Video blog: Why numbers count when investing for the long term



http://sensibleinvesting.tv -- the independent voice of passive investing For many of us, memories of maths lessons at school are not the happiest. But understanding the basics of mathematics - especially the effect of compound interest - is essential if we are to make the most of our investment experience and avoid expensive mistakes. Small numbers can make a big difference - and this video blog explains why. There are many of us - myself included - who don't have happy memories of studying maths at school. We tend to shy away from numbers. But when it comes to investing that's a bad idea. It's essential that everyone has a basic grasp of the mathematics of investing. Let's start with some simple retirement numbers. Say you'd like to retire on £40 000 a year in today's money. Assuming you don't want to risk your capital eroding before you die, a rough rule of thumb is that you should withdraw a maximum of four per cent a year from your portfolio. For that you'd require a pension pot of around £1 million. You need to know how much to invest each month and for how long - assuming different rates of return. And you'll see from this table that the longer you invest for - and the higher your return - the less you need to put aside every month. It's all about compounding - the concept of interest-on-interest. As Benjamin Franklin once put it, "The money that money earns, earns money." Today's news media is full of mind-bogglingly large numbers - such as a €100 billion bailout, or a $1 trillion debt mountain. The temptation then is to be blase about small numbers, and even a little disappointed in them. But instead of saying, for example, "my portfolio only returned three per cent more than inflation last year", you need to remember that small numbers really do add up. Imagine one hundred thousand pounds invested in each of three different portfolios, delivering returns of one, threee and five per cent per year, after inflation. After 30 years, that sum will have grown to around £135 000, £240 000 and and £430 000 respectively. So, seemingly small differences in the compound rates of return (also known as geometric returns) convert into big differences in terms of financial outcomes. Now, we can be a bit unrealistic about how fast we expect our investments to grow. If you want to "get rich quick", try gambling. But you're at least as likely to fail as you are to succeed. Investing is more like "get rich slow". Over the past 12 years, for instance, cash has delivered a return of around one per cent above inflation, government bonds around one-and-a-half per cent and UK equities a shade under five per cent. So, as investors, we need to be realistic. We also need to calculate compound returns and visualise the impact of cost on final outcomes. And that can be quite complex. But a useful tip is something called the Rule of 72. If you take the compound (geometric) rate of return and divide it into 72, you can estimate the number of years it will take for you to double your money. So, for example, with a two per cent rate of return, it will take about 36 years, or with a four per cent return, 18 years, and so on. Alternatively, the Rule of 72 can be used to establish what rate of return is required to double your money over a specific number of years. It's vital to ensure you keep your costs as low as possible - that's things like adviser fees, taxes and transaction costs. Clearly, the less you pay out, the better. Just one per cent here or there can make a big difference. Another big factor investors need to beware of is inflation. Used in reverse, the Rule of 72 can illustrate just how damaging even low rates of inflation can be to the value of your investments. You can see from this table that three per cent inflation will halve the purchasing power of your capital every 25 years or so... In other words, prices will double in that time. Now one final concept you need to understand is that if you reduce the volatility of a portfolio - in other words, narrow the range of returns experienced by diversifying across markets and asset classes - you can improve the compound (or geometric) return. Just look at the relative values of Portfolio A and the (less volatile) Portfolio B after two years. Diversifying makes mathematical sense. So, what conclusions can we draw for this short maths lesson? 1. Time is your friend. Small numbers matter. Keep costs low. Beware the corrosive effects of inflation, and Diversify your portfolio to reduce volatility. Finally, a take-home point for non-mathematicians like me. Perhaps we didn't enjoy maths at school, but to be successful investors we need to understand a few simple mathematical concepts. Invest a little time in grasping those concepts, and you'll be very glad you did when you come to retire. For more videos like this one, visit http://sensibleinvesting.tv

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    Duration: 5m 50s

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