We have a problem.
Once we have our money that we’ve worked very hard to save, we have to do something with it. The question is what.
You invest it, right? I thought personal finance was basically: get out of debt → save → invest. It’s not that difficult.
Sort of. Aside from the obvious conundrum of deciding what exactly to invest in, as well as other problems, it’s actually not clear that we should be investing at all.
Because there are lots of useful things you can do with that saved money. Some people want to buy a house. Some people want to start a business. Some people want to take a year out to travel. And some want to invest – in perpetuity, or to accumulate a pot to give them financial independence.
This isn’t a problem if you know exactly what you want to do and how your life will play out. But 1) lots of us don’t and 2) people change their minds. And those that are certain may want to think about if they should be. Doing some reading and maths and introspection might lead you to different conclusions.
This means that most people are (to some degree) uncertain as to which financial option they should exercise. And this is a problem, because unfortunately banks only let you send money to one location. How do we decide to send it to our Vanguard SIPP, our Nutmeg ISA, our Hargreaves Lansdown LISA, or our OakNorth savings account?
One option is not to send it anywhere. Why not just keep it all in cash (or cash-like equivalents)? Despite lots of common advice, this isn’t a bad idea. Cash gives you options. So if you’re saving to buy a house but decide instead to travel the world, you can. At no loss. And you can do a similar thing with non-cash use cases: you can decide to invest when you had previously been saving – you just make investments with the savings. Simple.
Going in the opposite direction, however, by liquidating investments to provide you with cash, has its problems. And that’s if you even can move in that direction: imagine if you decide that over-contributing to your pension was a bad idea – you can’t really get that money back.
Cash has different faults. The first of these is that its real value is eroded by inflation. With inflation > interest rates, the real value of the money you have been accumulating in your account slowly starts to shrink. Second is opportunity cost: if you don’t invest this money, you miss out on investment returns. Or if you decide to use this money to purchase a property, you could miss out on the benefits of utilising a government scheme.
Cash gives you ultimate optionality and robustness. As always, we pay for these advantages with the loss of optimisation. If you’re right, it pays to go all-in. It pays to optimise. If you know you definitely want to buy a house as soon as possible, you can start to live where you might want to eventually do this, save as much as possible, and use government schemes to maximise your deposit, etc. If you know you want to retire early, you can try and maximise your income, work out how to live frugally, and invest in income-generating assets early. Being right allows you to compound early gains.
The problem is when you’re wrong. And most people will be wrong, to some degree, because it’s very hard to know what future you will want. Hence most people should act with the assumption of some uncertainty.
What do you do when you’re uncertain? You maintain optionality and you diversify.
So just buy everything or just hold cash?
No. To start with, most people can reduce their set of possibilities to those they really care about. I don’t know many people who want to save money to start a business and buy a house and increase their pension contributions and retire early and save for something big like a wedding. Ok, everyone might think they want all these things, but in reality you can usually eliminate a few.
How do we allocate money to those that remain? One approach might be to split the location of automatic transfers depending on the degree of certainty of desire for each use case. E.g. I want to do some investing but I’m more certain I want to buy a house. I’ll invest 20% of savings and send 40% to a LISA, then. The rest I’ll keep in cash.
The problem here is that splitting funds might render them useless for each goal. A £20,000 deposit might not be adequate. £200,000 isn’t enough to retire early. Concentrating efforts might be more effective.
One way to mitigate this possibility is to try and adapt as quickly as possible to changing plans and desires. You can adjust your percentages annually or otherwise – I would expect them to become larger and more concentrated as you get older and more certain. But ultimately this might just be a possibility that we’ll have to live with.