Savings and investments

Introduction

Charles Dickens' Mr. Micawber highlighted the importance of living within one's means, contrasting with modern views where debt for assets like homes or education is more accepted. This section introduces household finance concepts.

\text{income} = \text{consumption} + \text{saving}

Saving involves accumulating money in liquid accounts for easy access, which can serve as an emergency fund.

Savings: Accumulating income not spent on immediate consumption.

Cash savings accounts offer liquidity at a 'risk-free rate.' Savings bonds are agreements between financial institutions and customers. Near cash accounts, like NS&I Premium Bonds, offer security and potential prizes. Households invest to guard against inflation, though investing involves risk.

The media's portrayal of investing can be misleading, often oversimplifying complex financial decisions. Key trends include the 'advice gap' (lack of affordable financial advice) and increased access via online platforms. Bonds and shares fluctuate in price, and all investments carry risk.

Savings: Total financial assets at a specific point in time, representing accumulated deferred consumption.

Near money: Liquid assets that can be easily converted into cash with minimal loss of value.

Investing: Building a portfolio by allocating capital to different assets, such as lending capital via bonds or owning equity via shares.

A successful investment strategy blends loan-type (bonds) and own-type (shares) investments to balance risk and return.

How Much Do Households Save?

Household saving is crucial for both individual financial goals and the overall economy, providing funds for future consumption and investment. Saving habits vary significantly across households and countries.

Saving Inequality

The model of income flowing neatly into consumption and savings is not universally applicable. Income distribution and individual circumstances greatly influence saving behavior.

Economists study the 'marginal' unit to understand how incremental changes affect behavior. The satisfaction from additional units of a good decreases, influencing consumption and saving decisions.

Some households can afford more consumption and substantial savings, while others are 'dissaving' due to debt or low income. Marginal propensity to consume (MPC) and marginal propensity to save (MPS) describe how an extra unit of income is allocated.

Marginal propensity to consume: The fraction of added income spent on consumption, indicating how much consumption increases with each additional unit of income.

Marginal propensity to save: The fraction of added income that is saved, showing how much savings increase with each additional unit of income.

MPC + MPS = 1

Low-income households may have an MPC approaching 1 and an MPS near 0, as nearly all income is needed for essential consumption. High-income households may have a low MPC and a high MPS, saving a large portion of extra income. A direct correlation exists between increased income and savings, though this relationship is influenced by various factors.

Household Saving Ratio

The household saving ratio is the percentage of disposable income saved annually, reflecting a country's or region's saving habits. This ratio varies significantly between countries due to cultural, economic, and policy differences.

Importance of Household Saving

Household saving benefits both households and corporations. For households, it allows building assets to manage future expenses, fund retirement, and provide a financial buffer. For corporations, savings provide funds for investment, expansion, and innovation.

Shares (or equities): Investments that give part-ownership of a company, entitling the holder to a portion of the company's assets and profits.

Why Do Households Save?

Saving defers consumption to the future, enabling individuals and families to achieve long-term financial goals. Motives for saving significantly impact financial planning and investment strategies.

Financial resilience requires understanding aims, risk attitudes, and life stage challenges. Tools like GROW-ER aid financial planning, while the Financial Conduct Authority (FCA) regulates financial advice to protect consumers. Suitability ensures advice aligns with the client's best interests.

Suitability: Providing financial advice and products that fairly and professionally serve the client's best interests, considering their financial situation, needs, and objectives.

Some saving motives require liquid cash balances for emergencies, while others need longer-term investment to outpace inflation and grow wealth. The choice of saving and investment vehicles should align with specific goals and time horizons.

  1. Saving for a 'rainy day' fund is a priority for financial stability, helping cope with unexpected bills such as medical expenses or job loss. The recommended amount should cover three to six months of essential expenditure to provide a sufficient financial cushion.

  2. Saving for specific short-term aims, like holidays or purchasing a car, requires a different approach. Funds are usually spread between instant access and interest-bearing accounts to balance liquidity and growth.

The Financial Services Compensation Scheme (FSCS) protects balances up to £85,000 per banking group, ensuring savers are protected in case of bank failure. NS&I is backed by HM Treasury, guaranteeing 100% of deposits, providing an additional layer of security.

  1. Saving for future lifetime needs, particularly retirement, is increasingly important due to increased average life expectancy. Individuals are being pressed to take more responsibility for providing for their own old age through pensions, investments, and other savings.

  2. Saving to pass on wealth to future generations is driven by rising tuition fees, housing costs, and a desire to provide financial security. Savings act as a buffer against unexpected bills and can also facilitate intergenerational wealth transfer.

Saving and the Life Course

A household's saving level typically varies over the life course, reflecting changing income, expenses, and financial priorities. The 'life cycle hypothesis' suggests people start with spending exceeding income, then accumulate savings during their working years, and draw down savings during retirement.

A key motivation is saving for retirement to maintain a desired standard of living. This model doesn't account for individual habits, unforeseen events, or the generosity of welfare state provisions, which can significantly influence saving behavior.

Net saving: Disposable income minus household expenditure, representing the portion of income available for saving and investment.

Positive net saving leads to asset growth, increasing financial security and wealth accumulation. Assets increase through saving and reinvested returns, enhancing long-term financial stability. Figure 5.2 illustrates Dan's cash flow and net worth changes, including mortgage debt, providing a visual representation of financial progress.

Saving Within the Household

Money management practices influence saving outcomes within households, affecting financial stability and well-being. Individual savings offer financial security, particularly important for retirement and in the event of relationship breakdowns.

Gender differences in saving habits are affected by employment opportunities, income levels, and caring responsibilities. Women may save less due to career interruptions for childcare and the gender pay gap.

Studies show that women tend to save smaller sums and for shorter terms, with saving patterns often disrupted by divorce or childbirth. However, adjusting for income level reduces these differences, suggesting that income inequality is a significant factor. Feminist economists argue that focusing solely on financial risk aversion overlooks the overall risks women face, including economic vulnerability. Women in developing nations often prioritize children's needs over their own saving, influenced by local culture and societal norms.

Making Sense of Saving

Households save to preserve or grow capital value, aiming to achieve financial goals and security. Saving involves depositing cash in secure accounts without capital risk, while investing involves risking capital for potential returns.

Bonds: Certificates of debt issued by a government or corporation to raise money, offering fixed-income returns over a specified period.

The choice of savings products depends on interest rates, taxation, and individual financial goals. Savers must consider the trade-offs between liquidity, risk, and return to make informed decisions.

Interest Rates on Savings

Savings products vary in interest type (simple or compound), payment frequency (monthly, annually), and rate (fixed or variable). Interest rates can be a significant motivation for altering saving habits, with higher rates attracting more savings.

Simple and compound interest affect savings growth differently. Compound interest reinvests earnings, leading to exponential capital growth over time.

Annual equivalent rate (AER) is the savings account equivalent of APR, providing a standardized measure that considers compounding effects for comparison purposes.

Term accounts offer fixed rates over a specified period, providing certainty but limited flexibility, while variable rates fluctuate with prevailing interest rates, offering potential upside but also downside risk. Savers should consider inflation's impact on real interest rates, as inflation erodes the purchasing power of savings.

Taxation of Savings Interest

Interest is typically treated as income and may be subject to taxation, reducing the effective return on savings. Governments encourage saving through tax-free options like ISAs, premium bonds, and personal savings allowances. Taxpayers benefit from net payment schemes, while non-taxpayers may prefer gross payment options.

Making Sense of Investments

The aim of investing is to achieve a positive return, generating income or capital gains and increasing wealth. A negative outcome – or capital loss – is to be avoided, but risk is inherent in investing.

\text{Total return} = \text{capital return} + \text{income return}

Capital gain: A rise in the market value of an asset to more than the price originally paid, resulting in a profit when the asset is sold.

Capital loss: A fall in the market value of an asset to less than the price originally paid, resulting in a loss when the asset is sold.

Evidence suggests that investing yields positive returns over longer periods, typically at least two years. The Barclays Equity Gilt Study compares UK equities, bonds, and cash since 1899, showing that equities outperform cash 69% of the time over two years and 91% of the time over ten years, although past performance does not guarantee future results.

Two Ways of Making Money

There are fundamentally two ways of making money by investing: loaning or owning. Both involve buying and selling financial securities that fluctuate in price, differing from saving where capital remains relatively constant.

Loan-Type Investment

Households can 'loan' money to governments and companies via fixed-income securities like gilts and corporate bonds, receiving interest payments in return.

Two potential returns:

  1. Capital return: Buying low and selling high as bond prices fluctuate based on market dynamics.

  2. Income return: Fixed interest payments (coupon) set at the issue date, with some bonds offering index-linked coupons to protect against inflation.

Factors that influence gilt and bond prices:

  • Bad news: Drives bond prices up as demand for safe assets increases. If gilt and bond prices go up, the real yield goes down, making bonds more attractive relative to other investments.

  • Good news: Bond prices fall as investors take more risks, shifting capital to potentially higher-return assets. If gilt and bond prices go down, the real yield goes up, increasing the attractiveness of bonds.

  • Share prices fall: Bond prices increase as investors seek safer havens during market downturns, increasing demand for bonds. A successful investment strategy involves using a balanced portfolio of gilts/bonds as well as shares, providing 'downside protection'.

  • Share prices go up: Investors take more risks and bond prices fall as capital shifts to higher-growth opportunities. A successful investment strategy involves using a balanced portfolio of shares as well as gilts and bonds, providing 'upside potential'.

  • Interest rates go up: Demand and prices for existing bonds fall as newly issued bonds offer higher yields, reducing the attractiveness of older bonds. The trading price will fall until the yield is similar to the new interest rates on offer.

  • Interest rates go down: Demand and prices increase as existing bonds become more attractive compared to newly issued bonds with lower yields. The price will go up until the yield is similar to the new interest rates on offer.

Financial securities: Assets like shares, investment trusts, exchange-traded funds (ETFs), gilts, and bonds that can be bought and sold, usually through a recognised investment exchange or stock market.

Equilibrium price: The price at which the planned quantity demanded equals the planned quantity supplied in a simple demand and supply model. Within a stock market, if the quantity supplied exceeds the quantity demanded, the equilibrium price will fall, and vice versa.

Collective investment funds can be a better way for households to invest in bonds, providing diversification and professional management that individual investors may lack.

Own-Type Investment

Households can 'own' equity in companies through shares, properties, or commodities, participating in the potential growth and profitability of these assets. Returns come from capital gains (selling higher than purchase) and income (dividends).

Buying and Selling Investments

Traditionally, stockbroking companies handled investments, providing advice and execution services. Now, wealth management and private client firms manage portfolios for high-net-worth individuals, and online platforms offer easy access for retail investors. The growing advice gap makes professional advice inaccessible to many small investors.

Advice gap: Refers to the lack of affordable financial advice, leaving many households without access to professional guidance. This gap arises from a lack of awareness, high costs, and a shortage of qualified advisors.

Taxation of Investments

Investments held outside ISAs or pensions may be subject to Capital Gains Tax (CGT) on profits from the sale of assets. Stamp Duty Reserve Tax (SDRT) is imposed on share purchases, adding to the cost of investing. Inheritance Tax (IHT) may apply to inherited portfolios, potentially reducing the value passed on to heirs. Surviving spouses can inherit ISAs tax-free, providing a valuable tax benefit.

Planning Savings and Investments

This section covers various savings and investment products, examining associated risks and returns, and emphasizing the importance of tailored financial planning.

Risk and Return

Investment risk is typically measured by price volatility or the probability of capital loss. Low-risk investments generally offer lower returns, while higher potential returns require accepting higher risk. Figure 5.3 illustrates share price volatility and an upward trend using the FTSE All World Index.

Risk-Reduction Strategies

Diversification is a key strategy for reducing risk, including investing in different sectors and regions. Figure 5.4 shows sector and region fluctuations, illustrating the benefits of diversification. Asset allocation balances shares and bonds to provide downside protection and long-term growth potential. Time in the market is crucial for achieving positive outcomes, as short-term market fluctuations are less impactful over longer investment horizons.

Portfolio: A set of financial assets held by an individual (or a bank or other financial institution), including stocks, bonds, cash, and other investments.

Asset allocation: The way an investor decides to divide their portfolio up between different types of investments, balancing risk and return based on their financial goals and risk tolerance.

Cost averaging: Allocating a fixed sum for the regular purchase of particular investments, buying more shares/units when prices fall and fewer when prices rise, thereby lowering the average purchase price.

Unregulated Investments

Unregulated investments, such as cryptocurrency (volatile and often used in money laundering) and peer-to-peer lending (higher returns but are not covered by the Financial Services Compensation Scheme), carry significant risks.

Saving and Investing in Practice

Saving over the life course varies due to the life cycle model, influenced by income, expenses, and financial goals. Even with spare income to save, many low-income households may lack access to the kind of diverse portfolio necessary to reduce risk. Exceptions exist in paying off debt rather than saving, which can be a prudent financial strategy.

Conclusion

This chapter focuses on saving and investment, examining their importance, available options, and decision-making factors. It emphasizes tailoring plans to individual circumstances and understanding risk and return tradeoffs