Few people are born understanding compound interest. As a result, some are seduced into buying things today using loans, and forgetting who really pays for their debts tomorrow.

An interest rate of 6% or 7% doesn’t sound so bad when you’re 21 and earning for the first time. But over the long-term, a life lived on credit will be very expensive and less rich than one where you live within your means.

• A £10,000 loan at 7% paid off over ten years costs £14,000

• The same loan over 30 years would cost £24,000

Sure you can get a lower loan rate than 7%, but for most of my life you could have paid a lot more, too.

The point is you spend a lot of your future income for the benefit of owning something now when you buy it via a loan, due to compound interest.

Compound consequences

Some people never do grasp how compound interest adds up over the long-term. They fail to get out of debt, and they end up in all sorts of difficulties.

However, most of us are at least bailed out by buying a house with a mortgage, which forces us to save for most of our working lives.

The average UK home has increased in real terms by 2.7% a year for the past 50 years, according to a report by Halifax a few years ago. Because of the power of compound interest, this seemingly tiny growth rate has made residential property a good investment for most homeowners. ¹

A minority of people also start saving into pensions early on the advice of an older family member, or even their employer. Assuming they are lucky enough to avoid being stuck in an expensive pension scheme, most early birds will again benefit from compound interest over their working lives. ²

But some of us go further. We “get” compound interest the way other people get religion or vegetarianism or cross-dressing at weekends. It becomes a way of life, and an ever-present calculation.

If compound interest grabs you like this, then you start to see the whole world – certainly the world of money – in a new light.

Once you have seen the historical returns from shares – and you’re a believer – then it becomes much more difficult to splurge half a year’s salary on a new car or a fancy sofa, even if you’re paying with cash, not debt.

In your mind’s eye, you see the £3,000 you might recklessly divest yourself of at John Lewis one fine Saturday morning as the £40,000 it could become if you invest it for 30 years.

What’s wrong with sitting on old suitcases, anyway? It’s bohemian!

Warren Buffett’s Folly

If being in thrall to compound interest is a problem for you, just imagine how it feels for Warren Buffett. The world’s richest man has compounded his wealth by 20% since the early 1970s. Before that has was doing even better.

Every can of soda the notorious Coca-Cola fan swigged in the 1950s therefore cost him thousands of times as much as he paid for it, compared to if he’d put the money into his investments and had a glass of water.

Of course Buffett is well aware of this – and he was prescient about it, too.

From the excellent Buffett biography The Snowball:

The Buffett’s bought their first house [in 1957]. It stood on Farnam Street, a Dutch Cape set back on a large corner lot overlooked by evergreens, next to one of Omaha’s busiest thoroughfares. While the largest house on the block, it had an unpretentious and charming air, with dormers set into the sloping shingled roof and an eyebrow window.

Warren paid $31,500, and promptly named it “Buffett’s Folly”.

In his mind $31,500 was a million dollars after compounding for a dozen years or so, because he could invest it at such an impressive rate of return. Thus, he felt as though he were spending an outrageous million dollars on the house.

Now I’d say the opportunity cost of paying cash for a charming house that you live in for the rest of your life can be filed under ‘billionaire problems.’

But the point is clear. If compound interest really grips your imagination – and it’s clear from his biography that it had Buffett in a headlock by his teens – then spending money will never be the same again.

Frugal fundamentalists

Of course few us will be the exception that proves the rule when it comes to super-investing like Buffett. We will be aiming for perhaps 5-10% from our diversified portfolios, over the long-term, depending on how optimistic we are. Some are gloomier.

For us mere mortals then, a can of Coke today isn’t going to cost our future selves a car. But if we’re saving in our 20s, it might still cost us a couple of  pizzas delivered to the retirement home. Those Coca-Colas we skip will all add up.

How do we square this circle? It can only come down to personal choice, as we’ve seen in the excellent discussion among Monevator readers recently about what to sacrifice to achieve financial freedom.

For some people, saving more than the standard 10% to 15% for retirement smacks of being tight, not frugal. But for those who’ve really got the compound interest religion, almost any spending beyond housing, decent food and clothing and access to fresh air equals money wasted on fripperies.

True believers scoff at the latte factor, which is the idea that you can pay for your pension by skimping on Starbucks. Try the PG Tips factor, where you spurn expensive branded teabags for Lidl’s finest. Compound interest extremists use the teabags twice.

Clearly there’s a law of diminishing returns here. Personally I’m prepared to give up owning a sports car, but I’m not prepared to give up the occasional foreign holiday. Your mileage will vary.

Don’t be dead wrong

The other side of the equation is the iron law of mortality. As the famous economist Keynes pithily put it: “In the long run we are all dead.”

In the worst case scenario, there’s no point in giving everything up today for a future you’ll never see.

Plus all of the other cliches you hear:

• You don’t want to be the richest corpse in the graveyard.

• He who dies with the most toys still dies.

• Tomorrow you could get hit by a bus.

• Own-brand tea bags used twice taste like old socks. (Okay, I coined that one).

I’d add a few more truisms of my own.

Firstly, it’s good to plan and to stress test your calculations, but beware of spurious precision. You can’t bank on expected returns.

Forget about precise asset allocations. A cheap and well-diversified portfolio is your best bet, but every investment can fail you and in the end you can still be duffed up by sequence of returns risk.

If only we knew exactly what returns we’d get from investing and exactly when we would die, we could save and spend our money perfectly – and go on a giant bender if the prognosis isn’t so hot.

Unfortunately we don’t.

We could save for years only to die relatively young, as I saw happen to a close family member. Or we could spend like crazy and condemn our future selves to an even more difficult old age.

Or we could hedge our bets and strive for a sensible middle-ground.

Balancing your books

My own view is young people are already rich, middle-aged ones still have most of their health and non-financial wealth, so I’d rather save more today and have some extra money to splash out on a bionic Zimmerframe and luxury crumpets if I make it to my 80s.

But some things are clearly worth spending money on now.

I think memories are often overrated compared to what they cost, but I also believe that looking forward to 30 years in a bedsit is no way to live. If penury was the only way I could fund a pension, then I’d strive to boost my income. If that failed then, to be frank, I wouldn’t save at all.

The point is a little sensible spending goes a long way.

Money can’t buy you love. Just ask that world’s richest man. In 2011, Buffett touched on his former “folly”, revealing to shareholders that…

All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.)

For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come.

…although re-reading that, I’m sure I hear the muffling impact of an octogenarian’s gritted teeth.

Do you think he really means it?

(Image by James Brown)

1. No, not all the people, all the time. But that is a discussion for another article.[↩]
2. Many of today’s 20-somethings will gain from the introduction of automatic enrollment into pensions. The scheme isn’t perfect, but from this perspective it’s much better than nothing.[↩]

After all the excitement of the first half of the year when the market was ‘hot, hot, hot’, the returns from our model portfolio have fizzled like an exhausted firework and fallen flat for the last three months.

We’re still up over 16% on initial purchase – and have made £1,681 since we began this investing adventure – but the previous quarter brought in all of £14.

The lack of drama tallies with the jittery recovery of economies that are still coming out of rehab. Progress comes in fits and starts, and is all too prone to relapse at the first sign of trouble. Like the cuffing of a shoplifter around the back of Primark, there’s nothing for passive investors to see here, and once we’ve added our new money as described below we can safely put our portfolio tracker away for another three months.

These days I only look at my own portfolio when I add new cash. And I’m all the better off for it.

The alternative is to sit there like a football club owner in the stands: emotionally rapt but powerless to influence the events playing out before you. An impulsive intervention is likely to have all the positive impact of Roman Abramovich substituting himself onto the pitch in search of a last-minute winner.

I digress. Here’s our model portfolio lowdown in spreadsheet-o-vision:

The Slow and Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000 and an extra £750 is invested every quarter into a diversified set of index funds, heavily tilted towards equities. You can read the origin story and catch up on all the previous passive portfolio posts here.

One other piece of business to note is we’ve earned £12.90 in interest income from our Vanguard UK Government bond fund. We don’t even sniff it though as it’s automatically rolled back into our accumulation fund. Here it will build up like a fine layer of silt, adding a few extra grains to our strata of compound interest.

New transactions

Every quarter we push another £750 into the market slot machine. Our cash is divided between our seven funds according to our asset allocation.

We use Larry Swedroe’s 5/25 rule to trigger rebalancing moves, but all’s quiet on that front this quarter. So we’re just topping up with new money as follows:

UK equity

Vanguard FTSE U.K. Equity Index Fund – OCF 0.15% (Stamp duty 0.5%)
Fund identifier: GB00B59G4893

New purchase: £112.50
Buy 0.6115 units @ 18395.3p

Target allocation: 15%

Developed World ex UK equities

Split between four funds covering North America, Europe, the developed Pacific, and Japan ¹.

Target allocation (across the following four funds): 51%

North American equities

BlackRock US Equity Tracker Fund D – OCF 0.18%
Fund identifier: GB00B5VRGY09

New purchase: £187.5
Buy 151.58 units @ 123.7p

Target allocation: 25%

European equities excluding UK

BlackRock Continental European Equity Tracker Fund D – OCF 0.18%
Fund identifier: GB00B83MH186

New purchase: £90
Buy 56.533 units @ 159.2p

Target allocation: 12%

Japanese equities

BlackRock Japan Equity Tracker Fund D – OCF 0.18%
Fund identifier: GB00B6QQ9X96

New purchase: £52.50
Buy 39.803 units @ 131.9p

Target allocation: 7%

Pacific equities excluding Japan

BlackRock Pacific ex Japan Equity Tracker Fund D – OCF 0.22%
Fund identifier: GB00B849FB47

New purchase: £52.50
Buy 24.741 units @ 212.2p

Target allocation: 7%

Note: OCF has gone down from 0.24% to 0.22%

Emerging market equities

BlackRock Emerging Markets Equity Tracker Fund D – OCF 0.28%
Fund identifier: GB00B84DY642

New purchase: £75
Buy 68.997 units @ 108.7p

Target allocation: 10%

UK Gilts

Vanguard UK Government Bond Index – OCF 0.15%
Fund identifier: IE00B1S75374

New purchase: £180
Buy 1.411 units @ 12755.24p

Target allocation: 24%

New investment = £750

Trading cost = £0

Platform fee = 0.25% per annum

This model portfolio is notionally held with Charles Stanley Direct. You can use that company’s monthly investment option to invest from £50 per fund. Just cancel the option after you’ve traded if you don’t want to make the same investment next month.

Take a look at our online broker table for other good platform options. Look at flat fee brokers if your ISA portfolio is worth substantially more than £20,000.

Average portfolio OCF = 0.18%

If all this seems too much like hard work then you can always buy a diversified portfolio using an all-in-one fund like Vanguard’s LifeStrategy series.

Take it steady,

The Accumulator

1. You can simplify the portfolio by choosing the do-it-all Vanguard FTSE Developed World Ex-UK Equity index fund instead of the four separates.[↩]

Good reads from around the Web.

We’ve written several times about the end of the bond bull market. We agreed that bond prices looked extremely likely to fall eventually as interest rates rose. But we’ve argued that even though the expected returns from bonds must mathematically be much lower than in the recent past – perhaps even negative, after inflation – there was a good case for keeping hold of your bonds, especially if you’re a passive investor.

Alternatively, if you must be different, then – while it’s not the same as bonds – cash in the best savings account is a reasonable alternative these days. Indeed it’s what I use currently for my safety net beneath the high-wire of equities.

Everyone knows interest rates are low. That’s not the point. The thing to realize is you’re not really holding bonds or cash for returns these days. You’re doing it to reduce risk.

Joe Davis of Vanguard made the point well this week:

Risk is a relative term. If someone asked you to set aside $150 a month, possibly with no return on your investment, you’d probably say, “No way!”

Yet what if you knew the alternative was losing your home and all of your belongings in a fire, flood, or other emergency, with no funds to help rebuild your life?

Suddenly, the $150-per-month payment for disaster insurance might seem like a good idea.

The same perspective can apply to bonds. If you’re considering an allocation to bonds but have been warned that this allocation may have low or even negative returns in the next few years, you may see bonds as a risky bet.

Yet by weighing the risks of the alternative — that an allocation to equities is far more likely to experience highly negative returns of –5% or more during the same period according to output from [our] model — you may begin to recognize bonds as the steady diversifier and volatility dampener they truly are when combined with a stock portfolio.

Read the whole piece – and our articles on bonds that I linked to in my opening paragraphs – for more.

The silenced minority

Now, somewhere out there a reader is set to jump to the end of this article and write a comment saying I’m an idiot who doesn’t understand bonds are sure to lose money etc etc. Bonds are the risky investment right now! And so on.

As if this has never occurred to me, or to Joe Davis of Vanguard. As if we are witless muppets doomed forever to lose our money to the cunning market.

In fact, this person ¹ is very unlikely to have read the Vanguard blog. They just want to make their point. Again.

But today they won’t be able to because I’ve turned off comments. Just on this post for now, as a one-off.

Most things about blogging about investing for six or seven years are great. But spending 4-6 hours writing a long and detailed post only to get these same sort of comments from the same 2-3 people (a revolving cast, they tend to wander off after a few months but are topped up by newcomers) is pretty tedious.

Please understand I don’t mean all of you who comment on articles!

There’s a great – collaborative and sometimes challenging – discussion happening on The Accumulator’s post about financial independence this week, for example. That’s community and commenting – and our site’s above-averagely clever readers – at their best. Everyone comes away smarter.

Also, I never mind people not understanding or genuinely having doubts, and voicing them. I don’t mind people disagreeing, for that matter, if they have the courtesy to actually read the article first and know what they’re disagreeing with and why they might be wrong.

But for a hardcore handful, blog commenting seems to be an excuse to try to explain what they know while only really demonstrating what they don’t.

The Myth of Sisyphus

The best of these people are at least polite – even nice – but repetitive and misguided. The worst are rude, and I need little excuse to delete their comments.

If you wonder what sort of comments I would delete, go and read either The Daily Mail or The Guardian’s comments under a contentious political story. It ain’t pretty!

Please be clear: this website isn’t a democracy. I will delete anything offensive or offensively stupid. Or that I want to, frankly, though it rarely comes to that. (Once or twice on my Thatcher post, perhaps).

It is incredibly tedious writing among the most long-winded investing posts you’re likely to find on the Internet – stuffed with more caveats and footnotes than a billionaire’s pre-nup – only to have someone pop up and say: “Your advice is reckless, anyone staying in this rigged Bernanke-market is doomed!”

Yet it’s almost worse when they make sensible sounding comments such as:

• The market goes through booms and busts, so you must always try to sidestep the busts

• Tracker funds are inherently dumb, so it’s easy to do better by avoiding their excesses

• Bonds are yielding 2%, so investors will obviously do better without them

• The market looks expensive because it’s on a P/E of X, Y, or Z, so best to get out

• Inflation/deflation is obviously coming, so it’s clear we should do X, Y, or Z

• The gold price is at $1,800 or $1,600, or $1,000, which tells you X, Y, or Z

• Neil Woodford has beaten the market, therefore it’s obvious that Joe Blog Commenter can too, isn’t it? Or do I really think Woodford is merely lucky? Or magic?

All these things sound perfectly sensible – whereas index tracking sounds idiotic at first. And of course that’s what makes their comments so dangerous.

Nobody doubts returns would be far better if you could be in the best asset classes all the time, exit the market in time to avoid crashes, and do a bit of judicious active management to juice your returns – or even to pay a well-known talent like Woodford to do it for you.

Unfortunately there is decades of data proving that all those common sense ideas will reduce returns for the majority of those who try.

That’s true whether they are professionals or simply a new investor asked to manage her own pension for the first time. Not for the gifted or lucky few, perhaps, but certainly for the majority who have historically done so poorly from investing in shares, whether from the cost consequences of active management, or from under-performance or dire market timing or worse.

On the other hand, passive investing in a widely-diversified portfolio has demonstrably delivered results that are acceptable to nearly everyone. It’s simple in principle and it gets the job done. Yet it’s under-discussed and misunderstood, especially in the UK.

So that’s why we promote it on this blog.

A family friend suggested I just ignore the handful of negative or incorrect comments tagged on to articles. “Everyone knows that comments on the Internet are nonsense,” she said.

But I feel I can’t.

I don’t want a casual reader of this website who might be about to get on the right track of lifelong investing to pick up the wrong lesson under my watch, even if it’s not from my mouth. So I can’t let these seemingly certain, obvious, and generally incorrect comments stand unchallenged. Hence I end up having the same tedious debates over again.

(What may not be apparent to a regular reader is some of this happens on old articles you probably don’t see anymore. The new articles are just the tip of the iceberg with an established site like Monevator. And then there’s email…)

Commonsense but uncommon success

Am I a hypocrite? One of these commentators asked me why I didn’t accept all his certainties about market timing and so on, given that I – as I have I always admitted – invest much of my money actively for myself, unlike my purely passive co-blogger, The Accumulator?

And that brings us to the crux of the issue.

It’s because I think the things that the active advocates call for are so difficult, so speculative, and so unlikely to work out for most people that I stress the much more sensible route of avoiding the game altogether and going passive.

Indeed if I turn out to have beaten the market over the long-term – and if it’s not luck, which we’ll never know for sure – then it will be in part because I think it’s extremely difficult to do so, not because I thought it was easy.

It’s also why The Accumulator joined the site a few years ago. His consistent passive investing message is exactly the one most people need to hear when it comes getting their investing sorted over 30 years.

In contrast, the people who claim timing markets or forecasting asset returns is easy are either deluded, or they have some other agenda to promote.

Study after study shows the generally negative impact of the kind of poor decisions they advocate. They’re simply wrong to suggest that anything other than luck or very rare and hard-to-identify skill is required to do these things.

Reading the riot act

One day I may turn off the ability to add comments to this site. I’ve seen many big websites and also a few friends do it. Mike at Oblivious Investor, for example, turned off comments a year or so ago. Negative comments are sapping the will of Sam at the Financial Samurai blog, too.

It’s not come to that yet on Monevator. The sort of comments I’m taking about are still in the minority, and the input we’ve had from readers about things like platform fees has made us all smarter.

And to be clear I’ve always been happy if someone has quietly asked us why, for example, they should hold bonds when the price can clearly only go down – provided it’s not at the end of a post that explains exactly that. If you still disagree then fine, more power to you, but don’t feel you need to tell me about it unless you see factual errors.

I’ve never been happy to be lectured in a way that ignores everything I’ve just written. It’s wearying, and I’ve genuinely never learned anything from these people.

Almost worse, I don’t think they’ve learned much from me.

So it seems an arid exchange.

This site is not for these people. It’s for the 100,000 or so visitors who now arrive at Monevator every month, the vast majority of whom can pull up a chair and consider themselves at home.

And – while it’s not compulsory – it’s definitely for the 2-3 newcomers who email me every week to say they’re pleased to have finally found the information they were looking for to demystify investing.

In fact if you’re new around here then I’m sorry you had to wade through all this. I’m not normally so self-indulgent, honestly!

Long story short, commenting on this blog is not like writing a letter to your MP or the BBC. More so than ever – because I am getting so fed up with the annoying few – it’s my house, and my rules.

So know that anything you write may be deleted on my whim. Consider this fair warning as to the comment policy on this website. I will not let Monevator turn into another poisonous bicker-fest, such as you see at the online newspapers these days. There’s an entire Internet out there if you enjoy flame wars with strangers. I don’t.

The majority of our 100,000 monthly visitors never write or even read the comments – or when they do write comments they’re the useful or constructive sort. So this doesn’t apply to you, anyway.

Some of you will feel this whole rant is ridiculously over the top. Even some of you good guys! And I don’t blame you. Unless you have a website and have to deal with this stuff, it’s very hard to understand how soul-sapping it is, and it’s hard to explain. Just to take it from me (or have a Google), or set up a website for yourself and see.

Finally, if you’d like to say something nice or supportive and can’t because I’ve turned off the comments on this post, then thank you!

If you’ve not already, please “Like” this site on Facebook via that link, or by using the box in the column to the right. That would be a nice gesture.

[continue reading…]

1. I am not really thinking of any specific person — it is more an amalgamation of 3-4 people[↩]