Investing – Index Trackers

Hopefully you haven’t lost the will to live and you’re super excited about the prospect of your spare cash working hard for you. In a previous post I explained what a stock and a bond was.

First things first, what’s an index? You may or may not have heard of the ‘FTSE 100’. This is an index that is based in the UK and it’s a group of the UK’s top 100 companies based on market capitalisation (no worries if you don’t know what this means, here’s a nice explanation: Market Capitalisation ).

A list of the companies in the FTSE 100 can be found here: FTSE 100

As the previous blog post explained. Investing in just one company is as risky as it gets when buying stocks (unless you can set aside a large proportion of your time researching the company and I’m talking about analysing annual reports, investigating the company’s industry and what economic and global factors could affect the company’s profits in the future) and for the majority of investors like you and me, being able to spread our hard earned cash over many companies is probably the best way to go.

This is where index trackers come in. Instead of buying 1 company’s stock, you have the option to buy all 100 companies in one go by purchasing a unit from a fund.

Fund Basics

  • Funds sell units (not stocks).
  • Each unit is made up of the value of the group of stocks from the index that it’s tracking
  • There are 2 varieties of units
    • Income – These pay out distributions directly to you
    • Accumulation – These use the dividends paid by the companies in the index to buy more stocks on your behalf

A more in depth look at the different between income and accumulation units can be found here: Income vs Accumulation

Here’s a quick run down of looking at a fund’s page: Vanguard FTSE 100 Index

  1. This tells us that this tracker follows the FTSE 100 index and it’s the unit type of income
  2. This is the cost of 1 unit (you don’t have to buy them in whole units). The ‘Change’ tells us the change in price from the previous day
  3. This is the number of stocks that unit price comprises of
  4. This is the Ongoing Charge Figure. More on fees later
  5. How risky the unit is out of 7. 1 being the least riskiest and 7 being the riskiest

Here’s an example of why buying a unit from an index tracker fund trumps buying an individual stock:

Investor A buys 10 shares in Company A.

Company A’s shares will fluctuate on a daily basis and in the worst case scenario the company may eventually go bankrupt, in which case investor A loses all of his cash.

Investor B buys 10 units in a FTSE 100 index tracker

The index tracker unit price is going to fluctuate on a daily basis, however unlike investor A, if a company in the FTSE 100 was to go bust, the unit price will drop but the investor is still invested in 99 other companies. The only way investor B would lose his money is if all the businesses in the FTSE 100 went bust.

Units do pay out distributions (much like stocks paying dividends). When these are depends on the fund but you should be able to see from a funds website, how often it distributes money to its unit holders.

As well as stocks, you can invest in bond funds too. Another example is Vanguard’s UK Government Bond Index Fund. This fund buys Government bonds of varying lengths of maturity.

Now you might be thinking. Great! I don’t have to put all my spare cash in one company, I can buy an index tracker unit and effectively buy into 100 different companies. Plus, if I don’t fancy too much risk with companies, I can buy a unit in a Government bonds index tracker because hey, when did the Government last go bust?

Fantastic, now your on board with index tracking, there is just one last bit I want to show you. There are many stock market indexes around the world. The S&P 500 (US), Nikkei 225 (Hong Kong) and FTSE All Share (London) are just a few.

Now what if there was a fund out there that followed all these different indexes, so not only was your spare cash invested in many companies but these companies were all over the globe. Well there are and one of the cheapest funds you can purchase is from Vanguard: Vanguard LifeStrategy 100% Equity

If you take a look at the portfolio data tab, you’ll see this is actually a fund of funds, which is giving you global diversification. Just think, when you’re sleeping, your cash is still working away.

They also do a whole bunch of other funds which are split between a globally diversified portfolio and Government/Corporate bonds, Vanguard calls these LifeStrategy funds.

I personally have chosen to buy the Vanguard LifeStrategy 80% Equity fund. This means that if you were to invest £100, £80 of that would be used to be stocks and £20 would be used to buy Government/Corporate bonds.

I’m hoping this hasn’t been too overwhelming. There will be future posts on fees (which is a hotly debated topic in the finance industry) and tax efficient wrappers (I’m talking about the beauty of ISAs and the SIPP, Self Invested Personal Pension)

If this has only left you wanting more then welcome to the club!

Just a practical note here. Please, please do further reading if this is the first blog you’ve come across on this subject. It’s by no means certain that you’re money will go up over time and that you won’t lose all that you invest. However, I’m of the opinion that unless global capitalism fails spectacularly, I think investing in index trackers is about as good a break as you’re going to get in investing.

Making Your Spare Cash Work Harder

So all that hard work has paid off. The SSBS has done its job and now you find yourself with some extra cash lying around and you’re not sure what to do with it. Well you have a number of options, one of those is lending it to the Government or companies (known as buying bonds) or buying a stake in a company (known as buying stocks).

I’m reluctant to use the word ‘investing’, purely because it instantly brings up images of gambling and people like Jordon Belfort.

I want to make this as clear as possible. With a little effort (and I’m talking about doing a small amount of reading) you will realise that the term ‘investing’ isn’t the big scary complicated monster, you may think it is. Investing does not have to the equivalent of putting all your money on black at the roulette table and waving goodbye to your hard earned cash.

I’m going to quickly talk about 2 of the most widely bought asset classes, stocks and bonds. No problem if you’re unsure what an ‘asset class’ is, here’s a nice explanation: Asset Class. I’m going to keep it short in the hope you don’t lose interest, so please bare with it, you’ll be glad you did when you’re done.

Bonds

First off, what is a bond and why would I buy these with my spare cash? Put simply a bond is a loan from you to the Government or company. The Government or company will put a price and time frame (known as maturity) on the life of the bond and a rate of interest (known as a coupon) you will earn for loaning them your cash. Once the time frame is up on the bond (it hits maturity) you get the cash back that you paid for the bond. For example:

Company A are offering a 5 year bond with a 5% coupon for £100. So the math plays out like so.

You buy 1 bond for £100.

Every year you’ll earn 5% interest on the £100. So 100 * 0.05 = £5

After 5 years you will get your £100 cash back and have earnt £5 (interest earnt per year) * 5 (number of years) which is £25. Which gives you a grand total of £125.

Government bonds are considered safer than company bonds because the Government isn’t likely to go bust anytime soon. However, because of the relative safety of your cash, the interest rate the Government offers is usually much lower.

How do I buy bonds?

Buying individual Government bonds can be done via the NS&I website.

As for buying company bonds. You will have to investigate this yourself as I’ve never bought a company bond directly. However, it’s not going to be any more complicated than buying a bond from the Government.

Stocks (also known as equities)

What is a stock and why would I buy these with my spare cash? A stock is you buying a stake in a company and in return for buying a stake in the company, you will be entitled to regular payouts known as dividends.

Similar to bonds paying interest, stocks pay out dividends. Dividends come from the companies profits and it’s a sort of thank you from the company to the shareholder for taking the risk and buying a stake in that company. The biggest difference between bond interest and a stock dividends is, a company does not have to pay its shareholders dividends. Companies set when a dividend is paid, so a company may decide on paying a dividend every 3 months, every 6 months or once a year. It all depends on the company as to when this happens.

As well as the dividends the stock price may increase or decrease overtime. Ideally you’ll want the stock price to increase but this is not a guarantee. A stock price may increase or decrease for many, many reasons. Imagine you buy stocks in a pharmaceutical company and they find a cure for a widespread disease and they are the only company that can produce the drug. Based on this information, the company is likely to be more profitable in the future due to the research breakthrough and so the stock price will likely increase. However, this works both ways, the company may be trialing a drug and the results come back as it’s no better than a placebo. This would then likely cause the stock price to fall as the company’s profits may not be as high in the future due to the new drug not being a success.

How do I buy stocks?

You buy stocks through a ‘brokerage’. A brokerage is the middleman between you and the company you want to buy stocks for. They will handle all the complexities of buying the stock upon your instruction. For this they charge for each transaction. They will also charge a fee for holding the stock for you. This is usually a percentage of the total value of your stock portfolio (read that as the total value of all the stocks you own).

Monevator has done an absolutely outstanding job of comparing online brokers for UK investors: Compare the UKs cheapest brokers

Conclusion

If you’re now a little pissed because you’ve just spent a good 10 minutes reading this and although it all sounds like a good idea, it’s still confusing and seems risky, then don’t worry. You’re right to think it’s risky. Investing in bonds and stocks like this is about as risky as it gets. Now you may be thinking, OK, so I was right about it being risky, how do I reduce the risk but still take part so my spare cash works harder for me? Well, you’re going to love the next installment on this. It’s called indexing and it comes with some massive advantages for the average investor like you and me. It’s the equivalent of putting the eggs you own in many, many baskets without needing to think about it too much.

 

Saving

So you want to increase the amount of cash you’re saving each month. The quickest way to achieve this is by cutting down on your spending. It’s as simple as that. The tricky part is knowing which bits of your spending to cut down on.

In the example SSBS you’ll see in the outgoing column items you may be familiar with. Just in case you can’t remember, here it is again.

The easiest way to see what could be chopped off your monthly spending is by prioritising what you need to live and go from there. So my approach would be to start with the basics and work your way back.

The Basics

  • Mortgage/Rent
  •  Utility
    • Electric
    • Gas
    • Water
  • Council Tax
  • Food
  • Phone line/Internet

Now, ‘The Basics’ are going to different for different people. You may decide that your mobile phone or contact lenses are items that you cannot do without and that’s fine. For me, anything that comes after the above is a luxury and the cost should be watched like a hawk, if not cut out all together.

So going back to the SSBS example. One outgoing that I would certainly consider ditching is Sky TV. By cancelling Sky TV you’re already able to save £50 per month without making any other lifestyle changes. Over 12 months, that’s £600!

If I’m about to make a monthly commitment for the foreseeable future, the quickest way to decide whether it’s worth it for me is to times the monthly amount by 12.

For example:

Product Monthly Cost Annual Cost
Amazon Prime £7.99 £95.88
Netflix Premium £8.99 £107.88
Total £16.98 £203.76

The yearly total on these two services would be £203.76. Now to me, I would prefer to have saved that £203.76. However, if you’re a film/TV buff and enjoy these services, that’s fine. So long as you are aware of the potential savings that can be made by cutting out the non-basics from your outgoings.

So now you’ve reviewed your outgoings and are happy that you’re saving enough but you may be saying to yourself ‘but what am I saving for?’. For me, it’s piece of mind. Having a cash pile in the bank will reduce those anxiety inducing situations like having a car problem or needing to replace a boiler at home. A savings target of between 6 to 12 months of your take home monthly salary will put you in a very comfortable position.

There are many, many more ways in which to reduce your monthly outgoings. If for example you commute to work by car with a journey that is less than 4 miles and you live in a town or city, consider cycling or taking the bus. If you happen to live in a very expensive part of a town/city. Considering moving to a cheaper part or closer to work in order to reduce those commuting costs. Cook more at home instead of eating out. Cook larger portions of food when you do cook so you can take them to work instead of buying lunch. Get into the habit of multiplying the cost by the number of times you do it. Last example, I promise. Lunch at the sandwich shop each working day of the week.

Lunch £5

£5 x 5 (Monday – Friday) = £25

£25 x 4 (roughly the number of weeks in a month) = £100

And just to hit this home £100 x 12 (yep, the number of months in a year) = £1200.

Now is that shop bought lunch really worth 1200 of your hard earned pounds? O.k admittedly this is extreme but I’m hoping it’s helping with demonstrating where you can save and how even saving small amounts can have a big reward.

Fantastic, so now you’re budgeting like a pro, the debts going or gone, the non basic outgoings have been exterminated and you’re on your way to having a nice pile of cash just smiling at you when you check your bank account. You may be wondering what happens when you’ve hit your saving target, well I’m glad you asked. Up next we will look at what you can do with this extra cash to make it do more than just smile at you from your bank account.

High Interest Debt (Credit Cards / Payday Loans)

So hopefully you’ve got your SSBS filled out and you have come to the conclusion that something has to be done to increase the amount of cash left over each month. You may be unsure on where to start cutting back in order to achieve this.

If you have outstanding credit card / payday loan debt and only pay off the minimum each month. This is where you start. Simple.

Credit card and payday loan debt is one of the most expensive ways to loan money. Interest rates can go into the 1000s of percent. The quicker you pay this debt off the less interest you will pay on the outstanding amount, which means more cash in your pocket in the long run. Even if you can’t clear the balance this month or next. Throw whatever you can at it in order to clear it as soon as possible. Don’t be tempted to take out another loan to pay off a different loan. Keep things simple and just reduce the debt to 0 as soon as possible.

Here’s a quick example. The loan below is on offer from a well known payday loan company and it’s offering to take nearly double the amount of money off you, than you actually want.

For a loan of £600, over a 6 month repayment period. It will cost you a total of £1138.29. The total you are paying back is nearly double what was borrowed in the first place.

The ideal approach to this is, you use the SSBS to budget and save for that £600 purchase. The bonus being you then go on to keep the other £600 that nearly ended up in someone else’s pocket.

Credit cards can be just as bad although interest rates are usually lower. My advice is simple. Clear this debt as soon as possible. However, if you happen experience some kind of strange satisfaction from using credit cards, then make sure the balance is paid off in full each month.

A positive note on credit cards. Credit cards can be handy and do come with an advantage which I’m sure many people do not know about. It’s know as the ‘Consumer Credit Act’ and it basically means that the credit card company it just as responsible for the quality of items or services purchased than the seller. So credit cards can be useful when making expensive purchases and want an extra level of protection, as you can put in a claim to the credit card company and seller if something was not up to standard. If the credit card company agrees with you and pays out, then they will go on to recoup their costs from the seller.

A further in depth look at this can be found on the Which website Section 75 of the Consumer Credit Act

Great! So you’ve now got a live and kicking SSBS, the credit card / payday loan debt is being wiped out as we speak, so what now? Saving. There is always room for more saving.

I NEED HELP WITH MY MONEY! Said no one, ever.

The majority of people in Britain are not comfortable with talking about money and that is fine. However, this becomes a problem when financial difficulty strikes and it feels like you have no where to go. Unfortunately, there are many companies out there which are more than happy to help you get out of trouble. Credit card companies and payday loan companies to name a few. Sadly, these guys are not out there to help you in the long run, they are there to make money and they are preying on the vulnerable in order to do so.

If this happens to be you, do not worry, with some effort and careful planning, the days of being short of cash will be a distant past.

To keep the blog posts small, this is just an introduction to a series of posts which will contain simple steps that will hopefully help you to get into a healthy financial position.

Upcoming posts:

  1. A simple budget
  2. Clearing high interest debt (credit cards / payday loans)
  3. Saving
  4. Making your spare cash work harder (Investing)

A Simple Budget

Knowing that more money is coming in than going out each month requires writing it down and seeing in black and white, if this is the case.

If a little effort is put in at the beginning you should not have to alter it much after that. Although this depends on how complicated your finances happen to be.

A budget can be as simple or as complex as you like. Here’s a simple spreadsheet to get you going. Feel free to download the Excel version and add in your information. This does not have to be done on the computer. A pen and a piece of A4 will do the trick.

Great, a spreadsheet but what do I do with it?

Add all of your the incoming payments (usually salaries) under the ‘Incoming’ heading. I realise your monthly salary may not be the same each month. If this is the case then average it out over the last 3 to 12 months.

Add all of your outgoings under the ‘Outgoing’ heading. This should include all standing orders, direct debits, rent, mortgage and so on. Anything that is setup to come out of your bank account automatically. If you pay for items yearly, then divide the yearly cost by 12.

The basics are going to be rent/mortgage, utility bills and food. Food is a difficult one of budget for. If you shop weekly, look at the bills over the past 4 weeks (if you pay by card, it’ll be on a bank statement) and add that total to the spreadsheet.

The ‘Total Incoming – Total Outgoing’ number at the top is how much money is left after taking all of the outgoings off your salary. Now this can be the scariest bit. Either realising that this is not as high as you would like or that it is a negative value.

Even if it doesn’t look too rosy at the moment, CONGRATULATIONS! This is probably the most important step in wanting to achieve any financial goal, whether that is getting out of debt or saving for a house. Now you’ve got an accurate picture of your finances. You can go on and plan your future. Well done!

You may be surprised to know that it’s this simple. There is no black magic, no golden bullet. Just numbers. Either on a screen or written down. I bet this chap wishes he’d gone through this exercise.

Next up we will look at high interest debt (credit card/payday loans) and why this should be tackled first when managing your money.