Saturday 3 October 2015

Investment Basics III: Unit Trusts and Index Funds

This post has been a long time coming, sorry wonderful readers! Life has been good and busy lately so I suppose you can take it as a good thing that I don't prioritise writing the blog over living in the real world :-) That being said, I do enjoy writing these posts and I do believe that they are fulfilling a need. It's good to be behind the keyboard again.

Today's post continues our mini-series on Investment Basics. In the previous post we covered the basics of what shares are and we ended with the idea that diversification is important. We want access to lots of shares and we want to make it as easy as possible and as cost-effective as possible to own these shares. This is where Collective Investment Schemes (CIS) come in. 

1. Collective investment schemes help overcome the prohibitive mass of capital required to invest

Dale, Ellen and Felicity are good friends looking to invest in three top South African companies. Dale has R 1 000 to invest. Ellen has R 1 500 to invest and Felicity has R 500 to invest.

They want to be diversified so they don't want to buy shares in a single company. They definitely want to own all three companies. From the table above, the minimum investment that each of them would need to make is R 3 000 (1 000 + 800 + 1 200) if they buy just one share of each company. But none of them have this kind of money at the moment! Ellen has the great idea of pooling all their money, buying the shares together and then owning them collectively. Collectively they have the R 3 000 (1 000 + 1 500 + 500) required to purchase one of each share. Collectively they will own one of each share and individually they will own a fraction of a share that is proportional to the amount that each of them put into the collective investment.

So by pooling their resources Dale, Ellen and Felicity are able to achieve diversification that would not have been able to achieve by themselves.

2. Collective investment schemes help reduce trading costs

When buying shares there are various costs involved:
  • IPL (Investor Protection Levy) for 0,0002% of the value of the trade (excluding VAT). This is to fund the Financial Services Board's investigations into insider trading.
  • STRATE (Share TRansactions Totally Electronic) costs R 10,92 for trades below R 200 000 , 0,005459% of the value of the trade between R 200 000 and R 1 000 000 and R54,59 for trades over R1 000 000 (all excluding VAT). This is trading cost associated with keeping electronic records of all shares traded on the Johannesburg Stock Exchange.
  • STT (Securities Transfer Tax) for 0,25% of the value of the trade. This is only applicable when buying shares.
The above three costs (IPL, STRATE and STT) are fixed and in general will not differ from one stock broker to another. The only real cost that differs between stock brokers are:
  • Commission charged on each trade. These typically range from 0,2% through to about 0,6%. There is usually a minimum brokerage which ranges from R 20 to R120. The minimum effectively means that you only achieve the stated commission percentage after investing a minimum amount. For example with a commission percentage of 0,2% and a minimum commission of R 20 the most efficient investment is R 10 000 (20 divided by 0,2%). For smaller trades you still pay your R 20 commission which will represent more than 0,2% of the amount invested.
  • Ongoing 'platform fees'. These are either fixed monthly or annual fees or are a percentage of your total portfolio with the stock broker. A portfolio generally doesn't need to be that large before the fixed fee option is more cost-effective. Some stockbrokers do not charge platform fees for certain products (such as Tax Free Savings Accounts or if only Exchange Traded Funds are purchased).
Okay, enough of the dull theory of the different costs associated with trading shares. Suffice it to say that there are costs involved and that we want to minimise these costs so that more of our money actually ends up in our investment. Let's imagine a slightly different scenario which takes trading costs into account.

Dale, Ellen and Felicity each have R 3000 to invest in the following companies:

Let's also assume that they each have enough extra money to cover the trading costs. What we want to compare here is the total trading cost to each of them if they buy one of each share individually (Scenario 1, with a total of nine trades made) or if they pool their money and buy three of each share (Scenario 2, with a total of three trades made). If you want to skip the details of the following table feel free to go straight to the conclusion. I won't mind. This table is for those of you who really want to see exactly how costs the various trading costs are calculated. In the table below I've assumed a minimum brokerage commission of R 9,00 per trade (at 0,3% which means the minimum trade required to actually achieve the 0,3% would be R 3000). Wherever I've multiplied by 1,14 I'm taking VAT of 14% into account. In the table you can see that the only costs that are affected by the number of trades made are STRATE and the broker's commission. 

Although Dale, Ellen and Felicity could afford to buy one of each share by themselves, by pooling their resources, these three investors have managed to reduce their trading costs. Great!

So in summary, investing collectively does the following.
  1. Reduces the amount of capital needed to achieve diversification.
  2. Reduces the trading costs associated with purchasing shares.
Types of Collective Investment Schemes

Unit Trusts

Unit trusts (also known as mutual funds) are a type of collective investment scheme set up by various financial institutions that formalise the above process except on a much larger scale - we're talking millions or billions of rands in the total fund and tens or hundreds of thousands of investors!

You can get unit trusts with different allocations between equities, bonds and cash. Equity funds generally have about 100% exposure to equities and will offer the best growth over the long term. Balanced funds can have up to 75% invested in equities with the remainder invested in less volatile asset classes (bonds and cash). These balanced funds suffer less in an economic downturn and are eligible for use in retirement products (they are Regulation 28 compliant), but they will experience less growth than pure equity funds in the long term. You can also find funds that focus on investing in property or that invest in companies that pay good dividends.

The good things you get from a unit trust:
+ Trading costs are spread out across a large number of people.
+ Diversification is really easy to achieve.
+ You don't need to micromanage selecting, trading and keeping track of different shares.

On the other hand:
 You give up some control (someone else chooses individual shares to buy).
  You're paying someone (a fund manager) to make choices for you. These costs can add up and you don't necessarily always get value from an active fund manger.

A range of actively managed funds can be bought from various providers. My personal favourite is Allan Gray. Before you choose a fund you should take a look at the fund "fact sheet" for that fund (just Google the name of the find together with the words 'fact sheet') so that you know what you're investing in.

Index Investing

Index funds are passively managed and stand in contrast to traditional unit trusts which are actively managed

With active management a fund manger is employed by the fund to do research into the various companies available on the stock market and to choose which companies to invest in and how much to invest in each company. These decisions are not once off and the active fund manger will buy and sell shares in accordance with how they read the prevailing market conditions.

With index funds (sometimes also called tracker funds), a computer is used to track a given index (essentially a weighted average of different companies satisfying specific criteria). For example, a fund may track the top 40 companies in the stock exchange. As the various companies grow and shrink or move into or out of the index (the top 40 in our previous example), sales and purchases of an appropriate number of shares are done automatically. An active manager is not required to do research into which companies offer value. The costs of most index funds are thus much lower than those of a traditional unit trusts. (The ongoing costs of most actively managed funds are between 1,5% to 2,5% with most index funds closer to 0,5%).

For more on index investing see Mom and Dad MoneyMr Money Mustache or jlcollinsnh. All good reads with explanations far better than my own :-)

Essentially with an index fund you will always get the returns of the market. You won't beat the market, but you also won't under perform the market. Since the market inevitably keeps growing this is not a bad thing and for long-term serious investors they are a really great tool. With actively managed funds there is potential to beat the market, but with that potential is the ability to under perform the market . Very few active managers will actually beat the market and there's no real way of predicting from one year to the next who those active managers are going to be. In which case there was no point paying additional management fees if you would have been able to get the returns of the market through a passively managed index fund. 

You can get unit trust index funds as well as Exchange Traded Funds (ETFs). The difference between these? Not much. The main difference is to do with how they are traded. 

Unit trust index funds can be bought from Linked Investment Services Providers (LISPs) and are priced once per day. There are usually no costs associated with purchasing, selling or switching between these funds. However, there is usually a management fee and the internal costs associated with managing these funds are often (slightly) more expensive than ETFs (about 0,4% is pretty good). We have quite a few unit trust index funds with Sygnia.

ETFs are bought directly from stockbrokers and trade in the exact same way as shares. So unlike their unit trust counterparts there are broker commissions payable when trading ETFs. However, the ongoing costs can often be lower with lower internal costs (you can get certain good ETFs in South Africa for as low as 0,2%). Our main ETF at the moment is the RMB Top 40 (which aims to replicate the Top 40 Index) which has a total expense ratio of about 0,2%.

So do you go with unit trust index funds or ETFs? Or both? Here's a table summarising the main differences between unit trust index funds and ETFs:

In short, if you're investing for the long term and you know what funds you want to invest in then ETFs are a good way to go. If you're investing for a slightly shorter term or you want the flexibility to change funds without worrying about the cost of doing so then unit trust index funds may be more appropriate. There is also absolutely nothing wrong with a blend of the two. 

My wife and I have a good mix between actively managed unit trusts (where we started), unit trust index funds and exchange traded funds. We're heading more and more towards ETFs, but we're holding on to the actively managed unit trust funds that we've accumulated so far.

Hopefully this post has helped you better understand how to achieve diversification in a pretty easy and safe way. I know it's been a bit technical but feel free to use the summarised bits if you want to skip over the details:

The Executive Summary

  1. Diversification is important. We want access to as many (good) shares as possible, as easily and as cost-effective as possible.
  2. The best way to do this is through making use of collective investments schemes.
  3. Actively managed unit trust funds are one way to go. They cost more than index funds. My personal port of call for actively managed funds is directly from Allan Gray online.
  4. Index funds come in two main types, unit trust index funds and ETFs. They are very similar products and will experience similar growth. The differences are only really in how they are traded and the costs of trading. Index funds are cheaper than actively managed funds. My personal port of call for unit trust index funds is through Sygnia and for ETFs through ABSA Stockbrokers.
  5. As with any summary (and here I'm referring to the blog post as a whole) there are subtleties and other options that I've ignored. These are just the basics to get you going.
Yours frugally
Mr Cent(ri)frugal Force

Sunday 6 September 2015

Going Gift Free...and not hating it

When my husband first suggested going (largely) gift free last December*, I was horrified. I adore presents; choosing them, wrapping them, giving them, getting them, unwrapping them... the whole shebang.

But after a long year, the thought of trying to pick out non-bankrupting presents that weren't largely meaningless additions to clutter and/or consumerism was overwhelming.

I agreed to try it.

We persuaded most of our immediate family to do the same.

Somewhat to my surprise, I didn't hate it.

Now WHY would you cut these delightful things out of your life?
Photo credit: JD Hancock (CC-BY 2.0)

Why Replace Gifts?

Why do we give gifts? Sometimes we do it in order to satisfy social convention, but in the best case scenario we genuinely desire to show love and appreciation for another person by giving them something that they will enjoy, and something which they wouldn't necessarily have gotten for themselves.

Now ask yourself: does my gift giving always actually end up doing this? And if so, is it the best way to do it?

Often, it seems to me, we spend a huge amount of time and a scary amount of money trying (sometimes unsuccessfully) to express our love. The stress of malls and shopping centres in the run up to Christmas can consume our attention for weeks ahead of "the big day", and being in that environment often increases our dissatisfaction with the gifts we've chosen and the lifestyle we live: being exposed to all that consumerism and advertising definitely has an impact. It's all very well to be strong willed, but companies spend millions of rand trying to make their product irresistible to people just like you and me.

And then, too often, the gift you settle on isn't quite right. You end up buying something for the sake of having something to give, but it isn't quite what the person needs or wants, and you end up feeling even more dissatisfied. 

(This isn't to say that when you find that perfect gift you shouldn't buy it. But don't buy it because you have to. Buy it "just because". We did that once. Three years on, the gift in question is still being used daily. This is a win.)

But when you are buying bulk gifts for everyone, it's unlikely that you'll hit the giver's jackpot for everyone. You'll probably have to settle in some cases, and end up back where we started. Dissatisfied.

Or they'll get you a bigger/better gift, and you feel guilty.

Or they'll get you a smaller/worse gift and you feel grumpy. And guilty for being grumpy.

Either way, you lose. Money. Time. Peace of mind. Even relationship value.

Wouldn't it be better to take that time, and a small portion of that money, and spend it with the person you love?

The gift of time?
Photo credit: Moyan Brenn (CC-BY 2.0)

Time and Effort

I am a firm believer in this principle: if you want to cut something out of your life, replace it with something better. Otherwise the gap will either hurt like the blazes, or get filled by something worse.

We replaced Christmas presents with two things: time and effort. Or, as we phrased it amongst ourselves, acts of service and family activities.

Basically, we got together and made two lists. One was of things that we would like to have done for us, or that we needed help with. My requested act of service was making a headboard for our bed. My dad wanted help painting his puppet theatre. My mom needed help with organising her digital music collection, and so on. Then we made (and diarised!) times  to do these acts of service for - and more importantly, with - each other.

Mostly, the acts of service weren't necessities - of course we would help each other with urgent and essential things at any time during the year. They were just those little niggly things that you want done. In that way, they mimicked an important quality of gifts: no-one wants nothing but socks and toothpaste for Christmas! You want things that you just want.

The second list was of family activities. Climbing Table Mountain, going to the Planetarium, having a mini carol service and baking gingerbread were some of our chosen activities. Some activities involved a smaller subset of the gifting community, others were much wider. We made a conscious effort to spend large chunks of time doing things that we wanted to do, rather than letting the whole "festive season" take over and leave us exhausted but without having actually spent quality time together.

Family outings aren't limited to the human race!
Photo credit: Boris Kasimov (CC-BY 2.0)
Saving Money vs Financial Freedom

You will notice that I haven't spoken much about saving money. That's because although that was a side-effect of our Gift Free campaign, it wasn't the main purpose. In fact, some of our acts of service and family outings actually cost some money. Gasp!

But although it wasn't about saving money as such, it was definitely about financial freedom.

Because financial freedom isn't only about being free to quit work if we want to. It is also about having our happiness independent from money. It's about satisfaction getting disconnected from consumerism and reconnected to relationship.

From this point of view, and in fact from many points of view, I am more than happy to repeat the Gift Free strategy this year, without feeling the least bit sad about those glittery packages.

What would you do to replace gifts in  your life? If you're not ready to replace them altogether, how could you reduce the impact of stress and consumerism on your gifting decisions?

To freedom!

*If you're wondering why I'm talking about December/Christmas in September it is because we have had to start planning travel arrangements and family events already... so it is at the forefront of my mind. 2015 is almost over, people!

Wednesday 2 September 2015

Investment Basics II: Shares

This post is designed to sort out some terminology that can be a bit confusing in the investment arena. Starting to invest can seem like a really scary thing. I know that when I first started I was almost too scared to actually start because there just seemed so much to know. It turns out that, yes, there is a lot to know, but not that much that you really need to know before you start. The important thing is actually to dive in and start once you've got the Basic Theory and Good Investing Principles down. Don't wait until you know everything before you start - remember that time in the market is one of your biggest friends when it comes to compound growth.

Shares / Stocks

What does it mean to invest in the stock market or to buy shares? A share is a very small part of a company that has chosen to list on a stock exchange. When you buy a share you actually own a small piece of that company. Let's do this by way of example.

Bob and Mike start a pizza company. They're extremely creative in the kitchen, but not so much when it comes to names. So they decide to call their company Bob & Mike's Pizza Company. Bob has R600 to invest in the company and Mike has R400 to invest. So to be fair, they agree that Bob will have 60% of the company and Mike will own 40% of the company. The initial total investment in the company was R1 000 and this was the value of the company. Several years pass [pages fly off a calendar, a clock spins really fast and a sun rises and sets several times through a window] and before they know it, their pizza company is worth R10 000. How did it get there? They've been working hard for years and any profits that they have made they've put back into the company (after taking modest salaries for themselves to fund their frugal lifestyles).

At this stage Bob and Mike decide that it's time to expand. They don't have any more of their own money to put in so they list on the Johannesburg Stock Exchange so that the public can invest in their company. Sure, they'll have to start sharing their earnings with the members of the public who are brave enough to invest, but the profits will be bigger too. Without access to additional capital from the public their growth will be severely limited (and you thought crowdsourcing was something new?). Bob and Mike decide to slice their company up into 10 shares. Bob keeps three slices of the company and Mike keeps two slices (in keeping with their original 3:2 ratio of capital injection into the company). The remaining five shares they make available for sale. I'm a huge fan of pizza and I've been wanting to diversify into the industry for a while so I decide to buy one of the shares on their first day of trading which leaves four slices still available on the market for other potential investors.
Bob & Mike's Pizza Co.
Photo of original pizza: Food Recipes (CC-BY 2.0)

So how much does this one share cost me? Well in principle each share should be sold for the total value of the company (R10 000 on the day of listing on the JSE) divided by the number of shares issued (in this case ten shares). A simple way to calculate the price of a share would look like this:
Using this simple model my single slice of Bob & Mike's Pizza Co will cost me R1 000. Okay, fine. I now own 10% of a pizza company (1 share out of the 10 issued). 

What does owning a share do for me?

1. The company pays me a share of the profits.

As the company earns money, I get my fair share of the profits. Now a company will not always pay out all of the profit to its shareholders. Some profit is retained by the company to aid future growth. Whatever profit is left over is paid out to the shareholders per share so the shareholders who own more shares get more of the profits. When a company pays outs profits to shareholders these are called dividends.

If Mike & Bob's Pizza Co. makes R2 000 profit in the year following my share purchase they may decide to keep R1000 in the company to keep it growing. The remaining R1 000 of profit gets paid out to the shareholders. Because there were 10 shares the divident payout will be R100 per share and I will receive R100 because I own one share. Bob owns three shares so he will get R300 and Mike owns two shares so he will get R200. If the remaining four shares haven't been bought yet, then they are still owned by the company and those dividends are retained.

2. My share increases in value as the company grows. 

My investment has helped the company to grow (they can buy a bigger and faster pizza oven, hire more delivery staff start a new branch in a nearby suburb etc.). As the company's value increases the value of my share increases (and here's the important bit) without me needed to put in any additional money or work. If after a few years [more pages fly off a calendar] the company is worth R20 000 (according to the company's books) then my share (being 10% of the company) will be worth R2 000. 

This might be the actual value of the share, but this can be very different from the market value (what you pay for to buy a share and what you get you you sell a share). A more realistic share price calculation looks like this:

The market value  of a share depends on how the company is seen by the public (prospective investors as well as customers), how many shares are actually available for sale and how the company is expected to perform in the future. This is where most of the volatility of investing in the stock market comes in. The market share price goes up and down throughout the day and from day to day without the actual share value necessarily changing. The actual share value does change, but not from one second to the next. The actual share value changes as the company earns profits (and puts them back into company so that it keeps growing) or as the company makes losses. In the long run the the market share price can't help but mirror the actual share price. Public perception (and all the other complicating factors) can skew the share price in either direction at any one moment or even for several months or years at a time, but over a long period of time the actual value of the company can't help but be the real basis for the market value of the share. The market value of a share tends to bob up and down around the true value - the graph below might make this clearer. 

Imagine a company that experiences fairly steady growth year on year - sometimes it may grow a bit faster, and sometimes it may grow a bit slower. The growth of this company is represented by the smoothly increasing blue graph. The green graph shows what the share price might be on the stock market at any moment. In the long run it tracks the blue graph fairly well. This means that when you come right down to it in the long run, the market does actually care about the actual value of the company - otherwise there would be no correlation between the actual share price and the market share price. I've annotated the same graph below.

Now, I need to come clean. What I've told you so far isn't strictly accurate for a single company. It's much better if we think of the above scenario and graphs as representative of the stock market as a whole (the set of all publicly listed companies). So why is the above a little naive as far a single company goes? Well, although in the long run the market value might care about the true value of the company in the short term the market might not yet know the true value of the company. For example (Graph A below) hype could drive up the market value of the company in the short term. Meanwhile, the company itself may be in turmoil (the CEO is resigning, the storehouse burned down and the insurance hadn't been paid...). Sometimes the market just can't catch on fast enough until it's too late. The share's true value might hit zero in an extreme case and the market value will hit zero too. It is definitely possible to lose everything when investing in a single company. 

As another illustration, Graph B shows how volatile the market value for a single company (or even a single sector of the economy) can be. Graph C shows volatility, but over a large number of companies across different sectors of the economy the volatility is lower and the ride less bumpy. This is the reason why it is good to be diversified. Overall risk is lowered and the ride is smoother as well. 

So we don't ever invest in a single company. We want to invest in lots of companies. But there are costs involved in buying and selling individual shares. Plus how many of each company should we buy?

In the next post we'll look at Mutual Funds (aka Unit Trusts) as well as Index Funds to see how we can achieve this diversification easily. These investments products are ultimately invested in shares (lots of shares in lots of companies) so it's important that you're comfortable with what a share actually is. Hopefully this post has helped give you sufficient detail as well as the bigger picture.

Yours frugally
Mr Cent(ri)Frugal Force

Sunday 30 August 2015

Ethical Decisions: Avoiding the Fool's Choice

We recently stumbled across a website called Made in a Free World. This is about sourcing ethical products, ones which don't make use of what is essentially modern slave labour. They have an alarming survey called Slavery Footprint.

You fill in data about your lifestyle (in great detail, like how many rooms your house has, and how many pairs of pants you have!), and they work out how many slaves/indentured labourers work somewhere in the world to make that lifestyle possible. Obviously things like cotton, coffee, cosmetics and so on are really problematic. Electronic devices also seem to be a real problem.

The two of us got 26 and 35 slaves respectively.

This was scary.

This is the number of people - including children - who work in conditions that I'm sure all of us would consider unacceptable in order to provide us with our insanely luxurious lifestyles.

The economic chains which keep people in slavery are just as real as these ones.
Photo credit:Trevor Leyenhorst (CC-BY 2.0)

I recommend everyone does this survey. Rethink your life choices. It's a humbling exercise, and one which we should all do once in a while.

Avoiding the Fool's Choice

Now I know that often ethical consumer choices are prohibitively expensive. So how can we save money but still consume ethically?

This can be an example of a Fool's Choice or false dichotomy. You feel like you have to choose between two bad options. Actually, there is often a third option.

False dichotomy: forgetting the third option.
Photo credit: Dan Moyle (CC-BY 2.0)


Don't buy the dodgy product. And if you can't afford the good product, then buy nothing.

Mostly, you don't actually need either of them.

Consuming less is a good idea anyway. Buying less saves money, cuts down on slaves and is also better for the environment.

When there isn't a third option...

Even food, the obvious exception to just not buying anything ever, can be part of the false dichotomy. Maybe the third option there isn't so much "neither" as "something else altogether", such local, in season fresh products.

But nonetheless, we have to accept that sometimes there is a genuine payoff here, and we have to make a genuine choice between cheapest and ethically acceptable.

This is a complicated, entangled issue. In each of these situations we need to make a moral choice as best we can. All I ask - and I am asking myself as much as I am asking you - is that we really think about the choice, rather than just grabbing the quickest, easiest, or even just cheapest option.

Think first. Consume later.
Photo credit: Taymaz Valley  (CC-BY 2.0)
Yours, in a most challenged frame of mine,

Tuesday 25 August 2015

Why Budgeting can be Dangerous

Over this weekend, we went down a Youtube rabbit hole: The One Rand Family. This was a Sanlam initiative (advertisement) during the month of July which was National Savings Month. The original version was The One Rand Man, which ran during July 2014. 

The big idea was that the participants got their whole salaries for the month in the form of one rand coins, and locked away their plastic money for the duration. This not only gave them a very visual sense of what was going on with their money (stacking up piles of coin-filled plastic containers makes you aware of the size of your car repayments on a very visceral level) but also made them think twice before spending. When you've actually got to dole out your last few piles of one rands, it makes you think more carefully about whether you really need whatever it is. And when you've only got a couple of hundred rands and 9 days left in the month... well, then you really start changing your spending behaviour, at least temporarily.

Watching all of their episodes, as well as some other interviews with the participants, it seems that the biggest challenge for them was not making use of overdraft/credit card facilities when the cash flow got tight at the end of the month. 

Even for those of us who aren't quite as extreme as the One Rand Tribe, using credit as an escape route when our money has vanished is a very bad idea, short of a once off emergency. Because unless we have saved a lot already, this means that we are spending next month's money this month, with no particularly wonderful prospect of making up for it next month. Borrowing for lifestyle expenses means that a month's salary is not enough for a month's lifestyle; and it definitely won't be enough for a month's lifestyle plus debt repayments. Ask yourself: what will be different next month? The sad truth is that next month we'll have the exact same problem except probably worse: after all, your salary won't be any bigger; it still won't be enough to pay for your lifestyle. 

If you aren't careful, you'll end up getting further and further behind, unable to pay the full credit card bill every month and therefore creeping further and further into debt.  As soon as you start paying the minimum payments rather than the full balance it is scarily easy to end up in a situation where you are constantly a month or more behind: and then half your income is going to disappear into repayments that hardly even touch the capital of your debt but instead scrabble around in the foothills of a massive interest rate. 

A truly alarming number of South Africans seem to be in this predicament.

The beast of the night called DEBT makes a guest appearance...
Photo credit: GotCredit at (CC-BY 2.0)
This got me thinking about BUDGETING: the process of trying to fit your lifestyle into your monthly income.

Here is the usual idea behind budgeting, one to which I have unfortunately subscribed for many years: 

  1. List all the expenses you can't avoid, such as rent and utilities, tax, medical insurance and so on. These are usually the ones that bounce straight out of your bank account as soon as your salary arrives. You should know what they are. You probably can't do anything much about them. The exceptions to this are debt repayments, which also come off at this stage, and which you can definitely do something about (pay them off quicker!).
  2. See how much money you have left. This is usually a lot less than any of us would like. Now allocate as much as  you think you will need for other essentials like food, petrol and school fees.
  3. Whatever is left is for spending however you like. This is where you "budget" for eating out, clothing, movies and holidays: all the things you'd actually like to spend your money on.
  4. If by exerting colossal effort you have managed to ensure that there is some money left at the end of the month, save it.
Now, budgeting like this is definitely better than not budgeting. At least you know where your money is going, and you have a reasonable expectation of not going into credit for the essentials of life. Depending on your self-control on step 3, this process will even prevent you from going into credit on the non-essentials: yay!




Why Budgeting is Dangerous:

Step 1 shouldn't have any debt in it whatsoever. Making debt repayment come off like a normal expense makes it feel like it's okay. It is not okay to be in debt. Half of the reason South Africans are in such a debt hole is because of the perception that debt is like an awkward uncle: not ideal to have around, but everyone has one, so it's fine. If you have a debt, then budgeting should involve Step 1, Step 2 and NOTHING ELSE until the debt is paid.

Step 2 is open to (mis)interpretation. It is too easy to make yourself believe that something is essential, when it is actually a discretionary item. Here is an example: for the first three years after we got married, we had yoghurt with our breakfast muesli every morning. Once in a while we would look at the price and wince - because yoghurt is a lot more expensive than milk - but we convinced ourselves that it was good for us, and therefore necessary. In fact, once you look at the sugar involved in most yoghurt, the "good for us" premise is unlikely. And unless you have a very specific medical situation no-one would say that the yoghurt cultures (or whatever they are) are necessary for health. The main thing healthwise for ordinary people is the calcium: and that is available much more cheaply in milk. It takes a huge amount of self-control to be totally honest with yourself about the true essentials of life, particularly when it comes to food. A similar process often happens with petrol - we use too much of it, because we drive too much. "Allowing" this expense in our budgeting can make us feel like this is an acceptable situation.

Step 3 is a disaster waiting to happen. We all know that the "I want" section is where budgets fall apart. When I was a student I budgeted to buy one soft drink per week, on my way to tutoring. This was my discretionary spend. But guess what? When I walked past the shop on other days, sometimes I brought myself a soft drink anyway, because what's one extra soft drink? Yet if I did this once per week, my discretionary spend would have doubled. Yes, this is a silly example, and probably made no difference to my financial health. But when you're earning more than a student pittance, the tendency is to repeat this pattern in an increasingly unhealthy volume. R400 becomes R600, because I've worked hard and deserve it. R300 becomes R450 because it was a special deal and worth every cent. R200 becomes R370 because I don't want to look stingy in front of my friends. Making it okay to spend some unnecessary money often opens the door to making it kind of okay to overspend - and even to use credit to fund your lavish lifestyle. 

Putting discretionary spend before savings is a major catastrophe: but it is a catastrophe that too many of us overlook in our monthly budgets. If your budgeting process looks like the one I outlined above, you are treading water. And yes, that is better than drowning. But at the very best, you are probably making a small contribution to your pension fund as required by your employer, and perhaps perhaps saving something at the end of the month. But over all, you are (hopefully) breaking even, and making little to no provision for the future. Yet you probably feel as if you are doing quite well. But if a wave comes along... you could too easily go under. News flash: your financial position may not be as awful as other people's. That doesn't mean you're in a good place.

Budgeting is the process of fitting lifestyle into cash flow, not the other way round!
Photo Credit: Tax Credits at (CC-BY 2.0)
What does healthy budgeting look like?

Don't get me wrong, budgeting is a really important and helpful part of living a frugal lifestyle, fueling the independence engine and (hopefully) reaching financial independence. But we need to budget in a productive way. Here are some ideas for healthy budgeting:

  1. Budget descriptively, not prescriptively. Budgeting should be a process of observing your own spending habits. This means that you can plan cash flow effectively, and work out if and when you will be able to afford those unavoidable large expenses. It also means that you can safely save your maximum without being afraid of accidentally running out of grocery money.
  2. Save first. I've said this time and time again, but looking towards the future cannot be an afterthought to your month. Use your descriptive budgeting to work out how much it is possible to save, and get that amount out of your bank account ASAP, before you accidentally spend it.
  3. Budget with a critical eye. When you look at your spending for last month, look out for danger areas. Perhaps when you look back you notice a gradual creep in expenditure on clothing. This enables you to cut back in those areas next month.
  4. Don't budget for wants. If a "want" spending opportunity comes up, either do it or don't do it, based on careful consideration of that situation. Don't have a general rule like "up to R200 is okay for discretionary items", because the truth is that sometimes it is and sometimes it isn't. Make each choice deliberately, not automatically. (Imagine paying for it in one rand coins if you think it will help!)
  5. Budget long term. Create a spreadsheet or plan for the next ten years. Where would you like to be? This helps you to keep an eye on the bigger picture, without getting too bogged down in month to month expenses.
  6. Whatever you do, don't create a series of ineffectual and unrealistic budgets which you know you'll never be able to follow. This will just make you feel bad about yourself OR make you feel unhelpfully good about yourself while making no actual change to your financial health.

Overall, your budget should be a means of you (and your spouse/family) planning financial choices sensibly. It isn't a magic spell which will make all your financial problems go away. As with all financial tools, if a budget is used badly, it will have a negative impact on your financial situation. But used with caution, it can be enormously powerful.

Postscript/PostInvasion from Mr Cent(ri)frugal Force:

You may find some of these tools helpful for putting together a healthy budget:

Picking the right tool can make all the difference.
Photo Credit: Lachlan Donald (CC-BY 2.0)

  • Google Sheets - an online spreadsheet tool. I like to keep my descriptive budget in the cloud so that I have access to it anytime and anywhere - it's also easy to share it with others (once I've made a more user-friendly version of my spreadsheet I'll share it on the blog).
  • 22Seven - this really cool company (now owned by Old Mutual) has an app (and a web version) that pulls in all your account balances from all your online accounts that you choose to link to your 22Seven account. You'll need to do your own research and choose how comfortable you are putting your passwords into their service, but their security appears to be pretty solid. Their software tracks your spending and categorises it for you - this is a very good way to see exactly where your money is going. Personally, I prefer to micromanage things so I like my spreadsheets and accounting software (see below). But I've been making use of 22Seven as well (mainly to decide if I'd like to recommend it on the blog) and I've been pretty impressed with them. They also have a blog which is pretty good - you should go check it out. One word of caution - the service is free, but they're probably hoping that you'll make use of them to save in a Tax Free Savings Account. The signup process looks ridiculously easy and the fees are not too bad (0,68%). But you can definitely find lower fees elsewhere - this 0,68% is a fee over and above the fees paid on whatever unit trusts you'll be investing in. Fees really matter so you'll want to do your research on this one. I'll try to do a blog post about fees soon.
  • You could also make use of some accounting software. Back in the day I used to make use of Microsoft Money, but I found the "category approach" for income and expenses not as helpful or powerful as a proper "account approach" that one would use in accounting. This is when I switched to gnuCash which is free and cross-platform. You can even turn off words like "debit" and "credit" and make them display something like "money in" and "money out" if that helps you ;-)
  • Other than the above I haven't dabbled in any other budgeting tools, apps or services. If you have had a particularly good experience with other apps let us know in the comments!

Happy budgeting!
jjdaydream & Mr Cent(ri)frugal Force

Sunday 23 August 2015

Investing Basics I: Asset Allocation

At this stage we've established the importance of saving money in order to invest it. The Financial Independence Engine is most potent when powered by the stock market, but there are many ways to access the stock market so we'll explore some of these as we go along. Non-stock investments should not be overlooked - they add value at any stage of your financial independence journey and the role they play will change as your needs change.

This mini-series will be about where your money is (or will be!):
  1. what form it's in (cash, bonds or stocks), and in what proportions
  2. which companies and parts of the economy you've invested in
  3. what type of financial product you invest in (fixed deposit, money market, retirement annuity, unit trust, ETF, tax free savings account etc.)
  4. which financial institution you use as a platform
Let's start by understanding the different forms in which you are able to invest, why you would choose each form, and how you should decide on the approximate proportions of each.

Different forms of investments are called different asset classes
Photo credit: GotCredit at (CC-BY 2.0)
Asset allocation
There are three main asset classes: cash, bonds and stocks/equities. In the investing world you might come across the idea of asset allocation. This is simply the ratio in which your assets are spread across these asset classes.

Essentially anything that earns interest counts as cash. Money placed in a savings account, fixed deposit, money market fund or similar are all examples of cash. In a previous post we established that cash is not the investment we are looking for because anything invested in cash typically only just about keeps up with inflation (sometimes not even). 

What cash investments offer that the other asset classes do not offer is accessibility. If you need money in an emergency or for day to day expenses the last thing you want to do is to be forced to sell off some of your longer term investments at a bad time - for example when the markets have taken a large (but temporary) dip. 

We have about 4,5% of our investments in cash form (Capitec bank accounts and Allan Gray Money Market Unit Trusts) and the rest is in as aggressive a form as we can make it. The cash component of our investment represents more than six months worth of expenses which is available in case of emergency and for cash flow. Building a buffer like this is important so that you never need go into debt. The cash component of our investments enables us to be more aggressive with the rest of our investments.

When you lend money to an institution (or even the country itself) for a fixed period of time for either a fixed or variable interest rate you have yourself a bond. It's the exact opposite of the bond you might have on a house. Governments and companies make use of bonds to raise funds for pretty much anything - but since they're getting money they don't actually have yet they need to pay you interest for the privilege of having access to your money. 

Bonds are typically considered more risky than cash, but less risky than stocks. We haven't invested in bonds directly, but we definitely have exposure to bonds through the various unit trusts we've invested in.

The stock market... scary, or not really?
Photo credit: Andreas Poike (CC-BY 2.0)
Stocks / Equities
When you buy stocks or equities, you are essentially buying a small part of a business or group of businesses. You then share in the profits or losses of that business, either in the form of dividends or growth. Your shares in the company grow as the business grows.

The stock market is where you will make returns well above inflation if you're investing for the long term. However, in the short term, it is very possible for your stocks to decrease in value, which makes this seem like the most "risky" form of investment. Actually, the risk isn't as bad as it sounds: the risk isn't really that you will lose all your money (short of a catastrophe) but that at the moment you want to sell your shares they won't be at their most valuable. If you are able to wait for the correct moment to sell (either because you have time on your side because of youth, or because you have a good cash buffer) then this risk is minimised.

The real risk is losing out to inflation in the long term. Not the stock market. But it can definitely feel like it at times!
Photo credit (CC-BY 2.0)

If you're investing over a long time horizon (30 years and more) then the risk of losing in the stock market is virtually zero. The real risk is not being in the stock market and losing the race against inflation. The longer you are invested for, the lower your risk.

Instead of working with the traditional asset allocation of "cash:bonds:stocks" we think of our asset allocation as as "things that roughly keep up with inflation : medium growth investments : high growth investments". The medium growth investments are more balanced, are typically Regulation 28 compliant (retirement annuity regulation that allows maximum 75% exposure to equities within the retirement annuity) and we're aiming to get about 5% above inflation on these. The high growth investments are pure equities and we're aiming for about 7% above inflation in the long term on these investments. 

We're very young so we've maximised our exposure to the stock market through unit trusts and more recently passive exchange traded funds (ETFs). These are simply mechanisms by which you can diversify (invest in lots of different businesses so that the risk of your chosen business failing is minimized) and reduce investment costs - more of that in the next Investment Basics post!

Monday 10 August 2015

Stuff Minimisation and Financial Freedom

Over the past two years, we have been on an EPIC QUEST please tell me we’re not the only people for whom thinking of things as quests makes the admin feel more bearable… One of the parts of this quest, as you know, has been reduction of expenses. Another part has been self-education regarding personal finances, and a resulting increase in investment income. A third branch of the quest, one that has been essential to the financial freedom frame of mind, has been the process of STUFF MINIMISATION. 

Does your life feel like this? Time for STUFF MINIMISATION!
Photo Credit: Nathan Jongewaard (CC-BY 2.0)
Minimisation and Financial Freedom

What does STUFF MINIMISATION have to do with financial freedom? 
  1.  It is about reducing our dependence on a consumer mindset, and retraining our brains to understand that STUFF does not make us happy.
  2. It is about (re)discovering useful and awesome STUFF that otherwise gets buried in all the other STUFF, and therefore getting the best use/most enjoyment out of the STUFF we have instead of constantly needing new STUFF -  otherwise known as expenses!
  3. It is about reducing the amount of time spent maintaining, cleaning and repairing all your STUFF, thereby increasing the amount of time available for everything else.
  4. It is about creating a calm environment (minimizing stress right alongside that STUFF) from which we are better able to cope with life. We are therefore better able to make tough, long-term decisions instead of lurching from choice to choice in the sometimes inexorable grip of what feels good now.

However, STUFF MINIMISATION is a process, not a destination. We, for example, still own far too much STUFF, despite all our efforts. We live a lavish lifestyle, if you get down to the basic needs, surrounded by sentimental and useful possessions.

The fact is, that although we may admire the homes furnished entirely by two blocks of concrete and a pot plant, we have no real desire to be minimalists. Some STUFF is handy to have around, and the premise of chucking everything not currently in use seems wasteful: after all, I will need that brand new extra beater at some point when my current one fizzles, as it inevitably will. But do I need ten microscopically different baking dishes, all of which fulfill the same essential function? Nope. Might I need the work trousers in one size up some day? Yeah, let’s be honest, I might. And why buy a new pair just because I didn’t want to keep one extra folded pair of trousers in the back of my cupboard? Do I need to keep the skirt which I’ve worn once in the three years since I bought it? Well… probably not. There is a balance here, and probably a balance which comes out differently for every family.

So I can't give you a date by which we will only have the optimal STUFF left in our home. I can't show you a picture of the ideal STUFF-free home, or tell you which of your STUFF you should get rid of.

But I can tell you that embarking on a process of STUFF MINIMISATION definitely makes you think twice before acquiring: for that reason alone, it is worth considering in our consumer-mad world. 

Fill your life with freedom, not STUFF.
Photo Credit: brett jordan (CC-BY 2.0)

Making Minimisation Practical

Most of us wouldn't mind a bit of a spring clean, and most of us would probably agree that we could stand to get rid of some STUFF. The difficulty is that, well, it's... difficult. Whether because of inertia or sentimentality, the STUFF MINIMISATION process is tough to start and tougher to make significant progress in. The choices are personal, and often emotional.

How do I make myself actually make those choices on a fairly regular basis?
  1. Give almost everything away. This is usually quicker and easier than selling, and it will probably give you a happy glow. Plus, (almost) everything can be given away, and not everything is saleable if you aren't going to do the massive garage sale thing. And I certainly do not have the energy for that. Most charity shops will take boxes and bags of unsorted junk with wide-embracing er, charity, and do all the sorting and  pricing themselves. Some will even collect. If they can make a bit of money out of my pursuit of freedom, awesome. 
  2. Sell the big stuff. Some STUFF is worth a lot of money: you know what that might be in your home. Double financial freedom whammy: less STUFF + more money. In South Africa, Gumtree is your friend, though you need to be careful (obviously). But if you don't have the bandwidth even for this... see #1! Don't get stressed about making a small amount of extra cash here: the main goal is getting the STUFF out of your life as efficiently as possible. Keep your prices low but fair in exchange for quick, easy sales.
  3. Keep a secret STUFF stash in between dumping trips. We have a big cardboard box in the garage. Whenever we decide that an item can go, we put it in there, straight away. No backsies. Then, when the box is full, we can take a trip to our favourite charity shop.
  4. One step at a time. Whether you work room by room, or have a special decluttering time in the week/month, or cope with one type of STUFF at a time, don't try to do everything in one go. That's just demoralising. Rather celebrate each item of STUFF that you manage to toss. And of course enjoy using the good STUFF unearthed!
  5. Embrace the process... and remember it. The pain has significant gain: if you can hold on to your irritation as you throw out another half used moisturizer, and bring it out at the right moment, you are way less likely to buy more useless STUFF next time you're at the mall.
Lastly, keep your eyes on the purpose of all your hard work: instead of gradually accumulating more STUFF, you are gradually accumulating more freedom. Instead of buying the latest and greatest, you are getting rid of the white elephants, the not-really-our-favourites and the no-longer-useful. Instead of filling your home with possessions, you are emptying it, to make space for possibility.

Make space for possibility!
Photo credit: Archana Jarajapu (CC-BY 2.0)
To freedom!