Can 5 years of passive investing get you a house?
We have already talked about various approaches to portfolio management. You can always brush up on the main features of each strategy in this article.
Let us dwell on specific options for passive investment strategies and what are their pros and cons.
The essence of this approach is to buy reliable financial instruments in your portfolio in order to diversify it. Blue chips, funds, individual industry leaders, physical real estate and precious metals, rare paintings or exhibits are used.
The main principle of such a strategy is to buy and hold until the end. There is no need to constantly speculate on the asset or try to guess the direction of its price movement. In the capitalist world, prices are constantly rising due to natural inflation, which forces participants to launch competition mechanisms, thereby moving asset prices.
Investment funds & trust management
If the minimum presence of you as an investor is required, then you can:
- a) buy shares of an ETF fund (for some stock index),
- b) or transfer your capital under management to an investment fund.
But not everything is so good and simple here. First, many funds charge a decent commission for their activities. Secondly, a number of funds may not pay dividends, which increases investment risks. Thirdly, with trust management, you give away your funds for a documented fixed period, and you can hardly withdraw your money without loss of profitability and commissions before it ends. And fourthly, an investment fund manager controls hundreds, if not thousands, of different portfolios that require close attention. This can adversely affect the profitability of your nominal capital.
Fixed income instruments
This passive investment option aims to use instruments such as structured notes, P2P lending, bonds, certificates, bills or bank deposits.
Everything is quite simple here – you buy only those instruments that allow you to earn stable interest. In the future, they can be reinvested again and start the mechanism of compound interest. The final profitability is known even before the start of investment. They suit any type of investor from conservative to aggressive.
This limits the expected return compared to investing in stocks or other high-risk assets, but the key word here is “expected” return. In fixed income instruments, the expected profit coincides with the real one, and this is good.
How passive investing strategies work in practice
Let's imagine that we are now 23 years old, it is January 1980, and we recently graduated from a university in England. For the third year in a row we have been working at a good job, reaching a salary of £1.5k per month and having saved £5k in cash.
Now we realize that we want our own house in the future, the cost of which is estimated at £25k, or good savings for old age.
We also take into account important economic conditions:
- the investor's consumption level has been constant since 1980;
- expenses in each year are equal to 80% of monthly income;
- unforeseen expenses are constant in the amount of 20% of the monthly difference between income and expenses;
- the annual inflation rate and the accumulated experience in the form of an annual increase in wages are 5% each;
- the increase in the cost of housing is not taken into account.
We need to apply passive investment strategies and see if we can a) save up for a house, b) secure our old age.
Let's try the first strategy — "lazy" investments.
Since our work is quite time-consuming, we have very little time to monitor the exchange. In this case, we decide to collect a conservative portfolio in the proportion of 50% of government bonds in England and 50% of bank deposits.
With a “lazy” investment strategy under given conditions, if we invested and replenished our account monthly by the amount of the balance, we would be able to save up for a house in 4 years by 1983.
And what about retirement savings? By 2022, we would have managed to earn about £800k over 43 years of work and constant investment. The final value of the investment portfolio in this case would be £177.5k (22% of the amount earned).
The next passive investment strategy is investment funds & trust management. In 1993, the first exchange-traded fund, the S&P 500 (SPY) SPDR ETF, appeared, so the time frame shifts to 1993. Let's briefly outline the characteristics of the SPY fund: the expense ratio (management fee) is 0.09%, the annual dividend yield is about 2%. Suppose we were among the first to learn about the fund and decided to invest all our savings in it.
So, using the second strategy, we would buy ourselves a house worth £25k in 5 years by 1997 if we constantly replenished our account by the amount of the balance between income and expenses and reinvested the received dividends.
Will we be able to secure our old age with this approach? Definitely, yes. The value of earned funds since 1993 will be £567k, the final value of the investment portfolio - £800k, 141% of earned funds.
The third option is fixed income instruments. With this strategy, we would have earned our house at best only in 6 years by 1985. At the same time, by retirement, we would have managed to save up to £129.3k by reinvesting the return on bank deposits and the balance of our income-expenses.
Finally, we will also turn to an innovative tool - P2P investments, which first appeared in 2005 in the UK. We decided to constantly invest in this financial instrument at 13% per annum, buying loans for 1 year. In this case, we would have earned a house in 5 years. At the same time, we would invest for only 18 years, which would give us the opportunity to invest more than in previous options.
It is important to understand that these figures are the result of investments over different periods of time and with different economic characteristics of the UK. But this comparison is close to reality. People are constantly looking for “good entry points”, thereby shifting the time frame for investing.
So what do we end up choosing?
The best strategy in terms of profitability was the second – investment funds & trust management. Here we took into account only the purchase of an ETF fund for the S&P 500 index, which has grown in price by 805% over its entire existence. Such a strategy carries risks associated with the functioning of the fund's company and its management, where there is a human factor. Therefore, as always, the higher the risk, the higher the return.
If we are talking about buying a house, as in our example, then it would be enough for us to put our previous savings of £5k in the bank at good interest, without incurring any risks. But, if we are talking about securing our old age, then the long-term return on risk-free assets is not enough in a constantly changing economic environment.
If you want to receive a stable high profitability, then P2P lending can become a viable option. This instrument, however, has high investment risks, but at the same time it is already legally regulated and controlled by financial authorities.
In order to achieve a comfortable life in retirement, in addition to the experience gained, you still need to take a certain risk. The most important thing here is the stability of deductions to the account and financial discipline to control your expenses.