Education, Pensions, Housing, Emergencies, Hedging

How to plan a sensible lifelong investment strategy

"Filthy Lucre" by .Larry Page is licensed under CC BY 2.0.

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When people I know socially find out that I earn a living as a financial journalist, some of them ask me about the stock market. I always tell them that I am not regulated to give investment advice, but that research shows that few things pay off as well as a good education; and the big advantage of buying a flat is that you eventually get somewhere to live for free. Private pensions and index funds are also amazing if you are able to avoid dipping into the money for decades.

This week’s column will take this basic point and make it a little more long-winded! Before we get stuck in, though, it is important to think about the difference between cash and equity. Let’s imagine two people, Alice and Britney. Alice lives in rented accommodation and never saves any money. One day, though, she wins €10,000 on the lottery. She immediately buys some designer clothes, has some epic nights out and books a holiday in the Caribbean. Lots of pictures get uploaded to Instagram.

Meanwhile, Britney owns her own home and lives within a strict budget every month. She might ask for one piece of designer clothing for her birthday every year, but she certainly doesn’t brag about it on Instagram. At the same time, her modest flat is worth €150,000 and she only has €50,000 left on the mortgage. She also has another €30,000 in a private pension that she has been growing by a small amount every single time that she gets paid over the course of a lifetime.

Who is richer, Alice or Britney? Obviously, Alice’s net worth is a rounding error on zero, even though she has cash in her pocket. Cash is often called a liquid asset. The metaphor of a fluid sloshing in and out of your bank account is a good one.

Meanwhile, Britney’s net worth, on the other hand, is more than €130,000 (the value of her flat minus the remaining mortgage plus the pension fund). It is highly illiquid - turning her flat or her pension fund into cash would be a very annoying process. The illiquidity is actually a bonus, because money tends to grow if you leave it alone, due to the power of compound interest. Benjamin Franklin memorably showed the world how this works by leaving a pot of money for 200 years. Left alone for close to three human lifetimes, it turned into a small fortune.

It is worth noting that Britney’s net worth is roughly 13x larger than Alice’s lottery win. The big issue is this: Alice’s cash is visible but Britney’s equity (capital after debts) is invisible. However, anyone looking at the two’s Instagram accounts, without any further information, would assume that Alice is richer than Britney.

We can derive three very important principles from this example:

• equity is nearly always more interesting than cash because it tends to grow in the dark rather than leaking out of your pocket;

• so, you should seek to maximise your cashflow while striving to convert at least some of your cash into equity;

• but it is best to avoiding converting equity into cash except when you retire, in a genuine emergency, or to help future generations.

If this is clear, we should be able to understand the difference between living on a budget and living from pay-cheque to pay-cheque. Both on the face of it look quite similar. However, deliberately living on a budget can be a clever way to generate equity, while living from pay-cheque to pay-cheque while renting property is a much riskier lifestyle.

Once we understand the difference between cash and equity, we are ready to divide all potential investments into five different categories. The first four involve slowly building equity over the course of a lifetime while working hard. This might sound a little boring, but it should form the base of a sensible approach.

Category One - Education

The first category is the most important of all. Education is often one of the best investments possible (not including Vladimir Putin’s intervention in the 2016 US presidential election). To see why, let’s game out some figures from Spain, where I live. The average rounded salary of someone someone with a post-graduate degree is €29,700, compared to just under €25,500 for someone with a first degree. Over the course of 40 years, that is a difference of €168,000 before tax.

How much does it cost to get a master’s degree? Let’s say, for the sake of argument, €10,000. This back-of-an-envelope calculations suggest a return of nearly 17x before tax on an investment in an advanced degree, which is a fairly amazing result. Few other investments can yield returns like this with so little risk.

As a general rule of thumb, I recommend starting with a general education and then getting more specific in grad school. This gives people scope to study degrees that some people might consider too airy-fairy for the real world (incorrectly, in my opinion). If you want to study philosophy, as I did back when it was free in the United Kingdom (UK), you could easily put a post-graduate degree in data analytics or journalism on top of your training in critical thinking.

If you want to study fine art, you could finish your education with some kind of master’s degree in design to convert your artistry into more bankable skills. This is even true of a degree in art history, which is assumed by many to be useless, much to my horror (my late dad was a scholar of Renaissance art and a university lecturer in the subject). Art history can be made much more financially rewarding by doing a master’s degree in arts administration (or even business administration) afterwards. In the case of fine arts or art history, an understanding of aesthetics could be useful background for an advanced degree in user-experience (UX) design, which is an area that is beginning to boom.

I sometimes see people in Spain who think it is a good idea to get another four-year degree straight after doing a first one. This makes zero sense to me. It would be much better to push on and get a post-graduate degree or to join the workforce, in my humble opinion. Of course, if someone wants to go and do a second degree in his or her spare time after spending a couple of decades at work, please be my guest. Going to university after retirement should also be encouraged.

It should be obvious that not everyone has aspirations to get a post-graduate degree. Education can also include a wide range of other options, including vocational courses. Investing in a course to become an electrician, a welder or a dental hygienist would also be likely to yield significant returns, assuming you do a little research on the opportunity first. The trick is to look for opportunities that will pay more than the minimum wage and will make you resilient as the world changes.

In Spain, the average salary for someone with a two-year vocational qualification (un grado superior) is around €21,500. Someone who leaves high school at 16 can expect to earn just over €16,500 per year. Over 40 years, an investment in four years of education (un grado medio or a baccalaureate followed by un grado superior) can yield a staggering €200,000 before tax.

Although education is nearly always positive, there can be the odd exception. Grifters who run pyramid schemes will often sell slightly dodgy seminars about the pyramid scheme they want you to commit to; and there are also one or two self-development cults out there, which make their format look as educational as possible.

However, I think that education can also be part of the solution for anyone who gets caught up in these traps. You paid for scam seminars about get-rich-quick schemes? This is probably a sign that you need to do a course on the basics of investing. Or maybe it shows that you are dissatisfied with your life, so you should look into learning some new skills. What about learning to code? You don’t need a university degree to get started. You fell into a self-development cult? Then maybe you should look into doing some courses on mindfulness or coaching to scratch that particular itch in a less destructive way.

There is a clear lesson for parents and grandparents too. It is important to save money for the next generation so they have the option of doing vocational or professional courses as they enter their twenties. I’ve said it before and I’ll say it again, but it is nearly always going to be better to save money to give a kid the option of doing a post-graduate degree than it is to send him or her to a private school that only has a slight edge over the state system.

In most cases, the trick is to get as high up the ladder as possible without worrying too much about the quality of the schools at the lower levels. This is particularly true for parents who themselves have university degrees. The exceptions are likely to involve families with aspirations to raise first-generation professionals, who need a little support from educators in this goal.

An alternative option, which more or less belongs in Category One, is to invest in a cash-generative business, which can expand your lifetime earnings; or to take on a side hustle that can earn some extra cash that can be turned into equity. Any decision should probably be based on some basic research rather than your hopes of having a job that could give you an attractive lifestyle if your plan happens to be successful. Opening a self-service laundry in a neighbourhood that lacks one is always more likely to yield equity than fulfilling a lifelong dream to own your own yoga studio (although, as always, there can be exceptions either way).

Practicing yoga might bring you joy, but that doesn’t necessarily mean that opening a studio is going to be a good business decision. I suspect that hobbies like yoga; sweat equity (unpaid time to get a project off the ground); and many side hustles, particularly creative ones, belong in a different category from investments. The primary reason why you choose to do creative or fulfilling projects should always be a deep commitment to it.

If you find it hard to live in a world where a certain blog, podcast, book, song, painting or sculpture doesn’t exist, then you should just go and make it happen while earning money elsewhere. If you can enter a flow state (total involvement) while doing the work, like a yoga practitioner on a good day, consider that a reward in itself. If you end up getting paid for a project like this at some point in the future, think of it as a bonus. If that day never comes, it doesn’t matter very much.

Investment can also refer to your time and your attention as much as your money. I have promoted the idea that startups are the best way to change the world many times in this blog. However, more than two thirds of startups will never make a positive return for investors. Why can startups still be a good bet for ambitious people, particularly young people without family commitments, despite these odds?

First of all, there is a fair to middling chance that the startup you found or join will be very successful indeed, particularly if you improve the odds by becoming an early employee at a company that is already gaining traction (as I did in 2002). Exponential growth can be a powerful force, particularly if it is based on creating large amounts of value for other people (something that is easier for people with advanced degrees in technical and professional subjects to do). Secondly, unsuccessful startups can get taken over by companies who like the underlying tech and appreciate the talent involved even if the execution of the project falls short of expectations.

Thirdly, the risks of joining the startup scene in a major hub are better than the odds of joining any one startup in particular. Although you might earn less money for your first startup or two than you would elsewhere, even a couple of unsuccessful projects will be deeply educational, with many networking opportunities. The experience could put your career on a new and more interesting trajectory than it would have had otherwise, paying dividends over the course of a long career.

Category Two - Retirement

One of the great triumphs of our species has involved pushing up our average life expectancy in recent decades (largely due to advances in hygiene and modern science, as well as lightly regulated markets providing incentives for medical innovation, combined with a welfare state, and governments finding ways of working together instead of going to war). In Spain, for example, male babies can expect to live 80 years, while the number for female babies is 85 (both on average).

Life-expectancy data obviously factor in everyone who dies young. Men in Spain who get to 65 can expect to live another 19 years, to 84; while women in the same country who reach 65 can expect to live another 26 years, to 91. It is worth adding that the retirement age here is gradually being increased from 65 to 67, with similar moves elsewhere too.

The stats show that getting to retirement is clearly a good bet for most of us. It is a sensible idea to put money aside. Private pensions are a particularly good way of preserving equity because they are so illiquid - it is so hard to turn them into cash before retirement. The longer you can leave your money in peace, the more it will grow, as mentioned earlier.

Of course, parents and grandparents who understand this point can set kids up for a very comfortable retirement. Even a relatively small sum of money, say €1,000, can turn into a reasonably large sum of money if it is left alone for 70 years.

Imagine a pension fund linked to the STOXX Europe 600 index, which has a record of returning close to 7% per year, on average. Over 70 years, there is a fairly good chance that €1,000 could turn into more than €100,000, which makes it an even better investment than education. The numbers get even more impressive if the person with the pension fund puts in money every month over decades after he or she enters the workforce. The benefits are particularly clear if the person starts early - money invested in your twenties and thirties has more time to grow before retirement.

As a result, starting a private pension for newborn babies is one of the best uses of grandparents’ spare cash. Think of it as being like an acorn that will eventually grow into an oak tree. Setting up a private pension for a newborn baby can also help future generations. If the child can expect a comfortable retirement when the time comes, it will be easier for him or her to support his or her own grandchildren (assuming he or she ends up having grandchildren).

Category Three - Housing

We all have to live somewhere. Although renting a room or a flat is a great option for young people, and those who move around a lot, it generates zero equity. The biggest advantage of buying a place is that in a few decades you get a place to live for free. If you plan it right and can afford to pay a deposit, your monthly mortgage should rarely be much more expensive than what you would have paid in rent, which basically gives you free equity just by sleeping indoors. The numbers can get very impressive indeed if you are lucky with the timing and the value of your property increases significantly over several decades.

You can also cash in your equity in an emergency; or if you want to move at a later date. Renting out spare bedrooms is also an option to bring in extra cash. Also, banks normally insist on life insurance and house insurance before giving you a mortgage. Both are sensible investments in an uncertain world.

It is important to pause for a moment and acknowledge that people who have help in getting a deposit from their parents or grandparents have a massive advantage over others who aspire to own their own home without any inter-generational wealth transfers. Even so, it should be possible to save enough for a deposit on a modest flat if you if you have a reasonable income, live within a budget and pick your city well. If you live in London or Paris (the most expensive cities in Europe), these words might not necessarily apply.

If you can afford a deposit, with or without the help of older generations, it is worth being conservative and not moving into a mansion, even if someone offers to lend you silly amounts of money. Try to set the monthly mortgage payments around one third of your net household income, as a rule of thumb. As always, check with a professional before taking any firm decisions.

As an alternative, there is also the German model, where the majority of people live in rented accommodation their whole lives. The idea behind this approach is to put aside so much money over a lifetime that your savings will pay for your rent after your retire. I might be biased (home ownership rates in my home country, the UK, and my adopted country, Spain, are much higher than they are in Germany), but I have serious doubts about this way of doing things. If you want to drill deeper, though, I suggest taking the time to talk to an independent financial advisor about which model works better for you.

What should you do if you already own your house and want to continue investing in more property? I think buy-to-let opportunities probably belong to Category One - it should be seen as a business opportunity rather than as a way of generating equity while keeping a roof over your head. While I am no expert in this area, I have noticed that people I know who buy one property as an investment in their spare time often have a hard time if tenants who stop paying the rent, while those who spread the risks over several properties and treat it as a full-time business or serious side project tend to be more resilient to shocks like these.

Of course, there is also an angle for parents and grandparents. Saving money to help kids with the deposit on a flat is a great thing to do and will help set them up in life. Buying a modest flat while young can generate equity that can turn into the deposit to buy a much larger family home at a later stage.

Category Four - Emergency Funds

Imagine you have invested in your education (or a business) to maximise your income; you put a little money aside every month for your retirement; and you are slowly paying off a mortgage on your home. You are also thinking of your kids, if you have kids. What should come next?

Debt is the shadow of compound interest on your savings - there is a serious risk of it growing. It is impossible for most of us to buy property without a mortgage; and having a credit card can help us deal with unexpected expenses and one-off payments, particularly if you pay it off in full every month. However, too much uncontrolled debt, particularly loans for consumer items or holidays, can quickly spiral out of control and ruin your finances.

Based on this idea, it is sensible to live on a budget (as Britney does in the example above) and stay out of debt as much as humanly possible. Having an account with money for emergencies is also a very good idea. Investment advisors often recommend keeping several months of net income in an emergency account.

If you have any spare cash that you would like to invest beyond this point, index funds combine growth with relative safety. These track baskets of investments in the stock market, such as the STOXX Europe 600 that I mentioned earlier. You are effectively buying the future earnings of a collection of companies (a diversified portfolio, in the jargon). When members of the index perform badly, they are expelled and new vigorous stocks come in to replace them. Investment professionals and automated systems do the hard work for retail investors, which means that the fees can be very low. As always, though, please check with a qualified advisor before committing your money to any financial products.

One big advantage of index funds is that they provide a baseline to assess other investments. Forbes attracted widespread attention in 2022 when it calculated that former (and future) US President Donald Trump would be significantly richer if he had just put his inheritance into an index fund instead of building a real-estate empire, becoming a television star and eventually a politician.

Also, if someone wants to become a cash millionaire without ever earning large sums of money (a significantly harder goal than becoming a paper millionaire including the equity in your home and your pension), it is perfectly possible to use index funds to hit this level if you are consistent over the long term and can resist dipping into the money. You would just need to invest €2,500 per year over 50 years in a fund that yields 7%. That is a little more than €200 per month every single month.

It would be hard to do this while earning the minimum wage, but it should be perfectly possible on a relatively modest income, assuming you start young and live within a strict budget your whole life. The trick would be to maximise your income by investing in your education early on; or alternatively moving somewhere with extremely cheap property prices. Either option should yield some disposable income. Although this proposal looks sensible on paper, the main disadvantage is that you wouldn’t get to enjoy being a millionaire until you are in your seventies.

Category Five - Lottery Tickets and Hedging

If you are interested in developing an investment strategy, my advice is to start at Category One and work your way up to Category Two and beyond. If you stick at Category Three or Four that is fine. These categories are your major focus and should make up a good 95% of your investment strategy.

Category Five includes get-rich-quick schemes, speculative investments and lottery tickets. Unfortunately, this is much more emotionally engaging than the basic investment levels. It is best to see Category Five as a minor focus. As the Americans say: don’t major in the minors!

Speculative investments can be fun! My free and unsolicited advice is to only spend small sums of money; and set your expectations very low. There is always a risk of grifts in unregulated finance. Only spend sums of money that you can laugh about if you lose it all. As an aside, one way of spotting grifters is to be aware that they will talk a lot about the benefits to the “investors” in a scheme, but will mostly skip any discussion on any benefits to end users or society as a whole.

On the other hand, you don’t need to spend a huge amount to win big if your timing is impeccable and you get lucky. Imagine buying 100 bitcoin at $0.10 cents a apiece in 2009 or 2010 and holding until today. Your $10 lottery ticket would be worth close to $10m at current prices. This is clearly an exceptional event. It is worth repeating a line in the previous paragraph: set your expectations low! Big payoffs are fun to day dream about, but avoid assuming your speculative bets will pay off while ignoring the basics (education, pension fund, your own home, and emergency funds).

The principle about being able to laugh off losses holds no matter what your net worth. Business angels, who write large tickets for early-stage startups run by other people, are normally multi-millionaires, who are only gambling a small percentage of their wealth as part of a diversified portfolio. They know the stats about the failure rates of startups better than most and realise that much of the money that they invest will end up nowhere.

One of the cleverest ways to see Category Five is as a way of hedging your risk profile. Let’s imagine an accountant, who specialises in the tax returns of self-employed people in the neighbourhood. The average age of his or her clients is in their fifties. Obviously, younger people will increasingly turn to artificial intelligence (AI) to help them with their tax returns.

The accountant should hedge against the destruction of his or her livelihood. Buying shares of Big Tech companies that are developing AI could help. Think about a video-shop owner who bought shares in Netflix from 2002. It would have softened the blow when everyone stopped renting DVDs in the 2010s.

Of course, I’ve mentioned the importance of seeking professional investment advice throughout this column. This is more vital than ever if you are thinking of investing in the shares of individual companies, which is a significantly riskier bet than education, buying your own home and putting money in pension funds or index funds. It is also an area that is well outside my area of expertise - I have been restricted from buying or selling individual stocks for my whole career as a financial journalist.

Funnily enough, the best hedge will probably always be education. An accountant with an ageing client list and a dying business model should consider courses so he or she can start offering other services, such as becoming a regulated investment advisor. Or why not think about gaining some expertise in AI consultancy for small businesses? Or learn about data analytics?

Of course, this takes us back into Category One and the beginning of this essay. Hedging your risks acts as a circle between speculative investments and the basics. In other words, hedging is just a fancy word for insurance; and education tends to be the best insurance policy in an uncertain and fast-changing world.

Hairdressers and haircuts

It is worth pointing out that this blog is completely free (see my earlier comments on creative side projects being a labour of love). I won’t make a single cent if you follow my rather boring advice; and I won’t lose a single cent if you completely ignore me and spend your whole pay cheque on lottery tickets. There is a clear contrast with the promoters of bitcoin and meme coins, who own assets that will always tend to gain in value if lots of other people follow their advice. You should bear this point in mind while doing further reading about investment. Does the person giving you advice stand to earn money if you do what he or she says? Please bear in mind the old joke that a hairdresser will always tell you that you need a haircut.

Finally, all this talk of investment will make some of my readers uneasy. Isn’t finance evil? It is certainly true that dwelling too much on money is never good for members of our species. Markets should have limits; and we can find joy in flow states, which work best in a non-commercial context, as commentator Ted Gioia recently argued.

Having said that, boring and sensible investing over a lifetime will tend to yield good results, particularly if applied by large numbers of people. There is no shame in making a sane plan to avoid poverty in old age. A market economy has its ups and downs, so a sensible investment plan can also make individuals and families a little more resilient when the bad times come.

Having a well-paying job, a pension fund, owning your own home, living on a budget and setting aside cash for emergencies should be part of the story when it comes to living a good life, although they are not the whole story. The luckiest people in the world are those who are able to earn a living while accessing flow states. This, dear readers, is why journalism can be such a fulfilling career for people with an over-developed sense of curiosity; and why you might enjoy day dreaming about running a successful yoga studio.

Projects, side gigs and hobbies that bring you joy are another part of the equation. It is also worth mentioning that most of us will find that family commitments and community are also necessary for a satisfying life.

Finally, there is a social element to finance. I see finance acting as a bridge between hardworking families who save money and entrepreneurs with interesting projects, as I discussed in a previous essay. Private pensions, banks offering mortgages and savings accounts (and loans to businesses), index funds, angel investors, startups and the stock market should all be seen as buildings on top of this bridge.

The comments are open. See you next week! Please note that I will publish next week’s essay a little earlier than usual due to personal logistics.

Previously on Sharpen Your Axe

Compound interest and Franklin’s lesson

Education is the best investment (part one and part two)

Grifts

Exponential growth (part one and part two)

Value creation (part one, part two, part three and part four)

Interest rates

Finance as a bridge

Further Reading

Flow: The Psychology of Optimal Experience by Mihaly Csikszentmihalyi

The Psychology of Money: Timeless Lessons on Wealth, Greed and Happiness by Morgan Housel

What Money Can’t Buy: The Moral Limits of Markets by Michael J. Sandel

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