Chapter 8 Short term savings and investment

Hopefully by now the best long term investment is quite clear. If you invest in a deposit account, your money will be gradually eroded away by inflation. Investing in the stockmarket might not be completely risk free, but in the long-term the risk gradually reduces away to an insignificant level and the risk is certainly less than the risk from keeping your money in a deposit account.

So what happens if you don't have a long term horizon ? What if you are investing for 5 years or for 2 years ? Where is the best place to put your money for the next 6 months ?

Conventional wisdom

Conventional wisdom is that the stockmarket is only suitable for the long term and this is generally regarded as a minimum of 5 years. This is because the stockmarket is volatile and might suffer a crash before you sell your investments. The stockmarket is risky in the short term, but is the risk justified by the potentially high returns ?

But in most cases, the risk is well worth the reward!

Over the past 36 years, the Irish stockmarket has returned an average of 16% a year or about 8% after inflation. So, on average, you can expect that your investment in the stockmarket will earn about 8% more than a deposit account.

But this 8% is an average and the highs and lows are much more extreme. Look again at Table 8:

Table 8 The highs and lows of the Irish Stockmarket

If the experience of the last 36 years was to be repeated, there is a 3% chance that you might lose half of your money over the next year. There is a 30% chance that you will incur at least, some loss.

Is this risk worth taking ? Absolutely. There is a 25% chance that your investment will increase by at least 40%.

The stockmarket is risky, but that risk is well rewarded.

Can you tolerate the risk?

It depends on how you are planning to spend the proceeds of your investments. If you are closing the purchase of a house in two months time, you need to preserve your investment. If you lose 25% of it, you won't be able to buy a house. This is one extreme.

If however, you are planning to trade up from your current house in about 2 years time, then you can tolerate risk. If the stockmarket declines by 25%, then you will have to wait another year to trade up. This is hardly a disaster. You will not be homeless. Say this happens 10% of the time.

But what happens the other times. Most of the time you will have a little more money than you had planned because of the outperformance of the stockmarket.

But 30% of the time, you will have 40% more money that you planned. This will enable you to trade up to a bigger house or to trade up earlier than you had planned.

The reward must outweigh the risk in these sort of cases.

THE IMPACT OF CHARGES

Another conventional reason for saying that you must have at least a 5 year horizon was the impact of charges. Most of the life companies had huge up front charges and distributed a good part of the returns as final year bonuses. In these situations, if you cashed before 5 years, you were likely to lose a large part or all of your investment.

If you bought shares directly, you face total charges of about 4% between stamp duty and the commissions on buying and selling . So you would have had to keep your investments for about 5 years to spread these transaction costs over time.

But with the introduction of products with no initial charges and low ongoing charges, this argument is no longer valid. If you invest £10,000 in a Quinn Life Freeway product and cash it next week, you will gain or lose according to whatever has happened to the underlying investments. You won't be paying a bid/offer spread or an exit charge of any type.

UNSUITABLE SHORT TERM INVESTMENTS

We cannot stress enough the impact of initial and exit charges.

With profits funds for example, you will probably not get any return for 2 years. This is a very poor short term investment.

Products with initial charges or bid/offer spreads
If you are saving £40 per month, a regular savings plan with quinn Life would not be advisable. The monthly processing fee of £2 has the same effect as a 4% initial charge. And this is the lowest charging, equity based regular savings plan.

Products with early exit charges If you buy a product with early exit charges, for example the Canada Life Focus 15, there are exit charges in the early years. 5% is a big cut - again these are unsuitable investments.

Direct investment in shares really requires a minimum of 5 years. You will pay 1% stamp duty on the purchase. You will pay up to 1.5% of the cost of buying and again 1.5% of the cost of selling. This can reduce the return on your investment by about 5%. This is just too high to try to recover from short term investments.

Property is a very long term investment - you should be expecting to keep it for at least 10 years. Stamp duty can be 9%. Buying and selling costs can be a further 4%. You may have to spend money on decorating it before letting it and decorating it again before selling it. You might have bad tenants who are difficult to eject when you want to sell it.

SUITABLE SHORT TERM INVESTMENT PRODUCTS

Any product with no initial or exit charges. Lump sum investments with the following companies:

Quinn Life
EBS
AIB
Bank of Ireland

I would like to buy a house sometime. But I am nowhere near it at present. What should I do?

You are a perfect candidate for a stockmarket based investment. You might not be buying your house for 5 years. By investing in the stockmarket, you will get a better return on your money over that period. If the stockmarket crashes, it might be 6 years instead of 5 years. But if the stockmarket goes through one of its really good years, you might be able to bring forward the purchase of your house.

As you get closer to the target deposit, you should consider moving out of the stockmarket into a less volatile investment. You don't want to be just in sight of your goal only to have a sudden stockmarket crash set you back another 2 years.

My two children are 10 and 12 years old. How should I save for their college education?

Most people put such savings into a deposit account and I would argue that they should be saving in a stockmarket based product. You are probably saving over a period of time and regular saving handles the volatility of the stockmarket particularly well. Likewise you will be spending your accumulated savings over a few years of your child's education and so your investment horizon is probably longer than you think it is. If the stockmarket crashes over the next few years, you will probably have enough time to recover. And even if it doesn't recover, is your child's education at risk ? If you own your house and have your mortgage under control, you will be able to remortgage if the worst comes to the worst.

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