Should we fix it?

 

Carole shakes off the slob monster to prepare for a visit by the Sorting Fairy – who convinces her to employ hindsight to an investment in fixed-term deposit accounts

 

I am writing this from the no-man’s-land that is the space between Christmas and new year and using the occasion to make two predictions. First, I predict that in the next day or two those around me are going to start using words like Dry January, Veganuary, Gymuary (I made that one up) and Januhairy (google it), while I smile encouragingly and marvel at how convincingly they have become Captains of their own Destinies. (For the benefit of any doubt I should make plain that I have never been remotely tempted to commit to an alien regime just because the month has changed. Not only that, but who wants to be a cliché when it all comes tumbling down long before the month changes again?) My second prediction is that I am about to be visited by the Sorting Fairy.

Wresting back control

It hasn’t happened yet, but I can feel it coming on. For although, as stated above, I am a complete stranger to January gym membership and the like, I am starting to feel the need to wrest control back from the clutches of the profligate slob monster that takes a hold of me at this time of the year. I know that for many people a similar process is kickstarted by the looming deadline for returning their tax form at the end of January. But for me it usually starts when I pick up an unopened letter from the dark age of the pre-festive season – one that has been deliberately misplaced to make space for food, drink, games or a homeless reindeer – and put it in the household filing pile.

This will prompt a mental note to actually do some of that filing before the work/school/regular-dinner-with-vegetables routine starts up again in the new year. And while that thought will take a day or two to settle, when it does, I will have no choice in the matter. It won’t be a conscious decision to take action but I will, at some point in the near future, find myself on my hands and knees surrounded by piles of – mostly finance-related – letters and statements in an exercise that has become something of an annual ritual despite my own internal protestations that ‘surely this can wait until after the holidays?’.

Time is against us – so let it ‘just happen’

Very often, I think, we declare that time is against us. If we had time to do all the things we are supposed to in order to live our best lives then we would clearly be living them (or, more likely, we wouldn’t have time to live them because we would be using it all up sorting them out). I have been surprised on more than one occasion when I pose the question in the Women Save Men Invest workshop ‘What are the barriers to you seeking advice about your finances?’ I have expected the answer to be money or lack of experience, but often it is lack of time.

What I like about the Great Annual Sorting is that is just happens. I really don’t plan it and I certainly don’t schedule any time for it. In fact, if I did, I would undoubtedly find that I couldn’t fit it in due to a TV scheduling clash or an urgent need for a nap on the sofa. And it ‘just happens’ partly, I think because there is time for it, and partly because the excesses of Christmas leave me feeling ever so slightly unbalanced. However trivial, the sorting of the filing that has built up over the months is a small attempt to feel that I am back on it (sort of).

Additional benefits of the annual Sort Out

And it has proved, over the years, to bring a couple of additional benefits beyond helping me to climb, bleary-eyed, back into real life. As a result of all this sorting out, we usually come across an inefficiency within our family admin that, it turns out, really doesn’t take that long to turn around. We have, for example, found ourselves changing energy suppliers, switching phone contracts, amending regular savings direct debits, redirecting money to better-suited accounts. One year, I spent 50 minutes doing two like-for-like online weekly shops to discover that I could save £17 a week by changing to a different supermarket. Martin Lewis would be so proud.

It is always a fruitful exercise and yet I know full well that if someone else told me that I had to do it at this time every year I would throw my hands up and say that I simply don’t have the time. Even the act of writing about it now is making me feel just a tiny bit duty-bound by it and so likely to want to resist. But, actually, I have even more reason this year to give in to the Fairy and go full-swing into sorting mode.

Time to put my own financial house in order

In 2019 I completed the exams I need to become a financial planner. I am now on that route and have a nagging feeling that I should really have my own financial house in order. And whilst I haven’t yet tackled that filing, I know that there is something in there that needs my attention. Seven years ago my husband had an inheritance. Despite my finance-y background, becoming a financial adviser was not on my mind at that point in our lives so we just went with our instincts. We used some of it to pay off a bit of the mortgage, some to pay for the conversion of the garage into a home office, some went on a car-shaped ‘toy’ (that wasn’t me) and some went into a fixed-term deposit account (sometimes referred to as a bond) vaguely destined to help with the children’s future (uni fees or, perhaps, towards a property deposit).

Fixed-rate deposit accounts: because we shied away from risk

If my memory serves me right we fixed for two years at the start, then three, then two again. Each time the term came to an end, we looked at the rates on offer for the various terms available and took a view on whether we thought interest rates outside of this deal would be going up before the term we chose came to an end. The longer we fixed for, the better the rate we would get. But we were always mindful of the fact that interest rates had been low for quite some time and would – surely – go up some time in the near future, and we didn’t want to miss out. We were disinclined to take any risks with the money – partly because it was an inheritance (irrational, I know, but at the time it didn’t seem the right thing to do), and partly because we didn’t give enough thought to the timescale that was in front of us before we would likely want to use the money.

Were we right to fix it?

What I want to do, whilst under the Sorting spell, is force myself to look at our decision about this portion of the inheritance and work out whether a) it has managed to keep pace with inflation – ie, would the amount it is worth now buy us more or less than the original amount invested would have bought us at the time; and b) how much risk we would have had to take to get a better return than we have had to date. I will also have to decide what to do with it as the fixed term runs out at the end of 2019.

My findings will appear in the ‘A bit more understanding’ section below, in case you’re interested. And, of course, in case you have time to read it in between gym visits and picking out the bits of meat from your turkey curry.

carole@talkingfinances.co.uk

 

A bit more understanding

Some days later: Well, the first thing to say, having done all that sorting, is that my memory did not serve me well in this instance. As regards the fixed term deposit, it seems we fixed for one year only in year six and then for two years at the end of last year. Lesson number one: don’t rely on memory, knock up a spreadsheet!

Nonetheless, I have still done the back-of-the-envelope exercises I wanted to do – even though there is another year to run on the term.

Summary of my findings: a real return of 1.06% per year

The summary of my findings is that, by reinvesting all interest earned, we have had an average return of 2.69% per year on our investment, which, if you take off inflation, gives a real rate of return of around 1.06% per year. This doesn’t sound like much but the capital has been safe and we have incurred no costs. Had we known at the outset that we would want to access this money for a specific purpose at any point between 2013 and now, this looks reasonable to me (if not exciting). Partly thanks to the fact that we have not paid any tax on the interest earned, we have more than kept pace with inflation and have taken virtually no risk.

With the timescale we had, we could have taken some risk

That said, we won’t actually be needing the money for at least another two years – in other words, nine years from when we started. And we knew that at the time. So, with this timescale – and with a financial planner hat on – I now see that it might have been sensible to consider taking some risk with the money and investing it in something other than a deposit account. This is because, the longer the timescale, the greater the chance there is that any ‘falls’ in the value of a riskier investment can be recouped over time.

Comparison with a mixed portfolio of investments

To make a rough and ready comparison I looked at the sort of portfolio of investments that I think we would have considered at the time, had we been prepared to take some risk with the money. For the purposes of this exercise I have chosen a portfolio from a number that are labelled ‘Cautious’ and that are classified as being allowed a maximum of 35% in the ‘riskier’ type of investments called equities (or shares). This portfolio returned an average of 5.49% per year over the seven years in question.

Taking out inflation and costs for a better comparison

But an investment like this would have incurred management and other costs (it is hard to say how much these other costs would add to the total as that would depend on whether advice was being taken, what sort of advice, whether the investment was held on a platform and how much the investment was, but I have assumed a middle-of-the-road cost of 1.5%). If we strip out both inflation and my estimated cost of having such an investment, the return looks more like 2.36%.

How much risk would we have taken?

This is clearly more than the real return of 1.06% a year that we have had from the fixed deposit account. But we would have taken some risk with the money and we wouldn’t have known at the start what the return was going to be (unlike with the fixed-term deposit account). So, we should weigh up the risks involved. By looking at the way the investments in the portfolio have behaved in the past (not always a reliable indicator, as we know, but it’s all we’ve got), it can be calculated – by use of a clever analysis tool that we really don’t need to understand – that, for this particular portfolio, there is a 5% risk that the value of an investment in it could fall by 9% or more. By comparison, had we chosen a ‘higher risk’ type of portfolio with more equities, we could be looking at potentially far higher returns but a 5% chance of a fall in value of more than 20%.

Key to suitable investing: How much risk is right for you?

And there we have, within those probabilities, the essence of risk and investing – all delivered in one short burst of ‘sorting out’ activity! For, if we had gone down the investing route seven years ago, we would have been faced with exactly these sorts of variables: How much risk would we be prepared to take in return for the chance of a higher return?

The answer to that necessarily depends on what we wanted the money for and when. As we knew at the time that we would not need it for at least nine years, we would have been taking a view on whether a 5% chance of a more than 9% fall in value at any point was acceptable to us, given the length of time we had for the investment to recoup any falls of this magnitude. There is no right or wrong answer – only the question of what was suitable at the time.

Investing decisions require a good understanding of risk

This has been a useful exercise for me. I can’t turn the clock back – any more than I can use the benefit of hindsight – to take a different course of action. What it has done is to reinforce what I know about investing – that there is rarely a clear answer to the question of how much risk to take with your money. Everything depends on what you want out of it and how you would feel if you lost any of it.

It has also helped to consolidate in my own mind the importance of having as much information to hand as possible and – crucially – understanding that information so that decisions can be made for the right reasons. And this, in turn, has convinced me of the need to continue running workshops on investing for those who feel that their understanding is not as full as it could be.

Even more understanding (with numbers)

Here are the numbers, if you’re interested:

    • Deposit account returns: Using the rates we fixed at, if we had invested £100, this would be worth £118.81 at the end of 2019. This is a return over seven years of 18.81% – or approximately 2.69% on average per year
    • Managed portfolio returns: If we had invested in the cautious managed portfolio that I have picked, we would have enjoyed an average return of 5.49% over the seven years
    • Inflation: I would need £111.39 at the end of 2019 to buy the same things that I could have bought with my £100 at the start of 2013. This is an average inflation rate of approximately 1.63% per year

 

We can therefore work out that the REAL rate of return (over and above inflation) on the deposit account has been 18.81% minus 11.39%, which equals 7.42% over seven years, or an average of 1.06%. And the REAL rate of return on the managed portfolio (excluding costs) has been 5.49% minus 1.63%, which equals 3.86%.

 

We should note the following:

  • All the interest earned on the deposit account has been reinvested – or ‘compounded’
  • No tax was paid on the interest because we put the account in my name and I wasn’t earning enough in the early years of the investment for it to take me into tax-paying territory. Since April 2016, basic rate tax payers are allowed to earn up to £1,000 a year interest on their savings before paying tax (£500 for higher rate tax payers, zero for additional rate tax payers).
  • If I had had to pay tax on the interest earned, the returns would have been less

Even more numbers

The returns for the deposit account, the managed portfolio and the rate of inflation for each of the years in question are set out below (the interest rates are annual and gross – so no tax taken off; the inflation is the change in the Consumer Price Index (CPI) over the year)

Calendar year 2013

Deposit account interest of 3.25%, inflation of 2.0%, managed portfolio return 5.29%

Calendar year 2014

Deposit account interest of 3.25%, inflation of 0.5%, managed portfolio return 8.71%

Calendar year 2015

Deposit account interest of 2.35%, inflation of 0.2%, managed portfolio return 2.19%

Calendar year 2016

Deposit account interest of 2.35%, inflation of 1.6%, managed portfolio return 9.42%

Calendar year 2017

Deposit account interest of 2.35%, inflation of 3.0%, managed portfolio return 5.34%

Calendar year 2018

Deposit account interest of 1.71%, inflation of 2.1%, managed portfolio return -3.03%

Calendar year 2019

Deposit account interest of 2.20%, inflation of 1.5% (to November 2019), managed portfolio return 10.75%

 

Workings out

To work out the compound return from the deposit account I assumed a £100 investment at the start:

£100 X [(1.0325)² X (1.0235)³ X 1.0171 X 1.022] = £118.81

I did the same for inflation:

£100 X [1.02 X 1.005 X 1.002 X 1.016 x 1.03 X 1.021 X 1.015] = £111.39