Getting Minted

These are some ideas I passed on to a friend recently about taking a first step into investing in shares:

Dear

I was told that you have a lump sum of cash and are considering how to invest that for yourself and your children. I have some ideas on how I would deal with this which I can share with you. 

Interest rate returns on cash are very low at present. We get 1.10% on our instant access savings at the moment. This could be increased to 1.60% by committing to a 5-year bond, but price inflation is 2% (CPI measure) or 3% (RPI measure) so you are losing money in real terms. Therefore, I would only hold cash savings for immediate needs or as an emergency fund to cover 6 months of spending.

After providing cash savings for immediate needs and for an emergency fund I would invest in company shares. My preferred way of doing this is to invest in investment companies (also known as investment trusts).  I/We have invested in this way for many years and have achieved overall growth of 8% per year. This means that you can double your money every nine years. Individual years can vary, however, for example from a 23% loss in 2008 to a 27% gain in 2009, so you should reckon on staying invested for 5 years so any losses can probably be recovered.  

Here is a short video about investing in investment companies: Your investment journey.

The Association of Investment Companies (AIC) say that “Investment companies are a way to make a single investment that gives you a share in a much larger portfolio. A type of collective investment, they let you spread your risk and access investment opportunities you wouldn’t find on your own.” More information is available on the AIC website.

In order to invest you will need to choose a wrapper (investment account, ISA, pension, etc), and select an investment platform, before choosing an investment company or companies to invest in. If you are a first-time investor then a large global or UK investment company may be best. Here is an example of each that we hold or have held in the past:

F&C Investment Trust   They say that “the Trust is highly diversified and cautiously managed, with exposure to over 450 individual companies from around the world.”

City of London  They say that “the Company’s objective is to provide long-term growth in income and capital, principally by investment in equities listed on the London Stock Exchange.”

Please let me know if you are interested in finding out more.

Regards,

Small print: This is information not advice and it may not be appropriate to your individual circumstances.

I’d like to say more about my experience so far of living on 4% (or thereabouts) of my drawdown funds each year. Five and a half years ago I quit my job with a view that I could live on my existing assets if I chose to. I finished work in December 2013 so I regard 1 January 2014 as the start of this new phase. Apart from a two-week assignment in 2014 I haven’t worked since then and I’m not minded to seek work at present, although I don’t absolutely rule it out.

One of the reasons I quit when I did was because I felt I had enough. Financially I felt I had enough assets to live on. At that time the natural income of my investment portfolio had just exceeded my spending. I had reached and gone past the cross-over point as mentioned in “Your money or your life” by Joe Dominguez and Vicki Robin. Working on would have produced more cash than I felt I needed based on my current lifestyle.

I had read of the 4% “rule” – the so-called safe withdrawal rate. That gave me comfort that 4% was a reasonable level of drawdown. My portfolio then, and now, is mostly based on equity income investment trusts with a typical net dividend yield of around 4%. I knew with investment trusts that some income earned is held back from payment in a revenue reserve in better years so it can be released in order to pay the dividend in less good years. These trusts often have long records of maintaining and increasing their dividends. One leading trust has increased its’ dividend every year since 1966. This gave me confidence that the investment income I had in 2013 would be maintained and should increase over time. Historically it had beaten inflation going back twenty years or more.

I wasn’t assuming I would spend less when not working, but I was thinking that I didn’t need to spend more and could maybe spend less, and within reason I could choose when to spend anything significant. This was all of some comfort.

I have shown in the tables below how things have worked out so far in the five years to 31 December 2018.

2013 to 2018 - 4% Rule versus Dividends

The first table compares dividend income received and spending incurred against the guidance of the 4% “rule”, with the percentages calculated on the opening asset balance. I have uprated the 4% rule column each year using the RPI inflation measure. My current natural yield (4.89%) is now above what the “4% safe withdrawal rate rule” would suggest (4.39%) and also above the best flat rate annuities for my age (3.80%).

2013 to 2018 - Assets, Dividends and Spend

The second table shows the dividend income received and spending incurred, with the percentages calculated on the average of the opening and closing asset balances for each year. I have also shown spending as a percentage of income, and the growth (or decline) in the asset total.

Dividend income has been stable with an average yield of 3.96% and a range from 3.52% to 4.38%. Capital returns, including unspent income, have been more volatile with average growth of 1.47% and a range from -9.74% to +11.27%. Relying on the dividends enables me to be more relaxed about these capital fluctuations. Not selling the shares enables me to benefit from future capital growth and from dividend increases. Spending about 13% less than the natural yield has allowed me to reinvest a little.

I have chosen to invest in investment trusts in the UK equity and bond income, property direct UK, Asia Pacific excluding Japan (income), global equity income, and UK equity income sectors where the average dividend yields for each sector range from 5.9% to 3.9%. I am consciously selecting from a subset of the world market. I believe my chosen subset can match or beat the FTSE All Share index but not the global index at present. I reference my own returns as an equity investor from 1985 to 2018 and the published historic returns of my main holdings in coming to this view.

Going forward I see two possible threats to my approach. Firstly, inflation in the prices of what I spend my money on. Recently this has been of the order of 2% or 3% and the Bank of England is targeting inflation (CPI) of 2%. In the 1970’s, however, I remember much higher inflation and looking at the history of certain of my investment trusts it is true that their dividends didn’t keep up with inflation in those years. Inflation as calculated is based on a specific basket of goods and hence of continuous consumption. I reckon that my basket of goods will not match that of the statisticians, but more importantly I can choose to take less in my basket if I have to.

Secondly, the consistency and stability of taxes and the financial freedoms that we now enjoy could change. A future Labour government could threaten this with policies that could have an adverse impact on the UK economy, the UK stock market and UK dividend returns, and also a tax and nationalisation regime that could be a threat to investors. You can mitigate the some of this by investing overseas but you may not be able to avoid some of it. These concerns would, however, apply also to other strategies such as total return.

In summary given stability of prices and taxation and government policy generally then I am confident that my approach will suffice. Given the numbers so far it is so far so good.

The 4% “safe withdrawal rate” (SWR) is often mentioned on financial independence blogs (e.g. Monevator) or in books (e.g. Reset). I view it as a guideline based on a specific historical model. I prefer to use natural yield as my guide. Having ceased paid work just over five years ago I have now calculated how that has worked out for me so far.

The 4% approach suggests taking an income, or drawing down, only 4% of your available capital in year one and then increasing that amount by inflation each year. Some commentators suggest this draw down should be reduced to between 2.5% and 3.5% based on current high stock markets and to allow for fund expenses and taxes. Others suggest that a 4% draw down will leave you with a richer legacy to pass on in most cases.

Based on the original capital this 4% approach would start at a 4.00% withdrawal in year one and based on the UK retail price index (RPI) would have increased to 4.06%, 4.11%, 4.22% and 4.39% in the following four years.

The natural yield on my draw down portfolio started at 3.53% and has increased to 3.81%, 3.90%, 4.63% and 4.89%, calculated on the original capital value. This has been helped by a recent tilt to higher yield investments.

Interestingly both the above guidelines average 4.16% per year on the original capital value. The natural yield began 12% below the SWR (3.53% versus 4.00%) but is now 11% above it (4.89% versus 4.39%).

We can now consider how these guidelines compare to what was actually drawn down and spent. Being cautious in year one only 2.92% was spent, but this rose to 3.31%, 3.86%, 3.90% and 3.99% in the following years. This was an average of 3.60% per year on the original capital value and represents 86% of the SWR and 86% of the natural yield.

We can also look at how capital values have moved. Over the five years capital growth was only 3.07% but income exceeded draw down spending by 2.81% meaning that overall capital was 5.88% higher. This shows to me the importance of re-investing some income where possible and not spending capital gains.

Overall over the five years RPI Has increased at a compound rate of 2.42% (just ahead of the Bank of England target), spending has increased at a compound rate of 4.66% (after a low start), but investment income has increased at a compound rate of 7.38%. I’m pleased that the natural yield of income has grown to exceed that of the RPI and of my spending.

I am using tax free ISA’s and capital gains and income tax allowances to minimise taxes. My natural yield is after incurring individual investment trust charges. Low platform fixed fees and minimal transaction charges (as well as any tax charges) are included in my spending.

I aim to remain flexible on both spending and investing according to future circumstances and will use natural yield as a guideline.