The 85% Solution to Personal Finance
A few weeks ago I started writing Twitter threads on ‘The 85% Solution’ to different topics.
The goal is to distil the concepts that will improve people’s abilities in any given topic by the most disproportionate amount. That means by only applying those few principles, the improvement in any area will be disproportionate compared to trying to learn everything at once.
For personal finance, these are the most disproportionately important concepts that everyone should be aware of, and implement, in order to manage their money most efficiently.
Compound Interest Compound interest is what happens when the interest gained is reinvested, meaning that you get interest on interest. The basics of this are very obvious, but bear with me, it’s worth it. Let’s look at a visual example:
The effect of linear investing over a 25 year period.
The graph above shows 0 interest gained. Each bar on the graph grows by a fixed amount (however much you put into it) each year. This is what your money looks like when you save it. But look what happens when you apply a yearly interest rate of 7.75%. I chose 7.75% as this is the average rate of the FTSE’s returns since it was founded in 1978. During that time, there has never been a ten year holding period (investing and keeping that investment for 10 years) where the investor has lost money.
The effect of compound interest on investing over the same period.In simple terms, if you get 7.75% interest on an investment, over 10 years you will make 50% on top of the money you put in, but in 25 years, you’ll make three times the money you put in.
Over an extended time period, compound interest is extraordinarily powerful. This is why Warren Buffett has consistently spoken about the benefits of passive investing (investing over a long period in a fund that tracks the market).
However. There’s a nasty side to compound interest. Credit card debt.
It works off the same premise. If you don’t pay the balance in full every month, they charge you interest on the sum. If you don’t pay that balance for two months, they charge you interest on the new sum, which includes the interest that you had to pay before. (They probably charge you late fees and a bunch of other terrible things too, but that’s another conversation.) This continues until you pay the balance in full. What ends up happening is, you pay a ton of interest, as well as whatever you spent the money on in the first place. Bad times.
Compounding is important for because of the two things I mentioned:
Credit Card Debt
It is SO important that everyone understands compound interest because of the huge benefits, but also huge drawbacks that it comes with: One steals your money, and the other makes you money.
Free Money Opportunities Contrary to popular belief, there are opportunities for free money. The downside is that they often come with some caveats. Some would say drawbacks, but I like to say they come with conditions.
Exhibit A — The Lifetime ISA In the UK, the government will give you 25% interest on balances up to £4000, every year until you’re 50 years old. This is an example of a free money opportunity. In no other circumstance are you going to earn a 25% return, guaranteed. How you do it: Put in £333 per month into a cash Lifetime ISA. Over 12 months this equates to £3996, so in your first month, make it £337. The condition is that you have to use the money for either buying your first house (max value of £450,000), or your retirement.
Exhibit B — Cashback credit cards All of your spending should be on credit cards. You build your credit score by utilising credit, so getting a credit card and not using it isn’t enough. Cashback credit cards work under the premise that if you spend a certain amount, the provider will give you a small percentage back. Oftentimes this seems too low to be worth it, but when you add it up, it all adds up. More importantly, free money is free money. Even if you get 0.5% on whatever you spend, if you spend £500 per month, that’s £2.50 a month that you didn’t have before. An extra £30 seems like not worth the hassle, but an extra £30 year on year adds up to a tidy sum after a while. The biggest caveat here, and I CANNOT stress this enough:
PAY YOUR CREDIT CARD IN FULL EVERY MONTH BY DIRECT DEBIT.
The APRs on credit cards are NOT good. Like, terrible. See the above about compound interest for why.
If there’s an opportunity to get money in your pocket, take it.
Don’t Invest In Stocks This is a clickbaity title, and for that I apologise. But the meaning behind it is solid. What I really mean is, don’t invest in individual stocks. There is a whole methodology behind passive investing and index investing but this is it in brief:
PASSIVE INVESTING: Trading stock regularly vs buying and holding stock for a long term is the difference between timing the market and time in the market.
Timing the market = bad. Time in the market = good. This is because “Passive investment is cheaper, less complex, and often produces superior after-tax results over medium to long time horizons than actively managed portfolios.”
INDEX FUNDS: These track a whole stock market index like the FTSE, which contains a lot of different companies’ stocks. This means you are not tied to the performance of any single company, instead you’re investing in the market as a whole.
WHY INVEST IN THE MARKET: Individual stocks are risky, because their returns can go up and down year on year. If the stock goes up, congratulations you’ve made some money. But, if the stock goes down, you lose money.
Investing in lots of stocks is a bit of a luxury for most people, but what if you could track the movement of the market year on year. That means you’ve invested in all of the stocks, whether they have good years or bad years, without having to invest in any of them directly. When the market does well, you do well, when the market does poorly so do you, it’s investment after all. But when you extend the time horizon over a long period of time, the market has returned about 7%, which is damn good.
Save before you spend This seems like a nice idea in theory, but people have their own reasons for not being able to do it. From personal experience, the reason I struggled was that I spent the money first and then tried to save at the end of the month. I realised that I was setting myself up to fail, because everyone has expenses and wants and needs that cost money!
If you say to yourself that you need to save money, then start at that point. Pick a fixed sum that you’re going to put away, and set up a direct debit from the account you get paid into a few days after you get paid for either the full sum or part of it (if you aren’t paid monthly) so that the money automatically goes out of your account.
I now don’t even think about saving. it happens automatically and as a result I’ve saved thousands of pounds simply because I’m not consciously having to do it.
There’s an argument that “people can’t save because they’re living paycheck to paycheck” and I understand that, and it’s an awful situation to be in. For those people, I truly empathise, it can feel like an impossible situation where there’s no end in sight.
So, the more pertinent way to start thinking about saving is how do I spend even less than I currently am? Is there a way of getting what I currently do, for less money? There are wiser people than I who have written extensively on this topic, the website MoneySavingExpert by Martin Lewis is a great place to start.
Some simple options:
Call your credit card provider and ask them to cut your interest rate down. Firmly tell them that you will be switching to another provider if they aren’t able to help. You’ll be surprised to know that they’ll often oblige.
Call your utilities provider, tell them that you’ve seen better deals elsewhere and you’re thinking of switching. Miraculously there will be a whole set of deals, cheaper than your current one, that are now available!
Look at your grocery bill, if you’re buying name brand, buy private label (Sainsbury’s own // generic supermarket) instead — it’s often a fraction of the price.
There are always ways of saving money, but it takes having a conscious goal of doing it to manage it.
And that’s it. If you save before you spend, utilise free money opportunities to maximise the amount of money you get, and put money into the market as early as possible, you have an 85% of perfect solution for your finances.
Follow me on Twitter @DavidJacob_1 for more like this!