In this article we’ll discuss how you should manage the savings you’ve already built up. We’ll also talk a bit about how you should balance this with the debt you may have, and also how you can get your money to work a bit extra for you by investing.
Why should I start thinking about saving now?
Even though you might only be in your 20s or 30s, it’s really important to start thinking about saving and investing early. The reason behind this is compound interest.
If you’ve ever done maths, compound interest might be familiar to you. Interest that accumulates in one year can then lead to future interest on that interest, causing a rapid snowball effect. You might be familiar with the school game:
Would you rather have a penny today, doubled every day for a month, or £1,000,000 today?
On the second day, you’d have 2 pennies, then 4 pennies on the next, then 8 pennies after that.
By 30 days, you’d have £5,368,709.12. But if you had checked at 25 days, the amount would be £167,772.16.
This simple exercise just shows how valuable compound interest is with time!
JPMorgan published a fantastic slide on the benefit of saving early. They compared three people:
- Susan, who saves $5,000 annually between the ages of 25 and 35 (10 years total), then kept her savings invested and accruing compound interest.
- Bill, who only starts investing at age 35, but saves $5,000 annually until age 65 (30 years total), with the savings invested and accruing compound interest.
- Chris, who starts investing at age 25, and saves $5,000 annually until age 65 (40 years total), with the savings invested and accruing compound interest.
Guess who was better off?
Susan was actually better off than Bill, who only started 10 years later. Chris was almost doubly better off than both.
So the earlier you can start getting on top of your money, the bigger impact it has!
As excited as you might be, there are first a few steps you should take to maximise your financial security, before moving on to focusing on interest and investing.
- Setting up a budget and being aware of your expenses. How much would you like to spend? Are you hitting your targets?
- Considering saving and spending goals. What are you saving for? House? Children? Retirement?
- Paying down expensive debt. There’s no point saving and earning a 2-5% return on your money when your credit card debt and overdraft is costing you 20% annually!
It’s a good idea to start off with some basic principles on money and finances first, and continuing on to read once you’re comfortable with this!
Initial savings – an emergency slush fund
It’s always advisable to have some easy-access funds in a bank account to cover any potential emergencies.
The size of this emergency fund can depend on your situation and risk tolerance – but a good rule of thumb is 3-6 months’ worth of expenses. Generally, as a doctor, your job is secure and your salary is predictable, therefore an emergency fund on the lower end of this range is probably sensible.
The money doesn’t have to be held as cash under your mattress. A high-interest current account will give you almost instantaneous access to your funds while still paying a 1-2% interest rate.
What you don’t want is to have the funds locked up in your cryptocurrency account, taking months to withdraw in case your car or boiler breaks down.
Contributing to your pension
Once you’ve covered your debts and built up an emergency fund, the next pot of money you should be saving into is your pension.
The NHS pension is notoriously good – we’ve discussed why in our dedicated article, so have a look once you’re done here.
Arguably, you might even want to consider paying into a pension before you’ve repaid all of your debts – as long as these debts aren’t extremely high interest. We’ll talk more about this in another dedicated article later on.
Advantages of saving in your pension at this point are:
- Pensions are “tax efficient”. The contributions are deducted before you pay income tax (hence you save income tax on this amount, equalling 20-45% depending on what rate you pay).
- Based on how the NHS works, your return on investment is pretty good compared to saving and investing it yourself. You can see for yourself using the pension calculator on this page.
- Pensions are very safe holdings. The NHS pension is government-backed, meaning it’s an almost guaranteed place to keep your savings to retirement.
Making the rest of your savings work
It’s worth visiting some principles of how money works, to help understand how we can best decide what to do with the money we have. I promise it gets better once you get through these boring bits, and it will all make sense!
An investment is allocating funds to a particular asset with the aim of generating profit (aka, returns).
It sounds really complicated, but doesn’t have to be!
Many everyday people have investments – over 50% of people in the USA own stocks and shares, compared with 31% of people in the UK. Most people will also own property at some point in their lives, which can count as an investment as well.
You should be learning and thinking about investments because they are a very important way of generating some kind of income on your savings.
The following picture illustrates how savings of £10,000 in 1980 would have performed if it had been kept in cash/savings (red), gold (yellow) or stocks (blue).
Of course, investments in the past doing well never indicates that they’ll definitely do well in the future. Investments can lose money, and you could end up with less than you started with.
It’s still important to understand how investments work and for you to choose the assets that are suited to your situation, and how you can minimize risk along the way.
Rate of return
In simple terms, this is the growth rate you can get out of the money you have.
For example, if you own £100 in a bank savings account that gives you 2% interest annually (per year), you could say that your annual rate of return was 2%.
It’s standard to describe this in annual terms because it allows for easy comparison.
Building on this picture:
- If you bought shares in a company that increased in value by 10% for the year, this would be a 10% return.
- If you bought a house for £300,000 and sold it the next year for £330,000, this would be a 10% return.
- If you bought a house for £300,000 and rented it out for £12,000 per year (£1,000 a month after subtracting maintenance etc) this would be a 4% return.
As you can see, there are many ways of gaining a return on your money, and the rate of return is one way of comparing these options.
Note that some assets have a negative return – things like cars and electronics are assets that decrease in value over time!
Risk versus return
Risk is an important principle to know about. Carrying an asset (such as holding money or an investment) has a risk, no matter how small:
- Keeping cash under your mattress at home – there is a risk of the cash being stolen or lost in a house fire!
- Buying a property for investment purposes – property prices could crash, it could sustain damage or you might not find a tenant.
- Investing in company stock – the company could sustain losses or go bankrupt.
- Keeping cash in a bank savings account – the bank could sustain losses and go bankrupt, and although your money in savings accounts is guaranteed by the UK Government to a certain degree (FSCS guarantee), the Government may not honour this (an extremely small but still non-zero risk).
- Giving your cash to the Government in the form of a bond (a form of a loan) – again, an incredibly small but still non-zero risk the Government may not honour this.
Government bonds and bank savings/current accounts are generally considered the lowest risk of all – so small, it’s deemed to be “risk-free”.
But the important principle here is that all assets have risks, and generally, the rate of return correlates with risk. For higher risk, you would expect a higher rate of return.
You might have heard of inflation before, but we’ll just discuss it here quickly to make sure everyone is on the same page!
Inflation is the rate at which goods increase in cost, and by extension the rate that money decreases in value.
It is calculated every year based on the rate of increase of a “standard basket of goods”, which gives a good picture of how the average consumer is affected by the decreasing value of the cash they hold. The basket might include things like groceries, transport, fuel, household goods, rent and other things you and other consumers spend on.
The average rate of inflation is currently around 1.5%, meaning that something that used to cost £100 might cost £101.50 the next year, then £102.25 the next. Every year, the value of each £1 you own effectively decreases!
You might hear people discuss how the cost of a Freddo or a pint of lager has increased since they were kids. This is inflation at play. Historically inflation has been a lot higher – in the UK, it was not uncommon decades ago to hear about inflation rates over 10%. In some countries like Zimbabwe and Venezuela, inflation has previously been over 1,000,000% – meaning something costing £1 today could cost £10,000 next year!
Deflation is the opposite of inflation, where money increases in value over time – this doesn’t happen very often.
Using these principles in practice
Why is all of this relevant? These principles come together to build some key principles of saving and investing:
- You want to ensure your assets aren’t being eroded away by inflation without realising it.
- You want to ensure your assets are generating a rate of return that is acceptable for your desired level of risk.
- You should then protect these assets from losses and taxes.
Where possible, you should be putting as much of your savings as possible in an ISA, which will shield your investments from taxes. There are various types, so make sure you read about them and choose the one best suited to your goals.
There are a few main assets that you can invest in, which are worth knowing about. They all have different levels of risk and potential reward.
You can mix any of the classes in any proportions to lower your chances of losing money overall.
- Cash and cash equivalents. Cash (also including cash in a savings account) is the safest and most stable “investment”. You probably won’t lose money by holding cash (unless the rate of inflation is higher than your interest rate earned, which is often the case in a lot of UK current accounts), but you won’t gain much either.
- Bonds. Bonds are loans made to a company or a government, in exchange for a regular interest payment. They can be UK-based or international. Bonds are relatively safe investments as they provide a stable income over time, but they can also fluctuate in price like stocks (to a lesser degree) and there is a moderate risk of losing money.
- Stocks. Stocks, aka shares, are “shares” of a company. A stock gives you ownership over a very small part of a company and entitles you to a share of that company’s profit. Stocks can go up and down in value based on the overall value of the company, meaning that it can give a large potential for gain, but a high risk of loss.
There are also many other types of assets. Some of the others include:
- Gold and precious metals
- Collectibles e.g. art, wine, classic cars
- Peer-to-peer (P2P) lending
- Foreign exchange (Forex)
- Derivatives e.g. options and contract-for-difference (CFD) trading
Beware that some of these assets can seem enticing with their high promised rate of returns, however the correlating risk of a loss is also extremely high.
Investments a few decades ago used to be very inaccessible – you would have to actively trade on a market or stock exchange.
Today, investing is extremely simple and can be done at home from your computer. “Baskets” of various stocks and bonds can be bought in a “fund”, tailored to meet your desired allocation and proportions of assets.
Mixing different asset classes (e.g. mixing stocks and bonds) tends to reduce your return, but also reduces your overall risk of loss.
Holding your investments over a long period of time also reduces risk, as the chances of a recovery in value increases with time. This means, for example, that buying stocks today and selling them tomorrow is very risky; there is around a 50% probability of a loss, as there’s a 50/50 chance of the price going down. However, over 10 years, the day to day ups and downs of the stock market are less relevant, because over most 10 year periods the net trend will be up. The risk of a loss is therefore much less. The following graph demonstrates this, showing the probability of making a loss in stock market investment versus the time for which the stock is held.
Depending on your risk tolerance, it is worth considering some type of investment for at least some of your savings.
To learn more about how it might work for you, head over to Vanguard to learn more about funds, how they work and how you can set up an account.
We are planning to write another dedicated article – an intermediate guide to investing – to cover some of the details about stocks, bonds and funds.
Shielding your assets from taxes
ISAs are super important for saving, as any investments kept within them are exempt from various taxes. Read the dedicated article on ISAs to learn about what they are, how they work and how you can set one up.
Cash, savings accounts and cash ISAs
Savings accounts are a good place to keep your money if:
- You would like easy access to the funds
- You would like absolutely minimal risk possible while sacrificing growth potential
It’s useful to compare savings accounts and choose the best one based on interest rate, accessibility and benefits. It’s impossible to tell you which one to choose as it’s really down to personal preference!
As discussed above, investments in stocks and bonds can allow your investments to grow with the downside of taking on some extra risk of loss.
Generally, risk can be reduced by:
- Choosing a diversified basket of investments – nowadays these are readily available in the form of “funds”. Some funds can be extremely risky but other low-risk funds can be selected.
- Investing over a long period of time – risk diminishes greatly when an investment is held over time. As a general rule of thumb, it’s often advised that these investments are riskiest if your timeframe for needing the money is within the next 3-5 years.
- Dollar-cost averaging – this is a principle investing money gradually over time as the money is earned. This attempts to reduce the risk of investing all of your money at the market “peak”.
It’s worth considering a stocks and shares ISA to keep your investments if you don’t have one already. You can also keep funds containing bonds within a stocks and shares ISA.
Please note that the information above doesn’t constitute specific financial advice, but is only general guidance to help you make an informed decision. An independent financial adviser may be required to ensure advice applies to your individual circumstances.
If you have any questions please do feel free to leave a comment below or send me an email. I’m happy to discuss things in more detail if you feel this was too superficial, or explain more simply if something was confusing!