium Bonds as these receive “prizes”, where the maximum could be £1 million. Effectively, you’re getting lottery winnings rather than earning interest with Premium Bonds. Please note it can take a couple of days to get your money out of NS&I. One option to consider is to keep a few thousand pounds in a bank account, keep some in cash at home and the rest of your emergency fund with NS&I. It doesn’t have to be all-or-nothing.

Should you invest your emergency cash reserve monies to improve the return you can get on it?
You might be tempted to invest your emergency fund instead of keeping it in cash. It’s true, interest rates are at all-time lows and you could make some sweet-sweet gains in the stock market if you YOLO it all on Tesla stocks or buy a few good old Bitcoins. After all, you could just sell your investments and then have access to your money. It will take a few days to withdraw the funds into your bank account, but it’s fine you say to yourself. The problem with this approach is that you might be forced to sell your investments at a bad time e.g. when the markets are down (stock markets crash every decade or so). Right now (during the Covid-19 pandemic), would be a bad time to sell investments and realise your losses but you are dealing with an emergency.

There’s another danger with investing your emergency monies. You could be unlucky and make investments in funds, which suspend their dealings (this means nobody can buy or sell your investment for a certain time – this is what’s happening to real estate/property funds today for example). Now you can’t even sell. Liquidity (the ease of selling your investment) is important. Cash has perfect liquidity.

If you’re sensible with your investments, then you might be OK using “boring” investments (such as money market funds) for emergency fund purposes. However, I would recommend keeping it in cash. You know what they say – cash is king. Don’t forget you have an emergency on your hands. Keep it simple, stupid!

TLDR
Emergencies will happen, things will break down and you might lose your job. Build a cash reserve, which will provide a huge help with a myriad of stressful situations. Aim to save 3-12 months’ worth of your normal living expenses and keep these monies in a safe easy-access bank account.

Now you know why you need an emergency cash reserve, how much you need to save and where to keep the monies. Go ahead and start planning for the inevitable emergencies today.

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