When cash was king

I promised my twitter followers something special:

So here it goes. It’s 1 January 1989, the Soviet Union still exists, Kylie Minogue has just conquered the charts with her debut album and Young FI Guy isn’t even born yet. Here’s the question: what would you take: 20 years of cash returns or 20 years of global equity returns. A no-brainer right?

Cash vs ACWI - 1989 to 2009

Quite remarkably the return on both was almost exactly the same (although with significantly different journeys!). Two months later, in February 2009, the cash return would overtake the equity return. That’s right, over a twenty year period, cash beat equities.1

What the hell?!

Financial economics says this shouldn’t happen. Over such a long period, higher risk assets should deliver higher returns. But it can happen. As Monevator recently pointed out: Taking more risk does not guarantee more reward. That’s because:

Risk means that more things can happen than will happen.

When cash was king

It’s easy to forget, but cash used to give a pretty great return:

Throughout the 90s and early 00s, cash paid out significant real returns. And we’re talking risk-free returns here. The return shown above is from the Building Society Association. This is the average interest rate you’d get from popping to your local building society and opening a savings account. No TIPS ladders, no money market shenanigans. Simple deposit savings. Completely risk and stress-free.2

Mr YFG’s journey – growing a princely sum

This result, though surprising, was instinctive for me. I grew up saving a lot. By the time I was 16 I had saved up 1,000s of pounds through birthday and Christmas gifts and working. I fondly remember double-digit interest rates up until the late-00s. Children’s accounts could have incredibly high rates. I very much rode that cash returns chart. But then the financial crisis hit.

Knocked off the throne

I suspect some of you will be screaming at your screens right now: “you’re not telling the whole story!”

Alas, you are right. Because since the financial crisis, interest rates have plummeted:

[Note: the BSA average Building Society rate data stopped in 2007, to create a longer dataset, I’ve combined this with the Bank of England average 1 year Fixed Bond interest rate from 2008.]3

I’m not a banking expert, but from what I gather there are three reasons why this happened:

  1. Quantitative Easing and Funding for Lending – these policies made it very cheap for financial institutions to borrow money. It dramatically reduced the need for customer deposits to fund lending.
  2. In addition, the Bank of England drastically cut the base rate, further reducing the cost of borrowing.
  3. The financial crisis caused a wave of consolidation in the market, reducing the competition for customer deposits.

This had a huge impact on returns:

Generally speaking, real cash returns have been negative since the financial crisis. Only popping up into positive territory for brief periods.

The full story

So let’s fast forward 10 years, how does our choice between cash and global equities stand after 30 years?

To put it mildly, the equities have usurped the throne. At the 20 year stage, you’d have roughly doubled your money (in real terms) with both cash and global equities. At the 30 year stage, you’d have a 550% real return with equities. Over the last ten years, you’d have actually lost money on your cash (in real terms).

In other words, if you had held on to tried and tested cash, you’d have massively lost out. This is one of the reasons I bang on at young people about how important it is to start investing as soon as possible. Those sitting out there with all their money in 1% Cash ISAs are getting poorer. If that’s you, I strongly recommend to close this window and open a broker account right now (look at this link on how to do it).

Some lessons

Let’s have a think about what we can take away from all this:

  • Even over very long periods, risky assets might now give you a better return than risk-free assets
  • Cash has historically been a great investment asset
  • But right now, it isn’t
  • That might change, but if you are currently sitting on piles of cash you are losing money
  • But even globally diversified equities are highly volatile, there’s no guarantee of high returns

I have fond memories of my old cash accounts. And I feel it is a shame that cash isn’t the investment it once was. Building societies were a great way to get individuals to start saving for their future. But times have changed. Am I the only one who is nostalgic? I’d like to know if you are too, or if you think I’m being a sentimental fool.

All the best,

Young FI Guy

1 Cash returns data sourced from BSA and BOE. 1989-2007, from BSA 2016/17 yearbook, “Building Society Average Gross Share Rate“. From 2008, BOE “Monthly interest rate of UK monetary financial institutions (excl. Central Bank) sterling fixed rate bond deposits from households (in percent) not seasonally adjusted” – ID:IUMWTFA. These returns are gross, as in before tax. Equities data from MSCI: MSCI ACWI, GBP, Index Gross. Unlike the cash return, you would not have been really able to get this return as I don’t think an index tracker has tracked this index back to the 80s – besides you’d have fees and tax to pay. In that respect, the equities return is overstated by more than the cash return! Inflation data is monthly CPI from ONS: Series ID: D7G7.

2 Datasets for interest rates periodically changed. Prior to 1989, Building Societies were somewhat enforced in the interest rate they had to offer. In the late 80s banking was substantially deregulated giving building societies greater flexibility to set rates (and demutualise). I tried to find the best fit with the BSA data from the various BOE data series. I went for 1 year fixed bonds as that seemed to be ‘the closest fit’.

3 This post is another example of why I don’t like the term “risk”. Risk, as defined by volatility, isn’t particularly helpful to individual investors. I prefer to think of three different types of risk: inflation risk, capital risk and shortfall risk (link).

How we track our expenses

Tracking expenses is one of the most important ways to take control of your finances. You can’t actively manage your money unless you know what you spend your money on. That said, tracking your spending can be tedious – manually entering hundreds of transactions a month is nobody’s idea of fun.

Things are getting better, there are now many automated apps that can do a lot of the grind for you. That said, I still think it’s better for everyone to track their own expenses in their own way. That’s because it means you are actively engaging with your spending. Automating expenses tracking can mean you end up on auto-pilot, not really challenging what you spend each month.

Each month, we track our expenses in a homemade spreadsheet. It means we don’t hand over our bank details to any third-parties and we can monitor our spending habits.

The process

At the end of each month, we sit down together and download our bank statements. We then input those into our spreadsheet, do a bit of labelling and out the other end comes our summarised expenses and savings rate. It only takes us about 30 minutes to an hour each month. Which is much less than any other non-automated process we’ve tried.

Over time, with lots of similar items (mortgage, utilities, groceries) the process becomes quite straightforward. It also helps to spot spending patterns, identify odd or expensive spending and has a side benefit of picking up on fraud (which has thankfully never happened to us).

The Spreadsheet

Enough abstract. Let’s talk about the spreadsheet. (link)

We’ve used it for over two years. After many requests, I’ve finally tidied it up and changed a few things so that I can share it with you.

It’s a deliberately very simple spreadsheet. There are no complicated formulas (for excel geeks: the most complicated formula is ‘SUMIFS’, the ugliest formula a not very nice ‘IF’ function). There are no macros or VBA. Sure, it could be cleaner, faster, better (if you have suggestions, or find errors do let me know). But, I believe this is a spreadsheet that anybody can use.

This is also a spreadsheet where you don’t have to fill everything (or in fact anything) for it to work. Likewise, this spreadsheet is pretty easy to customise and add/change things if you want. I’ve designed it with redundancy built-in for that reason.

How it tracks expenses

Let’s give a run through for how it works. Where you see a yellow or blue tab, that’s where you manually enter data. Everything else is automated.

There are three elements to the spreadsheet:

  • The ‘labels’ – where you input a few things on first use
  • The ‘bank account tabs’ – numbered 1 through 10, each represents a bank account – here you input your bank account transactions
  • The ‘summaries’ – these summarise the data from the bank account tabs in various ways, with the option to add some more data if desired.

The labels

First up, there’s the ‘Labels’ tab.

There are a few things to do in this tab:

  1. Enter the starting date.
  2. Customise the expense ‘tags’ in column 2, these can be whatever you want, use as many as you need.
  3. If you want, you can then label whether these tags are bills, one-off items or if you want to exclude them from the summaries:
    1. We label some items as ‘bills’ these are the things that Mrs YFG and I split between us
    2. Some items are ‘excluded’ these are where we transfer money between accounts (‘transfers’); money we invest (‘investments’) and capital expenditure (such as, our house extension. These won’t show up in the summaries.
    3. Some items we label as one-offs, these are big expenditure items that will only occur once. There are then separate summary lines which show expenses and income minus these lines, to show the more ‘regular’ in and outgoings
  4. Next up is to do the same for the income tags (blue cells)
  5. Next, enter your names, this is used to split expenses and income by person (you can use ‘joint’ or similar if you have a joint account).
  6. Finally, you can designate how the bills are split between yourselves.

The bank account tabs

On first use, there are two things to do. One, select the person from the drop-down menu and two, put in your bank account name (or identifier) for reference (so you know which tab is for which account.

The process for using this tab is quite straightforward. What we do is to login to our online banking; navigate to the page where you can download your bank statements; and export them as an excel or csv file.

We then copy this data into the relevant yellow boxes. Be careful to make sure all items are entered as positive (not negative figures). Money going into the account should go in the “money in” column, money going out into the “money out” column.

Finally, for each item, select the relevant ‘tag’ (i.e. mortgage, groceries, etc.).

Here’s an example of how to enter the data:

Expenses tracking example
Screenshot of expenses tracking spreadsheet – transactions

Two minor things.

You’ll notice I’ve left a cell with “-1.00”. If you’ve got negative values, select this cell, and hit copy. Select the negative values, then do CTRL+ALT+V (aka ‘paste special’) then under ‘operation’ select ‘multiply’ this will multiply all the negative values by minus 1 to turn them positive.

Another thing to note is refunds. There are three ways to deal with these:

  1. Set up an income label as ‘refunds’ or something similar
  2. Move these items into the money out column as negative values and label them the same as the earlier expenditure (so they cancel out the earlier expense).
  3. Delete the entries manually, and the corresponding expense.

(I’ve tried to think of a better solution, but couldn’t come up with one!)

You do that for each of your bank accounts and all the automation is done for you by the snazzy formulas.

The summary tabs

First up, there is ‘Expenses by individual‘. This tab brings together the expenses for an individual across all the bank accounts. No need to enter any data here. (To the excel geeks: this is the tab with the horrible IF formulas – sorry!)

Next is the ‘Income by individual‘. It works in the same way as the expenses tab above, just for income. One difference is that you can manually add in income which you might want to include, but doesn’t flow into your bank accounts (such as, interest in investment accounts etc.) This can be done in the yellow boxes as usual.

The third summary is ‘Savings rate by individual’, here you can calculate each person’s savings rate. There are some tabs where you can add in extra savings that don’t go through your bank accounts (i.e. pension contributions, SAYE, etc.)

The main summary is surprisingly named ‘Summary’. This aggregates everything together. With a table for expenses, income and finally savings rate.

Finally, there are some charts in the ‘Charts’ tab which are linked to the ‘Summary’ tab. These are the ones we use, but feel free to create your own.

Wrap up

And that’s it. If you’ve been looking for an expenses spreadsheet, please download it and give it a whirl (link). If you have any questions or suggestions, do leave a comment or drop me an email. I certainly think of this as a living document, so I expect to make updates and changes over time.

Do feel free to make changes, and edit it the spreadsheet if you want. I think it’s good to make the spreadsheets and documents feel like your own!


All the best,

Young FI Guy

Deciding between drawdown and annuities – 23 years before retirement…

I had planned a completely different post today. But, like a moth to a naked flame, I’m drawn to another post on pensions. This time, on deciding between drawdown and annuities. The catch is, you’ve still got 23 years till retirement.

The question posed comes from a This Is Money post:

I’m only 34 but my pension firm wants me to decide NOW between drawdown and an annuity – can it do this?


The post is a regular series where readers can send in questions to former Pensions Minister Sir Steve Webb. I found this one particularly interesting because it’s a question I’ve had to answer, and I suspect a large proportion of readers have also had to answer (perhaps without their knowledge!) On the face of it, it seems absurd that a 34-year-old should have to ‘choose’ between drawdown and annuities. Let’s have a little dig in.

The question

I’m 34, make regular contributions into a defined contribution company pension, and until recently have pretty much ignored it.

I logged on to have a look at the provider’s new portal and noticed I had a new range of options which boil down to me choosing now if I think I’ll be wanting to take an annuity or a drawdown pension.

What it doesn’t tell me is how this choice affects what I might get when I hit the magic age. Which is the least ‘risky’? If I say drawdown, but later decide annuity, does that put me in a worse position than if I flipped it around?

Should I be trying to split the pots – I’ve got a couple transferred in from other places? What if drawdown doesn’t exist in the future? What if some magical new pension option appears?!

I’m not looking for the differences between the options at retirement, more about the investments which will be made now. Help?

What brought about this madness?

Steve’s response is, of course, bang on the money – I’ll do my best to paraphrase. This mad situation comes about for two reasons.

First, the ‘choice’ arises because of pension freedoms. Before 2015, almost everyone would have to use their pension pot to buy an annuity. Since the freedoms, savers can opt instead for drawdown.

Second, when you contribute to a pension and haven’t explicitly chosen an investment for it to go into, it will go into a default fund. When everyone had to buy an annuity the fund would use something called lifestyling (or glide pathing). This is where, in the years before retirement, the fund moves out of equities and into bonds. This is to cut the volatility of your pension pot in the run-up to taking an annuity.

Here’s an example from one of my pension schemes:

This is for an ‘annuity’ type retirement:


This is all very sensible, lifestyling before an annuity is one of the few things most pension experts seem to agree on. But given that you no longer need to buy an annuity, and can opt for drawdown instead, the game changes.

If you’re opting for drawdown, there is strong evidence that you don’t really want lifestyling (or at least, not as much of it). That’s because you will continue to keep investing your pot after retirement, and will want to keep benefiting from growth in your investments.

What happened

Companies will make a decision for all pension scheme members. This is reflected in their choice of default fund.

Most companies now assume that savers will take drawdown. So they changed their default fund from one that used lifestyling into one that did not. Not all companies did this, and the default fund may continue to use lifestyling.

What you do about it

You have the choice as to whether you intend to buy an annuity or opt for drawdown. If you select to go into drawdown, your investments will likely not be lifestyled. You can change this ‘notional’ choice at any time pre-retirement (although you should check your scheme rules).

You can also usually actively dictate what happens to your investments in two ways.

In the first way, you stay in the default fund but you select whether you want lifestyling or not, and the percentage of your pension contributions that go into a lifestyle investment option.

In the second you instead pick which funds you invest into (and not the default fund). Your pension scheme will offer a list of different investment options and you can ‘pick and mix’ between them.

Does it matter?

If you’ve elected to stay in the default fund (the first option above), you won’t see any practical difference in your investments until about 10-15 years before retirement. As shown in the chart above, when I would get within 10 years, the investment proportions changes. It’s around that time when you should really start thinking about whether you want to drawdown or take an annuity with your pension pot (or a mix of the two). Have a look at two previous posts of mine on drawdown and annuities on each option.

A word on default funds

If you haven’t actively selected what funds you want your pension contributions to be invested in then you are likely invested in the default fund.

Unfortunately, this is not always a good thing. The default fund doesn’t mean ‘standard’. In fact, it is a lottery whether your default fund is any good or not (link – FT google result).

It is absolutely worth taking the time to find out more about your default fund and the other fund options available to you. Generally speaking, low-cost, passively managed equity funds are what you are looking for. With these funds, you are invested in higher return assets but with higher risk. However, very few investments are absolutely certain and even government bonds can go up and down in value.

A final question

I want to round off this post with a final question:

Why do I have to make these decisions?

I’m really interested in investing and pensions (I suspect many readers are too). But most people find pensions boring and confusing. Should people have to make these kinds of decisions? As I mentioned before, I think it’s better to make saving and investing as painless as possible than to encourage forced and painful engagement.

The reality is very few people will choose the funds into which their pensions invest. The government and the financial services industry have reluctantly come to the conclusion that it’s better for people to be saving something, anything, even if it’s not perfect than to be saving nothing. Faced with bizarre questions like the one in this post today, most people will (quite sensibly!) run and hide.

Unfortunately, it is rare to find open Defined Benefit schemes. The true beauty of these schemes is not the (usually) higher retirement benefits. Rather, it’s that those savers did not need to make any investment decisions for their pension. They could get on with doing what they are paid to do and leaving the scheme to deal with the complexities of investing.

Then again, that probably means more readers for my blog…

All the best,

Young FI Guy

Mrs YFG: our ideal life

I was listening to a ChooseFI podcast this week and it set off my idea for this post about our ideal life.

The podcast asked me to think about my ideal life post-FI. If money was no object, how would my life look? I’d never really thought about it in that way and so I got home and immediately directed Mr YFG to get thinking too.

Mr YFG’s ideal life

I think he kinda has it. He gets to pretty much do what he wants (within reason…)

Mind you I think what would make him happier is me being FI too and having me at home. Me at home means that I’m not stressed or miserable from work. Plus he’d have less housework to do as I’ll do my fair share. Mr YFG isn’t really the adventurous type. He can find as much enjoyment in a book or a lazy afternoon as he would from a ‘once in a lifetime’ trip. He likes things relaxed and to do things in his own time. I think what he enjoys most about his current lifestyle is that he gets to dictate his pace of life, and not having it dictated to him.

My ideal life

I get to wake up naturally (sans alarm), make and enjoy a cappuccino and go feed the guinea pigs. Yes, we have pets and our guinea pigs will feature heavily.

I enjoy crafts and making things. Over the years I have made cards, clothing, calendars, candles, jewellery, do cross-stitching, knitting, furniture up-cycling. You name it I’ve probably tried it. With varying degrees of success… My current obsession is making a patchwork quilt. I get frustrated because I don’t have the time I need to dedicate to doing these things right. So, I often rush them or just don’t get round to them. With only a few hours over a weekend to dedicate to what I want to do (and not what I have to do), I can’t get much crafting done.

So I can see my days involving crafts and possibly making my own clothes (again another wild fantasy). I like gardening and sorting out the garden and so I suppose that would feature in summer too.

The next thing I enjoy is cleaning, de-cluttering and organising. I am seriously considering a career post-FI as a professional organiser (yes…you can get a qualification for this…from APDO). Nothing makes me happier than upending a room to put it back together and to donate or chuck things we don’t need. I’ve done this since I was a child (on a Thursday as it was bin day on Friday). I would enjoy an evening session of organising and de-cluttering my room.

I could do babysitting, dog walking and general help for my friends and family. I have an idea of being a kind of fairy godmother who has the time and wherewithal to help those who are still working and are time poor.

Would we move house?

Not unless something horrible happened, no. We love our home and it’s a perfect location for London. Even no longer working in London wouldn’t mean we moved. We are in the suburbs and with great transport links. Moving away from London would mean less convenience and more reason to need a car (shudder).

We would continue doing up the house as bits fell apart, repainting and tiling etc. There is still a good amount of work to do on our neglected gem of a house (two decades of no repairs). We are firm believers in Do It Ourselves.

With Mr YFG being at home most of the time, our house is well looked after. When we go on vacation we often find the places we stay in a less clean and tidy condition than our own home.

If we did move, we would probably keep the house to rent out as it would do well rent-wise. And if we moved I can only imagine it would be to East Anglia (the round hump on the east side of the UK for those foreigners). That’s where Mr YFG hails from and it’s a beautiful, relaxing part of the country.

Would we travel?

Mr YFG and I like a holiday as much as the next person. Our version of travel is going to a nice hotel to relax and eat good food and sit on a beach and have a few walks, for a week max. We don’t hike and we don’t do extreme trekking or camping (no electricity? What is this, the dark ages!).

We find the idea of being away from our home for more than two weeks uncomfortable. We like to have a base and our home comforts.

Would we get a car?

We don’t think that post-FI life would need a car, at least not to begin with. We’ve talked in the past, quite strongly, about why we don’t own a car. We have taxi services and Uber and good train links. I can’t think what we need a car for other than visiting family and friends outside London. I suppose that will be more frequent. The thought of having to own a car is tiring and unappealing – parking it on our street alone is a joke – there’s been a number of fights down the years over parking spaces… Thankfully, being car-less, we can stay clear of all those shenanigans. Then there’s the cost of having a car. For now, I can’t see any way that it makes economic sense. But, We will see.

But let’s be honest….

I have these grand ideas for how I will relax once I hit FI. In reality, I’m very scared of leaving my profession. A lot of my self-worth is tied up in being a lawyer and tied to my status and salary. I enjoy the validation I get from my clients and from the size of my paycheck. Often, I even actually enjoy my job(!).

However, I am tired most of the time and don’t want to work anymore. I desperately want to have more free time and I dread Sunday nights. I don’t want to have to get up early, commute and wear work clothes and do things I don’t want to do. I don’t want to work late nights for no more pay or appreciation.

That said, the thought of open-ended free time disturbs me. This is why I have to think carefully about my ideal life and put things into play before I hit FI. I will need hobbies, a job that can offer me flexibility, less or no commute and the right level of brain activation.

What does your ideal life look like?

I’d be really interested to hear what your ideal life looks like. Does it look a lot different from how you live now? Would it change significantly after Financial Independence or retirement?

Pension costs and transparency inquiry

The Work and Pensions committee is launching their pension costs and transparency inquiry (link)[1]. According to the committee, they are seeking your views on whether the pensions industry provides sufficient transparency around charges, investment strategy and performance to consumers:

The Inquiry will examine whether enough is being done to ensure individuals:

  • get value for money for their pension savings;

  • understand what they are being charged and why;

  • understand the short- and long-term impact of costs on retirement outcomes;

  • can see how their money is being invested and how their investments are performing;

  • are engaged enough to use information about costs and investments to make informed choices about their pension savings; and

  • get good-value, impartial service from financial advisers.

Eight Questions

I became aware of this latest inquiry from Henry Tapper, founder of the Pensions PlayPen and a director of First Actuarial. The inquiry has asked for submissions to eight questions, which I copy from Henry’s blog (link) [2] with his highlighting:

  1. Do higher-cost providers deliver higher performance, or simply eat into clients’ savings?
  2. Is the government doing enough to ensure that workplace pension savers get value for money?
  3. What is the relative importance of empowering consumers or regulating providers?
  4. How can savers be encouraged to engage with their savings?
  5. How important is investment transparency to savers?
  6. If customers are unhappy with their providers’ costs and investment performance/strategy, are there barriers to them going elsewhere?
  7. Are independent governance committees effective in driving value for money?
  8. Do pension customers get value for money from financial advisers?

Paul Lewis weighs in

Paul Lewis (of, among others, Radio 4 Moneybox fame) was quick to offer his pithy answers.

For the most part, I agree with Mr Lewis. Here are my responses to those eight questions.

Do higher-cost providers deliver higher performance, or simply eat into clients’ savings?

They do not deliver higher performance – FACT. The evidence from the FCA is unambiguous: “there is no clear relationship between charges and the gross performance of retail active funds in the UK”. The FCA produced a comprehensive, detailed analysis of this (link)[3]. This is the same for not only individual savers but also for institutional pension schemes investing hundreds of millions or pounds.

Is the government doing enough to ensure that workplace pension savers get value for money?

No, the government isn’t doing enough. The FCA has found time and again that people do not have trust in pensions (link)[4]. It’s not possible to think you are getting value for money if you think you are getting mugged off. In fact, the government isn’t doing enough to help people save full stop. 2% contributions for auto-enrollment will not leave anyone with enough in their nest egg to worry about value for money.

What is the relative importance of empowering consumers or regulating providers?

You can’t put it in the consumers’ hands and expect them to correct deficiencies in the market. The providers have the ability and funds to make life easy for consumers. Besides, this isn’t the right question to be asking. I’m sure readers of this blog are very interested in their finances and investing, but most people aren’t. They don’t want to be empowered, they want someone to make it easy for them so they don’t have to worry about something they’re not interested in.

How can savers be encouraged to engage with their savings?

I echo Mr Lewis: Do savers need to be engaged? Do they want to be engaged? I think the answer to both is: No. It’s better to make saving and investing as painless as possible than to encourage forced and painful engagement.

How important is investment transparency to savers?

Very. Lack of transparency leads to lack of trust. Lack of trust leads to lack of saving. It’s important to remember that opacity comes from somewhere. It is a symptom of a market that is too complex and not focused on consumer outcomes.

If customers are unhappy with their providers’ costs and investment performance/strategy, are there barriers to them going elsewhere?

Yes. Both in time and money. But most importantly, in hassle. It can be utterly painful to switch providers and you often have a nerve-wracking wait while your money is being transferred in the ether. These are savers life savings yet time and again providers flout the transfer guidelines. ISA transfers that should take 30 days, can take half a year. This has been a problem for years and the regulators have done little about it. It’s all well and good encouraging savers to shop for the best deals, but if doing so is painful, then savers will not do it. (link)[5] (link)[6]

Are independent governance committees effective in driving value for money?

Somewhat. But IGCs (link)[7] will naturally be focussed on compliance as their number 1 priority. Value for money will always be a distant second. So when there is any ‘doubt’, bureaucracy is followed and improving investors’ outcomes is sidelined.

Do pension customers get value for money from financial advisers?

Rarely. That’s because it’s not cost-effective for most IFAs to offer non-regulated services. It’s these services: planning, asset allocation, behaviours, guidance that are the biggest determinants of financial success or failure. The regulatory regime forces IFAs to focus on products and makes it non-cost effective for the most people to access financial advice (the ‘advice gap’). IFAs need to buy food for their family too (and cover their insurance and compliance costs), we can’t expect them to reduce their prices to a loss or do it for free.

Your thoughts!

You can send your own responses to the committee, and I urge you to do so. (link)[8] The committee opened up responses on its ESA/PIP inquiry and received a flood of submissions that greatly contributed to the committee’s findings.

I would really like to hear your thoughts – please do leave a comment on your responses to some or all the questions.


All the best,

Young FI Guy



[1] – https://www.parliament.uk/business/committees/committees-a-z/commons-select/work-and-pensions-committee/news-parliament-2017/pension-costs-17-19/

[2] – https://henrytapper.com/2018/08/05/thinking-the-unthinkable-franks-at-it-again/

[3] – https://www.fca.org.uk/publication/market-studies/ms15-2-3-annex-4.pdf

[4] – https://www.fca.org.uk/publications/market-studies/retirement-outcomes-review

[5] – http://www.thisismoney.co.uk/money/experts/article-6002491/TONY-HETHERINGTON-leaving-investment-service-Smart-idea.html

[6] – https://www.telegraph.co.uk/finance/personalfinance/savings/11512350/Shambolic-Isa-transfer-errors-continue-to-hit-savers.html

[7] – https://www.fca.org.uk/firms/independent-governance-committees

[8] – https://www.parliament.uk/business/committees/committees-a-z/commons-select/work-and-pensions-committee/inquiries/parliament-2017/inquiry11/commons-written-submission-form/

Asset allocation and the UK efficient frontier

Asset allocation is the single most important factor in determining the returns of an investment portfolio

CFA Society UK

We would do well to remember that asset allocation is the most important thing for investors. A lot of the noise in the financial media is about selecting funds. Even I fall foul of that, talking about the funds I invest in, and not about my asset allocation. We live in a bizarro-world where the advice on which fund to buy is heavily regulated. But advice on asset allocation is almost ignored. The reality is how you allocate your investment funds across assets will be the biggest determinant of your investment return.

What I do

Rather than talk about the theory, let’s go straight into what I do. Overall, I’m 90% equities, 10% bonds in my portfolio. Including my various cash balances, I’m probably about 80% equities, 10% bonds, 10% cash.

I’m much more invested in equities than the traditional 60/40 portfolio. That’s because I’m after long-term investment growth and, historically speaking, the greater the allocation to equities the greater the long-term growth return on your investment. Another reason is that I can stomach a lot of the volatility that comes with having an equities-dominated portfolio (more on that in a bit).

The last reason is that I’m more worried about Inflation risk and Shortfall risk than Capital risk.

Hold on, there are three types of risk?

There are actually lots more types of risk. Inflation risk and Capital risk are the ‘big two’ for investors, but there is a third, often overlooked risk, Shortfall risk.

Capital risk is the risk that your investment may be worth less in the future than it is today.

Inflation risk is the risk that the purchasing power of your investment will be eroded by inflation.

Shortfall risk is the risk that your investment will fall short of the amount you require to make your financial goals.

In this respect, no one asset is ‘low risk’ in all regards. Cash has a low Capital risk, but high Inflation and Shortfall risk. Equities have a relatively high Capital risk, but a low Inflation risk. Over the long-term, it has a low Shortfall risk.

Circling back, for me, I’m more concerned that my investments will be eroded by inflation and that my portfolio will fall short of what I require to continue to be Financially Independent.

Notice what I didn’t say

The words ‘volatility’ and ‘uncertainty’ are missing from those definitions. Yet, that is what lots of Financial Economics refers to when we are talking about risk (and I’ll be using that later too).

But I’ve never heard anybody say: “Ooh I’m not going to invest in equities because the standard deviation is 18% compared to 12% for bonds.” Rather, the conversation is usually framed around what risk investors are comfortable taking and what risk they can afford to take. You can see that ‘comfort’ marries up with Capital risk and affordability with Inflation risk. The final consideration is what level of risk is associated with the return I require to meet my financial goals. This risk requirement matches up with Shortfall risk.

Investing is not a ‘have your cake and eat it’ type of thing. You will have to trade-off between those three risk types. And what’s suitable will vary for each investor. Unfortunately, financial economics tends to ‘fall down’ when we start getting pesky people with all their emotions involved!

That’s why I don’t like the term ‘risk’. It’s a red herring. I prefer the term risk tolerance (considered with my other three factors: Time-horizon, access and affordability. See link).

The efficient frontier

The fundamentals of investing are based on Modern Portfolio Theory (MPT)The theory states that risk-averse investors can build an investment portfolio to optimise their expected return based on a given level of market risk. It’s often boiled down to: the trade-off between risk and reward. The risk we are talking about here is volatility; not the three risks (capital, inflation, shortfall) we’re talking about above. That’s because volatility is easily observed and measured – it’s much more difficult to calculate the three risks we care about (although some smart people come up with some ingenious attempts).

From MPT it’s possible to build an efficient frontier. The set of optimal portfolios offering the maximum possible for a given level of risk. Plotting these points creates a curve. The idea is that investing in any portfolio that is not on this curve is undesirable.

A UK passive investor frontier

Using the amazing Portfolio Charts calculators I’ve created a set of efficient frontiers for a UK passive investor. I’ve looked at three simple portfolios:

  1. World Equities / Long-term duration Gilts
  2. World Equities / Intermediate duration Gilts
  3. World Equities / Short-term duration Gilts

I’ve created 11 points for each portfolio ranging from 100% in World Equities to 100% in Gilts. At each point, I plot the average annual return and the standard deviation ( how much the returns differ from the average).

Here are the charts:

(real average annual return with reinvestment on y-axis (note: not CAGR), standard deviation on x-axis, ticks at 10% intervals, data since 1970).

World Equities / Long-term Gilts

World Equities / Intermediate Gilts

World Equities / Short term Gilts

At 100% in world equities, the average annual return is just shy of 7% with a standard deviation of just under 18%. Each portfolio curves downwards as we move from Equities to Gilts. With the return falling sharpest as we move out of Equities into short-term Gilts (T-bill equivalents). This is more obvious when we plot the curves on top of each other.

Using the Efficient Frontier

There are two ways of using the Efficient Frontier.

The first is to look at whether your portfolio has a lower return than the frontier curve at its level of standard deviation. For example, if our portfolio is returning 5% at a standard deviation of 15%, Modern Portfolio Theory tells us that our portfolio is sub-optimal. We would benefit by moving into the portfolio at the frontier.

The second use is to ride along the frontier to the most efficient point on the curve. This is where use diversification and derisking to get a ‘better’ risk-adjusted return. If we draw a line from the 100% equity point, to the 100% bond point, this the frontier we’d get if there was no diversification benefit from holding equities and bonds together. So when we ride along the efficient frontier, part of our change is from derisking – accepting a lower return for less volatility and part is from diversification – getting a higher return because we are putting our eggs in multiple baskets:

Finding the sweet spot

Using this technique we can find the sweet spot – the mix of risky assets that delivers the best risk-adjusted return. To do this, we need to find the return on a riskless asset. The closest we have is cash. According to the Barclays Gilt Survey 2016, the 50yr real return on cash is 1.4% per annum. If we plot this on our graph and find where it meets a tangent with our efficient frontier we can find the sweet spot:

This chart shows that something around a 50/50 World Equity/Intermediate Bond portfolio would give the best risk-adjusted returns (i.e. 50% VWRL, 50% VGOV). Thus my somewhat flippant phrase in my How I invest my money post: “There is good evidence that on a risk-adjusted basis a more even split between bonds and equities is superior (in risk-adjusted returns).

But the return on cash varies significantly over time, were one to look at the 2010 Barclays Survey, the real return was 1.9%. If we plot that, we get a much different answer:

Our graph now tells us that something around 60/40 to 70/30 is the sweet spot.


Cash isn’t riskless. In terms of nominal volatility it might be, but once we account for inflation cash is anything but risk-free. We must also bear in mind that we are, generally speaking, less fussed about volatility than we are about capital loss and inflation erosion. So even if we’ve found the ‘sweet spot’ we still need to tailor it around our needs for our risk comfort, what risk we can afford and what risk we are required to take.

At this point, you’re probably cursing me for making you go through all that math for nothing. But I hope it underlies an important point about investing: you can’t invest based on numbers alone, you must also consider the qualitative side too.

A final chart

I have one final chart for you. This is a look at the spread of annual returns based on my portfolio allocation. Again, courtesy of the amazing Portfolio Charts:

(again, real average annual returns, since 1970)

I’ve input my asset allocations based on my How I invest my money post. First off, you can see that the return and standard deviation are relatively high, well towards the top right of any of the frontier curves above. You’ll also notice that in 27 years out 100 this portfolio would lose money in real terms.

Another interesting thing is that 77% of the time did the portfolio returned less than 2.2% or more than 12.2%; which highlights why you have to take average returns with a pinch of salt – investors rarely get the ‘average return’.

Lastly, you’ll notice two huge outlier returns. The loss is -41%. That’s right, you would have lost almost half the value of your portfolio in one year. That year was 1974. However, 1975 saw the other massive outlier, a return of 45%. (note that the UK data is patchy pre-1975, thus the shading).

Would you have been able to stomach such a massive drop? Well if you’d have been invested in this portfolio 10 years ago, you’d have seen a drop of 23% in 2008, followed by a gain of 21% in 2009.

I hope I wouldn’t flip my lid and keep cool in such market turmoil. Though that is easy to say before it happens. I know that one day, there will be such an occurrence. Hopefully, by putting this out here, it’ll keep me honest for that day.

All the best,

Young FI Guy



Please do visit the amazing Portfolio Charts which is an excellent data visualisation resource for investors: portfoliocharts.com

Part of the inspiration for this post was from Karsten at Early Retirement Now who created efficient frontiers for US investors to ask the question of how much bonds diversify from equities: https://earlyretirementnow.com/2017/04/26/have-bonds-lost-their-diversification-potential/

The other inspiration is Monevator’s piece on UK historical asset returns and asset allocation: http://monevator.com/uk-historical-asset-class-returns/

If you want to, you can look at the underlying excel spreadsheet: Link