Unfortunately, the simple way to becoming a millionaire is neither quick nor glamorous. Anyone proclaiming to have a magic formula to becoming rich quickly is usually only trying to enrich themselves. This is often achieved by selling ‘guides’ or ‘secrets’ to the inexperienced investor. Whilst these are often tempting and convincing sales pitches, you have to wonder why these people need to sell books on their website when they have the apparent secret to riches.
However, if you are in your 20’s and willing to take a long term view on investing your money, you can save a significant amount of cash. Although everyone has a different set of financial circumstances, I have laid out below in 3 simple steps a feasible way to make £1m over the course of 30 years. This sounds like a long time, but if you are in your 20’s, this gives you a nice big lump sum for retirement. Even if you are unable to save at levels I have assumed below, you will benefit greatly from saving your money by the same method.
Step 1 – Calculate your Monthly Savings
If like most people, you are salaried and paid monthly, this is a fairly simple task. First, establish a budget. This should consist of your net pay less any expenses. You should ensure that your budget is conservative – don’t overcommit on saving too much each month. I always include a £50 per week allowance for spending at weekends on things that you cannot specifically budget for. Whilst I am frugal by nature, it is important that you don’t compromise your day to day life in order to save money. See the table below for a simplistic budget as an example, let’s start with the assumption we have £400 free at the end of each month.
Now we have established the cash left over at the end of each month, we can put this to one side to invest in equal monthly amounts. If you are self-employed or paid more erratically, I would advise investing in lump sums less frequently, such as yearly. In order to do this your budget would need to be made on a yearly basis as opposed to monthly.
Although the above method is simplistic, it is effective in working out how much you can realistically save, and ensures you invest your money before you may be tempted to spend it on unnecessary things. Next, we need to establish the growth in your monthly savings over the years, and the return on our investment required to meet our £1m goal.
Step 2 – Saving Plan Assumptions
Firstly, we need to consider how many years we wish to save – 30 years is reasonable if you are in your early 20’s.
Then we need to make assumptions on how much we will increase our savings year on year – this is to reflect the increase in expected earnings over your working life. As we have started year 1 saving £400 per month, I have assumed that each year we will increase our monthly savings by £100 up to a maximum monthly saving of £2,000. This may be above the budget of many people, but is achievable if you are earning more than £55,000. I don’t think this is an unreasonable assumption of wage growth if you are currently a young professional working in the UK.
Next is our expected return on investment. As is discussed in Step 3 below in further detail, we will be investing our savings in stocks, and therefore our return on our investment will need to be assumed as the expected return from the stock market. According to Morningstar, there is an expected 6% nominal return on equity investments during the next decade. I have been fairly conservative in my assumptions, and selected a 4.4% yearly return after fees as these predictions are notoriously inaccurate.
Using this data, I have created a simple table and graph below of the growth of your investment over 30 years, assuming all dividends are reinvested. As you can see, the £1m barrier is reached in year 30. The key driver of this growth in the value of your investment is the percentage growth – compounding interest is an incredibly powerful thing. This is what gives the exponential increase in the value of your investment.
If we were to increase our expected return to 10% which is very optimistic, this would give your investments a value of £2.5m at the end of the 3 years. If we increased it to an incredibly unlikely 15%, your investments would be worth £6.7m!
Note that I have excluded the impact of tax on dividends paid out over the course of the 30 years.
Graph 1 – Investment Return Over 30 Years
Table 1 – Investment Data, Assuming Constant Return of 4.4% on Investment
Now we will look in detail at how we can practically invest our money in order to achieve the returns I have assumed in the above calculations. I will look at this from a UK perspective mainly as it is the country I invest in, however the principles will be the same regardless of what country you are investing in.
Step 3 – Investing your Money
Knowing where to invest your money in order to achieve the returns assumed in the calculations above may seem like a daunting task. As an individual investor, you are unlikely to have the expertise to pick winning stocks, and unlikely to have the money to diversify your investments across different investments.
Fortunately, there exists a very simple way to invest your monthly savings into a range of diversified stocks which you can simply forget about once purchased. This involves setting up a stock and shares ISA through an online dealer. This allows you to invest up to £15,240 a year entirely tax free, and once you have set up your ISA you can purchase a wide range of shares.
We are going to invest our monthly savings through our ISA into an index tracker. Index trackers are passive investments that follow the broad market performance – markets such as the FTSE 100, S&P 500 and many more. This allows you as an individual investor to diversify your investments and not have to worry about actively managing them. In theory these trackers will give a return equal to the market you are aiming to track, which I have assumed at 4.4% in my above calculations. The main advantage of using a tracker is that they have very low fees.
Although there are multiple ways to invest in index trackers, the best way is usually through Exchange Traded Funds (ETF’s). These are shares that are traded on an exchange the same as any other share, with each share representing a portion of ownership in multiple companies. ETF’s are most often the cheapest way to track an index.
To put the theory into practice, follow these easy steps:
1. Open a brokerage account at an online dealer. There are a huge range of fee structures, and the best option for you will depend on your financial circumstances. As a general rule, brokers whose charges are percentage based are better for smaller sums of money, whilst flat free brokers are better if you have a large amount of cash to invest. There is a good comparison of these different dealers and what will be best suited for you here. I personally use AJ Bell, and advise you spend some time working out which has the lowest fees before investing your cash.
2. Using your stocks and shares ISA, you now need choose your investments. Each site will show a range of investments available for purchase in an ISA. You will then need to select an Exchange Traded Fund (ETF) to invest in. My advice would be to invest in one of two indexes, which should be offered on your online brokers platform:
- S&P 500 Index – This is a 100% investment in the US stock market. As the world’s leading economy, this is gives exposure to the largest companies in the world, and these trackers often have very low fees due to the huge competition amongst companies offering S&P 500 trackers.
- Developed World Index – There is more room for variation of companies held in this index. Methods will differ, but most of these indexes will contain a broad range of companies across the developed world markets such as the US, UK, Germany etc. This is a more diversified tracker, but the fees are likely to be higher.
Make sure that you pick the lowest fee index you can find. You can’t control the markets performance, but you can control the level of fees you pay. Look for the Total Expense Ratio (TER) of the tracker, which is the yearly charge on the value of your investments. The TER should typically be in the range of 0.05% – 1%. 0.2% is the maximum TER I would want to pay for a tracker fund following the S&P 500 or Developed World Index.
One other very important point is to choose a fund which automatically reinvests dividends into the index tracker – these are often called Accumulation Units (Acc). That way you will never need to manually reinvest your dividends, and avoid the transaction fees associated with this.
3. Once you have selected your index tracker ETF, you now need invest into it on a monthly basis. First you will need to set up a direct debit with your monthly investment amount to be deposited into your ISA from your bank account. Next, most online brokers offer an automatic monthly investment service with reduced dealing fees. Using this you can invest your budgeted savings into your chosen tracker every month.
4. All you need to do now is increase your direct debit and regular investment amount each time you have more cash left over at the end of each month.
That is all there is to it! I have covered a very simple way to save a sizeable amount of money over the course of your working life. Note one thing that I have not included in my calculation is tax, as that can be a complicated matter.
Once you exceed the £15,240 yearly limit of your ISA, tax will be charged on dividends paid out each month. Additionally, you will be liable to capital gains tax when you sold your investments. Obviously, these tax charges you face will negatively impact your return. If you wish to minimise the tax impact, I would suggest investing into a tax free pension scheme, although this is a topic for another time.
The investing strategy above is simple, and is a solid way to build your wealth over the long term. To put my money where my mouth is, I am following this strategy myself as a method for saving for the future. Please be aware that you should only follow this strategy over the long term – the stock market is volatile over short periods, and you should never put in money that you will need in an emergency.
If you have any specific questions, feel free to leave a comment and I will try to help out where possible.
I am not to be held liable for any of your investment decisions, and I am not an investment adviser. Do your own research and make your own decisions before making any kind of financial commitment.