Pillar 2: The Financial Independence Engine

Pillar 2: The Financial Independence Engine

(aka sensible investments)

Recall that the second pillar upon which a financially independent life is based is choosing sensible investments which will grow faster than inflation. You need to choose investments that give the biggest possible rate of growth (i in the compound interest formula). In this post I hope to give some background to the options available to you.

Our Financial Independence Engine. Next stop, "Freedom!" Choo Tjoe!
Photo credit State Library of Queensland (no known copyright restrictions)

Saving vs Investing

Firstly, it's important to make a distinction between saving and investing.

Saving is a verb - it's what we do as we build up Pillar 1. We live a frugal lifestyle and the money that we're no longer spending on things we don't need we save. But once the money has been saved it has to be put somewhere.

Savings is a noun - it refers to our saved up cash.

Cash in a treasure chest may look pretty, but it's the Engine we are looking for.
Photo credit Tom Garnett (CC-BY 2.0)

 Now cash doesn't necessarily mean actual coins and notes. It can refer to something like a bank account, a fixed deposit or a money market fund: where your money is somewhere invested in actual coins and notes, and (some) of the interest on that is passed on to you. This is what we call a cash investment.  The thing about all of these cash investments is that they won't be working hard in the way that you need them to in order to build up Pillar 2. Even when you're earning interest on your cash (alarmingly NOT always the case in South African banks), this interest is usually in line with or lower than inflation.

Cash is not King
Cash is a Lazy Prince who is vulnerable to the Vampire of Inflation

Inflation is a Scary Vampire, but there is a way out!
Photo credit Enokson (CC-BY 2.0)

At some point I'll do a post all about inflation. For the moment, all you need to appreciate is that inflation is the rising price of goods and services as time progresses. Inflation is the reason that prices go up and why salaries need to have "cost of living" increases. Inflation has hovered around 6% in South Africa for the past few years and at the moment it's about 4,5% - so let's just simplify things and say we're dealing with an inflation rate of 5% (to see historic inflation rates click here). Now not all goods and services rise with inflation - some rise faster and some rise slower. But it's a good way to estimate the price you can expect to pay for something from one year to the next - something that costs R100 today will probably cost about R105 next year.

The problem, of course, is that although your cash is growing (hopefully) it isn't necessarily growing fast enough to counteract the effects of inflation. If you earn R3 in interest but the price of your groceries went up by R5, you've actually lost R2; even though you might have thought that your savings was growing!

If you are getting 3% in interest (since we're hoping to be earning on significantly more than R100), that isn't good enough - over the course of a year your savings will still get effectively smaller by 2%. Do this every year for 10 years? You've lost a lot of money. It's still more actual rands than you started with, but it can't even buy the same amount as you could at the beginning. You are further from financial freedom than ever.

If you don't want to lose out to inflation then you're left with a few options:

1. Spend your money now before the Vampire of Inflation sucks its value dry.
2. Invest your money in something that grows at the same rate of inflation.
3. Invest your money in something that grows faster than inflation. 

The first option seems attractive - spend now before prices go up next week. Logical, right? But with this approach all we're doing is spending, not saving. We'll never have our money working for us and growing with compound interest because we'll never have any money. So let's scrap this option immediately. It goes against Pillar 1 because it will leave us with no fuel for our financial independence engine (Pillar 2).

And who would choose the second option if they could choose the third option? So let's see how to achieve growth faster than inflation.

We need to save money and then once we've saved it we need to put it into a suitable investment. So far we've determined that this suitable investment is not cash under the mattress, a bank account, a fixed deposit or money market. So what's left?

The Stock Market

All evidence spells out "Stock Market" as our Engine of choice
Photo credit Simon Cunningham (CC-BY 2.0)

It's by investing in companies listed on the stock market that we'll get the inflation-beating returns we're looking for. But wait, aren't stocks "risky"? The short answer is No. The longer answer needs us to define what we mean by "risk". In the world of investing, risk is related to the probability that your investment will lose value. Okay, we probably agree on that definition. But how can I say that the stock market is not risky if a company that you're invested in can go bust and lose it's entire value?

Let's be clear at this point. It is entirely possible to lose money in the stock market if you invest in any of the following ways:

1. Investing for the short term. Investing now and expecting to cash in on your investment within a very short time period. At any particular moment your investment might experience a temporary (but possibly very large) dip in value despite the fact that it is growing overall. You don't want to be forced to withdraw it during the dip.
2. Investing in a small number of companies and tying the fate of your investment to those few companies. Those companies might die a horrible death, in which case your investment has gone down the tubes. Don't invest in a company based on "a hot tip" from a friend or because the media is going crazy about it.
3. Trying to time the market by "buying low and selling high". This is a nice idea in principle, but it's impossible to consistently get this timing right. Regular people are not soothsayers or stock market geniuses.

So how do we invest in the stock market and reduce the above risk?

1. Invest for the long term - minimum 10 years.
2. Invest in a large number of companies - this is called diversification. If one company goes bust you still have money in all the other companies working for you.
3. Don't try to time the market. Invest regularly and consistently. It's not about timing the market, it's about time in the market.

At this point I think it's really important that you get a decent level of understanding of the stock market before you start investing. One of the Overseas Masters, jlcollinsnh, has done a wonderfully readable explanation of investing in the stock market. He writes from the perspective of the US stock market, but most of what he says can be applied to the South African stock market as well.

We're nearly at the point where we can start looking at specific places to invest your money in South Africa. But it really is important for you to feel comfortable and confident when it comes to investing the money that you have saved through Pillar 1 - this is why all this background has had to come before the specifics.

Until next time!