This is the latest installment of our “Ask Wealthsimple” series, where our financial guru Brian Byrnes helps you navigate the world of investing.
“Does it makes a difference in cooking time if I roast two turkeys at once?” is not one of the five questions our investment advisers get asked most often. Nor is: “Frogs: reptiles or amphibians?” Or “Why is Odie the only animal in Garfield comics that can’t talk?”If you want answers to these questions, you will have to brave the internet and all its fake news (very little of which, thankfully, is about Garfield comics). But when we surveyed our investment advisers, there were indeed some questions they get asked way more than any others. And we figured that means there are some financial quandaries a whole lot of people are in the dark about.
Now, if you still want to call and ask your Wealthsimple Investment Adviser instead because you love the sound of her voice, we're not going to stop you. But in case you don't — or you don't even know what questions to ask! — check out our five most-asked questions, complete with really useful answers.
#1 Should I contribute to an ISA or a Pension?
The pension, naturally. Unless of course, the answer is the ISA.
Of all the questions we get, this one's the toughest to provide a one-size-fits-all answer. Which type of account you should choose depends on three factors: How much you earn now; How much you'll likely earn in the future; And whether you'll need to access the money before you retire.
In a perfect world, you would max out both your pension and ISA. Pension contributions will lower your tax burden right now, which is great. At retirement age, on the other hand, you'll be able to withdraw from your ISA without being taxed on your decades of gains, which is also pretty nice. But the world is not perfect — melted ice cream is not a slimming breakfast drink, and most of us don't make enough to put that kind of money aside every year. So you’re going to need to prioritise filling one up first. And in most cases, the pension usually wins.
Your objective when you invest money in one of these two types of accounts is twofold. First, to save money so you don't have to work until you drop dead. Second, to limit the amount of taxes you pay. For most of us, the way to do that is to reduce our taxable income as much as possible every year. Any contribution you put into a pension whether it be a workplace pension or a personal one does just that. And since you’re free to contribute 100% of your annual earnings, up to a a maximum of £40,000 if you are a basic tax payer, you can reduce your income by a pretty descent chunk. Possibly even enough to bring you down to a lower tax bracket — which means you're not only reducing the amount of money you're taxed on, but the rate at which that money is taxed.
An ISA’s annual maximum contribution, on the other hand, is only £20,000, and that money does not get subtracted from your income. ISA contributions are what's called “after tax.” But that doesn't mean it's never the right answer.
Here are some rules of thumb that can help you make the choice.
• If you make over £46,350, your tax rate goes up to 40% and pension contributions become very attractive. For instance, a pension contribution of £10k would only cost you £6k with the rest coming from tax relief.
• If you make between £100,000 and £125,000, you are effectively taxed at 60% as you lose your personal allowance at this level of income. Pension contributions are a great way of avoiding this tax trap.
• If you have a pension through your employer that offers matching funds, prioritise that above all else. Otherwise you're throwing away salary.
• If think your income after retirement age will be greater than what you earn now, your money should go into your pension first. Because it's better to pay the lower income tax rate on that money now, than the higher rate you'll pay when you take it out.
• If you think you might need the money before retirement age, ISAs are more flexible. With pensions you have to be sure you don't need access to the funds until 55, shortly to be 57.
#2 If I have a chunk of money to invest, should I invest it all at once or space it out over time?
This is really a question about a concept called pound-cost averaging. That's a term for investing your money over time, at regular intervals, with the idea that by buying into the market at many moments you'll decrease the risk that you'll buy whatever it is you're buying at a particularly high price. An oft-quoted study by Vanguard found that investing your money all at once gave investors better results than pound-cost averaging 66 percent of the time.Why? It's simple: investing beats not investing. You stand to lose more in future returns by having your money on the sidelines, trickling into the market, than you do from the risk of a momentary dip in the value of your investment.
But if you're worried about putting all of your money into the market anyway, it's OK to listen to that worry. Because if you panic during a downturn instead of sticking with your long-term plan — that's a risk even greater than sitting on the sidelines. The best way to answer the question of “all now” versus “a little bit at first” is for you to ask yourself a question: Even if you knew it would eventually recover, would you absolutely lose your mind if you invested everything and a week later your investment dropped in value five or even ten percent? If you answered yes, you should absolutely use pound cost averaging, since your sanity is worth a lot, as is sticking to your plan. But if you’re more of an ice-running-through-your-veins (and less of an obsessive-balance-checking type) you should go all in.
Again, the one scenario to avoid at all costs is cutting and running — investing all your money at once, getting spooked by a downturn, and selling everything to stem further losses. That's a recipe for losing your money.
#3 What kind of returns should I expect?
OK a couple caveats here. 1) No one can predict future returns. Anyone who claims they can is a Bernie Madoff. 2) In the short term, your returns can do anything—go up, down or sideways. It's only over the longer term that returns become predictable.
But over the course of recorded history (at least the last hundred years) a few things have been clear. One is that, over time, risky assets tend to outperform cash over time. And related to that: even among assets that are riskier than cash, some of the risker ones (like stocks) tend to outperform the less risky ones (like bonds.) It makes sense, if you think about it. If it didn't pay to take risks, no one would do it; everyone would just hold cash, nobody would invest, companies wouldn't have capital to fund their businesses and we would not be driving Teslas, or maybe even cars.
But we get it. You want a number. We'll do our best to give you a guess using history as a guide. Since 1900, equities (i.e. stocks) have earned, on average, between 5 and 6 percent annually above inflation. We think that, in the future, returns may be a bit lower than that. Why? It's complicated, but it has to do with the fact that equity prices have risen faster than corporate profits over the past century, which isn't a trend that's sustainable. So, let's account for that, and be conservative, and say history would recommend a guess of 4 to 6 percent above inflation.
But your Wealthsimple portfolio isn't only made up of stocks. That wouldn't be very diversified. We also use a mix of bonds.
So, all that taken into account, a portfolio like the ones Wealthsimple builds has historically earned between 3 to 5 percent returns above inflation, depending how much risk you take.
Now be aware: no one should expect a return of exactly 3 to 5 percent year in and year out. Some years you may see much higher returns, and some years you could find yourself in negative territory. That's what risk is about! But in the long term, markets tend to behave more predictably.
#4 How much money do I need to have in cash?
Short answer: you should always have an emergency fund tucked away in a safe, easily accessible place. We suggest at least three to six months of living expenses that's in a safe place, just in case something happens to prevent you from earning money for a time.
The longer answer is: how much cash you need to have on hand depends on your situation. If you’re single and child-free and working in a relatively stable job, you might be able to get away with keeping a cushion that's on the thinner side — say, two to three months of your total living expenses. If you’re the primary earner in a family, suffer from a lack access to a generous rich uncle who's always begging to give you money, or work in a job that’s 100% commission based, you’ll want to keep considerably more on hand — say, six or even eight months of living expenses.
If you still have questions about these questions — or have completely different questions — drop us a line. Or, if you're one of those contemporary people who'd rather avoid contact with other humans, just wait for part two: the second five most asked questions!
#5 What does Brexit mean for my money?
Since the 2016 referendum it’s been hard to go a day without being intruded upon by some alarming Brexit bit or another—newspaper headlines, political rows, dire predictions from strangers at the supermarket. First, it’s important to remember that no one can predict the future, especially when it comes to the financial markets. In the short term, there will likely be some volatility—markets don’t like uncertainty. It’s important to keep your eye on your long term goals. And the long term has been historically much easier to predict.
Consider this: over the last 100 years, stock markets have gone up and to the right. Sure, there have been some wild, short-term fluctuations thanks to World Wars, financial crises, the election of unpredictable presidents across the ocean, and lots of other events. But over time, markets tend to grow. In 2019 alone we’ve already seen the FTSE 100 (The UK’s largest stock index) grow by 10.28% against what many would call the greatest political turmoil in recent British history.
Besides keeping a view toward the long term, you also need to think about diversification. The ongoing Brexit discussions, for instance, have done damage to the value of the sterling against currencies like the dollar and the euro. That’s not something you—or even the British government—can control. What you can control is making sure your investments are diversified—in this case that you invest in assets around the world, so when the conditions in one country are a bit adverse, it can be mitigated by investments you have elsewhere. Wealthsimple will build you a personalised, and expertly diversified, portfolio in about five minutes.
The bottom line: successful investors concentrate on what they can control. Like paying low fees, being invested in a globally diversified portfolio and automating your finances - like setting up a monthly direct debit - so you're less likely to react out of fear (or elation) and forget the wisdom of your long-term plan.
All investing should be considered long-term. While stock markets have typically trended upwards over the long term, your investments can go up and down, and you may get back less than you invest.
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