2008 could well be the year when we investors are reminded about the benefits of asset allocation. This rather academic sounding discipline is generally forgotten in times of roaring stock markets, but when the weather gets rougher, people are glad they’ve packed umbrellas as well as beach towels.

I plan to learn a lot more about asset allocation ahead of 2008, but the principle is simple enough – don’t have all your eggs in one basket. Most private investors know about diversification, buying a range of shares or an index tracking fund to spread their risk of a particular company putting in a stinking performance or even going bust. But eggs is eggs, and a basket of shares is only a basket of shares.

You need different asset classes as well as different assets

Asset allocation says you need to have several baskets, investing in the likes of cash, government bonds (Gilts in the UK, Treasury bills in the US), corporate bonds, property, precious metals, commodities, emerging markets and so on, alongside your shares. The downside is likely reduced returns, especially in the long-term.

The upside is reduced volatility, as a bad performance by one asset class is hopefully compensated for by better returns from another, uncorrelated, asset. Some commentators go further to claim average performance will be boosted with optimal asset allocation, although luck and timing would seem to play a part here. Shares are the best performing asset by far over the past 150 years, after all.

So how much should you put into what asset class? That’s the $6 million question, and there’s no firm answer you can trust, since even the most detailed studies are based on past returns. Nobody knows what will happen in the future. [continue reading…]

You know Duncan Bannatyne. Okay, not the name perhaps, but you know the man. The accent.

Come on, you remember – the scary one on BBC2’s Dragon’s Den? The bloke who sounds moments away from thumping the next entrant who wants £100,000 for a 10% stake in their snake charming business?

The great triumph of Bannatyne’s Anyone Can Do It, the new paperback edition of which I’ve just read cover to cover, is that it transforms its subject from a man you’d avoid outside a pub to a man you’d love to share a pint with.

Bannatyne – perhaps we should call him Duncan, which sounds more human, less like an enforcement robot out of Robocop, and so suits the person in this book better – is certainly not the first Scot from a dark corner of Glasgow to be hastily judged by his consonant dropping speech-cum-warcry. Hell, to sensitive English ears even the posher denizens of Edinburgh can sound like they’re giving you ten seconds to run for it.

But in Bannatyne (Duncan’s) case, first impressions couldn’t be more misleading, as this revelation of a book makes clear.

[continue reading…]

Last time we saw how buying £550 worth of stuff on a credit card could take over eight years and £1,000 to repay.

Awful – but it gets even worse when you consider what else you might have done with your money.

Personally, I’d rather drink £550 in beer than pay it to a bank in interest, but I’d far rather save and invest it towards my goal of financial freedom.

A big deal: When compound interest works for you

Let’s assume that instead of using a credit card to furnish your bedroom, you saved up the money to buy your bed, mirror, picture of an attractive girl in the rain, and so on.

You paid cash, and had no more payments to make afterwards.

What if you take the money you would have paid in credit card interest over the next eight years, and instead invest it in the stock market?

Let’s keep the sums simple, and assume you saved £5 a month for those 99 months, or £495 in total.

According to the standard long-term study, the UK stockmarket has returned around 9.5% a year (or 7% above inflation).

Putting these numbers through a compound interest calculator:

• First payment: £5
• Regular monthly payment: £5
• Assumed growth rate: 9.5%
• Total after 99 months: £752

Does that astonish you? It should. Instead of spending £495 on interest, you’ve grown that £495 to £752 – so you now have 50% more money, not 100% less as when you spent on credit.

Shares should be held for the long-term – there’s no guarantee your £5 investment a month would compound by 9.5% in any particular year. But according to the history books, it’d be a good bet over eight years.

True credit: Save and invest for the long term

It gets better. Let’s suppose you discover you quite enjoy this investing lark, and decide to put that £752 you’ve now got towards your retirement.

We’ll assume you’re 30 – you bought your first bed eight years ago, after all – and you’ll retire when you’re 70.

What would the £752 be worth in 40 years, after you quit work?

Are you sitting down?

• £28,365

Incredible, isn’t it?

True, that’s in today’s money – after 40 years of growth adjusted for inflation (around 7%), you’d have more like £11,000 in real terms.

Still, that means you end up with 22 times more money than the interest you’d have paid if you’d bought the bed on a store card all those years ago.

Remember, you haven’t gone without here – you bought the bed out of your savings. We’ve only invested what you would have spent on the debt interest.

Another way of looking at it: When you buy on a credit card, your 70-year old self bought your 22-year old self a bed for £28,365! Not my idea of a great deal.

When you do these sorts of calculations, it’s easy to see that:

• Saving from a young age can make you rich.

• Spending on debt repayments will make you poor.

What’s the catch?

Economists will tell you that your bed is worth more to you when you’re 22 – you need somewhere to sleep – so it’s worth all that forgone cash.

A good bed might stay good for many years, whereas you can hardly wait until you’re 70 to buy your first.

There’s some truth in this – and there’s the time value of money – but the fact is that there’s always an alternative way to get a bed.

• You could get an old one from a friend.
• You could look on Freecycle.
• You could build a bed.

You only need to make do until you’ve saved up to buy the bed you really want, in cash, when you can afford it.

Personally, I would never pay a penny in interest to buy anything except property.

Life isn’t just about buying beds, but the principle is the same for the rest of your shopping. Delay and do without until you can afford to pay cash.

Don’t believe the hype, and don’t buy with debt. Divert your free cash into saving and investing instead.