Let’s say you have £10,000. There’s no rule that says you have to invest it.

In fact, many people would spend it!

Why not put it under the mattress, and leave it for a rainy day?

One word: Inflation.

Take a look at this graph:

This graph shows how what you can buy with £10,000 falls over the years, due to the impact of inflation.

Inflation is the tendency for the cost of things – bread, houses, wages – to rise.

As such it reduces the spending power of your money each year.

• In 25 years time, you will still have £10,000 in nominal terms. Your twenty £500 notes will still be under your mattress, and the Queen of England will still be frowning at you.

• But in real terms the spending power of your money will be diminished.

The graph shows the impact of just 2% annual inflation on your money.

2% reduces the value of your money by only a little bit each year, but it adds up to a 40% loss in real terms over 25 years.

The inflation rate can rise and fall

The Bank of England and many other countries target a 2% inflation rate.

But sometimes, such as in the 1970s, inflation can rise to 5-10%. Such a high inflation rate can halve the value of your money in less than a decade.

Inflation can get even worse in extreme situations, such as 1920s Germany or Zimbabwe more recently. Hyper inflation in a crisis can hit triple digits or more.

The first reason we invest is to maintain the spending power of our money. Every year we need to grow our savings by at least the rate of inflation.

Generally – but not always, and especially not in recent years – you can keep up with the rate of inflation by keeping your money in a good cash savings account.

Cash accounts pay interest on your total savings. By adding this interest to your existing pile of money, you can grow your savings over time.

This may seem trivially obvious, but it’s an important point.

The spending power of each £1 still goes down over time. But by growing the total amount of £1s in your savings pot by earning interest and reinvesting it, you can aim to offset the impact of inflation and maintain the spending power of your total savings.

In the graph above:

• The blue line shows how your £10,000 grows over 25 years with 2% interest. This is the amount you see piling up in your bank account.

• The red line shows how £10,000 would lose its value in real terms at 0% interest. For example, if kept under your mattress!

In reality you will get interest and see your wealth rise but – invisibly – each pound in your bank account will also lose some of its spending power due to the impact of inflation at the same time.

If inflation was running at 2% for the entire 25 years and interest rates were also 2%, then the two would cancel each other out.

This is shown in the green bar in the following graph, which is the real spending power of your money, with 2% interest and 2% inflation.

You’d very rarely see inflation and the interest rate on your cash savings exactly matched like this, of course, let alone for 25 years!1

Some times interest rates will easily outpace inflation. At other times it will be very hard to get a real return, especially if you pay tax on your savings.

But the principle is clear. At the very least, you need to grow your money in nominal terms, just to offset the corrosion of inflation.

Investing like this will at least maintain the spending power of your money.

Key takeaways

• The real value of £1 decreases over time, due to inflation.

• Over the long-term, this can seriously reduce your wealth.

• At the least, we need to invest to offset the rate of inflation.

This updated post is from our occasional series on investing for beginners. Subscribe to get our articles emailed to you (we publish three times a week) and you’ll never miss a lesson! And why not tell a friend to help them get started?

1. Some interesting products such as the government’s sadly suspended index-linked savings certificates did enable this, plus a bit of icing on top. [↩]

What caught my eye this week.

I always stress to friends who know of my investing obsession that – from the position of pure cost-benefit analysis – my stockpicking has been an unproductive waste of time.

Me and The Accumulator thrashed this out in debate years ago. I invest actively for the fun and challenge, I said. He wasn’t convinced.

And it’s true, I probably wouldn’t do it if I didn’t – naughtily, preposterously – think I had a chance of beating the market.

Luckily, I have done, the way I measure it, over the medium to long-term. (Unitised and against a few 100% equity benchmarks, but I don’t adjust for risk, which could make things look better or worse, depending on the year).

2020 has been particularly ridiculous. Everything has worked! It usually doesn’t. Luck has loomed large, too. It doesn’t always, either! It went against me in late 2018 / early 2019, for example, and I spent the year trying to claw back and making things worse.

Swings and roundabouts.

The point is I always caution my friends it’s only in recent years (especially this year) that earning an extra 1%, 5% or for much of the time even 10% has compared at all favourably to trying to earn more money from a traditional route.

Focusing on a career and boosting my salary would have paid far better, if I was wired that way. (I’m not!)

I started with mid five-figures in savings less than two decades ago. I’ve never earned a lot, by the standards of my peers. Compound interest takes time. The metaphor is a slow rolling snowball for a reason.

Even putting more effort into monetizing that perennial underachiever, Monevator, might have been more profitable.

The irony of alpha

Nick Maggiulli did his usual brilliant job tackling all this in a post this week. Explaining why You Don’t Need Alpha, Nick writes:

How many people have earned alpha (net of fees) consistently for multiple decades?

Conservatively, I would say there have been a couple hundred throughout history.

Being one of those people (or trying to select them ahead of time) is near impossible.

More importantly, how much will that alpha change your financial life even if you do happen to acquire it?

For a little bit of annual alpha, the answer is very little.

For example, let’s assume that the market will return 4% a year (after-inflation) going forward and you can earn 1% above this (net of fees) over the next 10 years.  How much more money would you have 10 years from now?

About 10% more.

Pfft!

Obviously you can play with these figures. You can model higher (and even more unlikely) alpha.

More – cough – realistically you can run the experiment for 30 years. It does add up.

But then you spent 30 years trying to beat the market when you might have been doing something else instead.

Where’s my novel, eh? That’s what the teenage me would want to know.

The irrelevance of alpha

I should mention my friends have typically needed little persuasion that I’ve wasted my time obsessing over the stock market.

I was living like a graduate student well into my 40s. My friends didn’t see the sports cars they expected from an obsession with the stock market. (Because they didn’t understand that compounding your own modest wealth sensibly takes time. If you need a sports car in a hurry, get hold of other people’s money and take a cut…)

There was a particularly delusional air about proceedings as my last rental place was run down before I finally bought my flat.

“Where did it all go wrong?” they gently wondered.

The other reason they need little persuasion I’ve been a dud is I try to mostly talk about my mistakes and bad calls.

Superstitious! It’s grounding.

And… luck, luck, luck.

But despite all this I don’t feel I’ve wasted my time pursuing alpha. While I didn’t end up trying to launch/run a fund (another story) it’s led me in interesting directions, career-wise.

It also resulted in this blog, which judging by the generous feedback is my best contribution to the world so far.

Finally, shepherding my nest egg so closely has really made me care about my nest. I’ve added more eggs over time than perhaps I would have, too, and I’ve been careful – big picture – not to break them.

“It is the time you have wasted for your rose that makes your rose so important.”

– The Little Prince

Have a great weekend.

[continue reading…]

Sign-up to Freetrade via this link and we can both get a free share worth between £3 and £200.

Whether you’re one of the nearly 200,000 people who’ve signed up to Freetrade’s commission free trading app and are excited about the money making possibilities ahead – or you’re looking for an online trading alternative to Robin Hood after the US giant scrapped its UK launch plans – now is a good time to think about your Freetrade* investment strategy.

• One option is to dive in at the deep end, watch a lot of sketchy YouTube videos, and get burned punting stocks based on internet rumours and tips.

• An alternative is to follow the advice of one of the greatest investors of all time – Warren Buffett – and follow a passive investing strategy.

Passive investing works. It keeps your costs low, helps prevent you being wiped out by a bad run, and harnesses the best evidence for long-term success in the markets.

You can put together a passive investing strategy on Freetrade using its commission-free Exchange Traded Funds (ETFs).

ETFs are low-cost investment funds that enable you to quickly diversify across global markets, because each ETF can combine thousands of shares (or other assets) into a single vehicle.

By using ETFs as your building blocks, you can put together a strong, diversified portfolio with a handful of trades that’ll set you off on the right foot.

You just need to know where to start.

Freetrade ETF model portfolios, made by Monevator

Model portfolios offer a customisable framework that investors can use to sense-check their ideas.

Model portfolios can also be used off-the-shelf to get you going. You can refine your positions later, once you’ve had a chance to do more research.

The type of portfolio you build depends on your personal circumstances:

• Your financial objectives
• Your risk tolerance
• How critical your investments are to your financial future
• Your age and investing time horizon

The right approach for you depends on how those factors mesh with your financial situation. There is no universal answer. But different model portfolios enables us to illustrate useful rules-of-thumb.

The ETF components of each of the portfolios below are chosen from the Freetrade Investment Universe.

These ETFs are commission-free with Freetrade and traded on the London Stock Exchange.

Freetrade’s minimum trade value is £2. In reality, the minimum trade size when creating these model portfolios is likely to be determined by the ETF’s share price. This is because you can’t trade a fraction of an ETF share on most UK platforms, including Freetrade.

Freetrade’s ISA costs £36 a year, which is very reasonable. There’s no charge for holding your ETFs in a taxable1 account, but we’d urge you to open an ISA for the long-term benefits.

Here’s a couple of quick notes on the tables below to help you read them:

• Asset class – Assume the asset class is equities unless otherwise noted. For example, ‘Global’ means ‘Global equities’ unless we refer to specific asset classes such as bonds, property, or gold. The bold figure is the percentage of your portfolio’s value to be held in that asset class.
• ETF name – You can quickly identify each ETF by using its ticker – the four letter identifier in brackets.
• OCF – The Ongoing Charge Figure (OCF) is the main annual cost levied by the ETF’s provider for management services. The OCF is the simplest way to compare ETF costs. The OCF is expressed as a percentage of your holding, although there are other costs of ownership.

Let’s get on to the portfolios!

The KISS (Keep It Simple Stupid) portfolio

Asset class	ETF name	OCF
70% Global	Vanguard FTSE All World (VWRL)	0.22%
30% UK government bonds*	Vanguard UK Gilt (VGOV)	0.07%

*Alternatively: £-hedged global bonds = iShares Global Government Bond ETF (IGLH) OCF 0.25%.

Investing does not have to be complicated. Most investors eventually conclude that complexity only offers the illusion of sophistication and they’re actually better off keeping things straightforward.

This two ETF portfolio ensures that you’re diversified across the two main asset classes that will drive the bulk of your investing results. The global equities ETF offers maximum stock market diversification and growth potential in a single fund, while the gilt ETF is the most important defensive asset for UK investors.

A more cautious, older, or inexperienced investor could place more weight on bonds and less on equities.

The High Risk portfolio

Asset class	ETF name	OCF
50% Global	Vanguard FTSE Developed World (VEVE)	0.12%
15% Emerging markets	iShares Core MSCI Emerging Markets IMI (EMIM)	0.18%
15% World small cap	iShares MSCI World Small Cap (WLDS)	0.35%
20% Total global bonds	Vanguard Global Aggregate Bond (VAGP)	0.1%

Younger or more risk tolerant investors may wish to concentrate more of their portfolio in equity sub-asset classes like small cap and emerging markets that have historically outperformed the wider stock market at times. Your hope is you catch a big wave of out-performance. The trade-off is that risky sub-asset classes can trail the wider market for a decade or more, and expose you to bigger losses during downturns.

Similarly, the Global Aggregate Bond ETF is more aggressive than the gilt ETF.

VAGP includes corporate bonds, which can offer greater returns during growth periods but are also riskier.

All-Weather portfolio

Asset class*	ETF name	OCF
50% Global	Vanguard FTSE All World (VWRL)	0.22%
10% World** property	iShares Developed Markets Property Yield (IWDP)	0.59%
10% Gold	HANetf The Royal Mint Physical Gold ETC (RMAP)	0.22%
15% UK government bonds	Vanguard UK Gilt (VGOV)	0.07%
15% Inflation-resistant government bonds	iShares £ Index-Linked Gilts (INXG)	0.1%

* Gain extra protection against deflation and fair-to-middling inflation by allocating 10% of your portfolio to cash. Hold the cash in a bank account rather than on a trading platform.

**The term ‘World’ typically denotes developed world markets whereas ‘Global’ incorporates emerging markets, too.

The All-Weather concept diversifies your portfolio across every worthwhile main asset class. The idea is that you’ll always have at least one asset that performs in every economic environment short of the Apocalypse:

• Equities and property for growth.
• Government bonds (and cash) for recessions.
• Inflation-resistant bonds for high inflation conditions. (Note, that the index-linked gilt market is widely thought to be subject to structural distortion at present.)
• Gold for when nothing else works.

Middle-of-the-Road portfolio

Asset class	ETF name	OCF
50% Global	Vanguard FTSE All World (VWRL)	0.22%
10% UK*	SPDR FTSE UK All Share (FTAL)	0.2%
40% UK government bonds	Vanguard UK gilts (VGOV)	0.07%

*Alternatively: iShares Core FTSE 100 ETF (ISF) OCF 0.07% is less diversified than FTAL but considerably cheaper.

The 60:40 equities:bond portfolio is the happy medium of investing portfolios. Its tilt towards equities makes it pro-growth, but the significant slug in bonds provides welcome relief during stock market crashes when investors flee to safer assets.

Note, that a dedicated UK equities ETF isn’t necessary – nor necessarily best practice – but many investors feel more comfortable holding a generous allocation in their home market. VWRL also contains a small slice of UK plc.

The Withdrawal portfolio

Asset class	ETF name	OCF
35% Global	Vanguard FTSE All World (VWRL)	0.22%
15% UK	SPDR FTSE UK All Share (FTAL)	0.2%
5% Global property	iShares Developed Markets Property Yield (IWDP)	0.59%
5% Gold	HANetf The Royal Mint Physical Gold ETC (RMAP)	0.22%
20% UK government bonds	Vanguard UK gilts (VGOV)	0.07%
20% Short-term UK government bonds and/or cash	iShares UK Gilts 0-5yr UCITS ETF (IGLS)	0.07%

Investing is much trickier for retirees who need their wealth to last them the rest of their days:

• Equity holdings are required for long-term growth but are typically pared back at the beginning of retirement to reduce early exposure to market crashes.
• Strong UK equity holdings can make sense for retirees to help manage currency risk.
• Short-term gilts or cash pay near-term expenses.
• Global index-linked bonds are a good defence against inflation but aren’t available through Freetrade.

Income portfolio

Asset class	ETF name	OCF
50% Global high yield*	Vanguard FTSE All World High Dividend (VHYL)	0.29%
20% UK high yield	SPDR S&P UK Dividend Aristocrats (UKDV)	0.3%
30% Total global bonds	Vanguard Global Aggregate Bond (VAGP)	0.1%

*Alternatively: SPDR S&P Global Dividend Aristocrats ETF (GBDV) OCF 0.45%. GBDV has a higher dividend yield than VHYL but a worse total return over the lifetime of the two funds.

Income investing is a popular strategy for managing wealth. The idea is to live on your dividends and interest while leaving your principal untouched. Advocates of this strategy favour high-yielding stocks to amp up their income payouts. The equity ETFs in the table aim to aggregate firms with strong dividend track records.

Socially Responsible Investing (SRI)

Freetrade does not yet have extensive SRI/ESG (Environmental, Social, Governance) ETF options. You’re limited to replacing your global equities and UK equities ETFs with:

• MSCI World Socially Responsible ETF (UC44) OCF 0.22%

• MSCI United Kingdom IMI Socially Responsible ETF (UKSR) OCF 0.28%

Investing for children

Newborns and very young children probably aren’t going to need the money anytime soon – even in an unforeseen emergency (it’s your job to deal with those).

They also aren’t prone to the performance pressure inherent in checking the stock market every five minutes on a trading app.

Therefore, the best bet for the kids is to go all out for growth – as long as you promise not to freak out when a stock market slump hits town. If you keep your head then it will probably have blown over by the time the kids tap into their portfolio. That means:

• 100% Vanguard FTSE All World (VWRL)
• Then start putting the brakes on by proportionally adding bonds 10 years before the money is needed.

Not worth it

There are large and well resourced marketing departments that earn their keep by pandering to investors eager to cash in on the latest trends: think funds dedicated to AI, cyber security, robotics, ageing populations, or the rise of China.

Typically this kind of diversification isn’t worthwhile – and at best a total crapshoot – because you know nothing that the rest of the world doesn’t already know.

The big money is big because it sees the trends before you can. They have swooped in and bid up the prices of the best firms long before Reddit got a sniff of it.

Still, if you must put 5% of your money into big tech then there’s an ETF for that:

• Invesco NASDAQ 100 ETF (EQQQ) OCF 0.3%

The reason you don’t have to worry about the smart money when you’re investing across the wider global market is because you’re not betting on the trend.

You’re creaming off the profits made by the entire market – the sum of human productivity.

FCA regulation

Freetrade is regulated by the UK’s Financial Conduct Authority. Here’s why that matters.

Investing essentials

There’s much more to learn about investing than we’ve been able to cover in this linkfest. Here’s some cornerstones to look up just as soon as you can:

• Useful investing basics.
• Comparing the past performance of one fund or stock versus another is irrelevant to your results.
• Asset allocation is as much art as science. Get the big picture right and don’t worry about the odd percentage point or two.
• Automate your investing.
• Drip-feed your money into the market.
• Use your tax shelters.
• Rebalance your holdings to control risk.
• Take less risk as you get older or have achieved your objectives. Don’t get greedy.
• To find out about other investing platforms.
• To find out about other cheap ETFs.
• To sign up to Freetrade.

Take it steady,

The Accumulator

*Sign-up to Freetrade via our link and we can both get a free share worth between £3 and £200. Monevator editor The Investor is a shareholder in Freetrade.

1. Non-ISA. [↩]