Expat investor cheat sheet

At British Expat Money we think you should handle your own investments.

But isn’t investing complicated I hear you ask. Don’t you need a PhD in finance and an in-depth knowledge of spreadsheet formulas?

Well as it happens. No.

You see it’s all about 4%!

Why 4% you might ask. Well, it turns out that all the big financial stuff that matters seems to come down to that one number.

In fact, for some reason or another the entire finance industry seems to be built on top of it.

When you look under the hood of finance, there are a multitude of so called ‘rules of thumb’ and said rules nearly always have a 4% in them (though sometimes just a 4).

And would you believe it if I told you armed with a few 4%s and a 4 you can pretty much do all this:

• Calculate your retirement income
• Estimate how much money you need to retire
• Work out your split between stocks and bonds
• Estimate investment returns from stocks
• Get an idea of whether or not property prices are likely to go up or down
• Estimate investment returns from property
• Get an idea of whether the numbers will work with a buy to let
• Assess whether the property market is currently under or over valued
• Know when savings rates are attractive

So without further ado. Let’s get into it.

Part 1 – Stocks

The original four percent rule

The Financial Independence Retire Early (FIRE) movement and a large chunk of the pension industry is pretty much based on the original 4% rule.

It comes from some in-depth research both in 1994 by a financial advisor named William Bergen and then in 1998 in the form of the Trinity Study.

4% refers to a withdrawal rate. And this is the amount you can withdraw annually from your pension pot without running out of money.

More specifically, according to the 4% rule you can withdraw 4% from your pension pot (or investment portfolio) in year one and then an inflation adjusted 4% for 29 subsequent years without ever running out of money.

This rule assumes your investments are split between stocks and bonds. In fact, you should have somewhere between 50 and 75% of your money allocated to stocks.

In practice, it works like this.

If you had £1 million in your pension pot this year you could spend 4% of that in the first year ie £40K. (£1 million * 4% = £40K)

Then next year say inflation was 2% you’d withdraw £40.8K. (£40K x 102%)

And then in year 3, assuming inflation increases to 3 percent you’d withdraw just over £42K (£40.8K x 103%). And so on and so forth.

You just keep increasing (or decreasing) the amount you withdraw based on inflation. Look at what you withdrew last year and adjust it based on the latest inflation figures.

Now there is a bit of controversy with this, particularly with people into early retirement as they worry it won’t last long enough for them, but based on the original research most pension pots lasted a full 50 years (never mind 30!). It’s just that the odd one didn’t.

The naysayers point out that there is always a chance you could be one of the unlucky ones. They worry your pension pot may run out midway through the race and for sure nobody wants that.

As a result there are some pockets of the finance industry that find a 3% withdrawal rate more appealing.

And that makes sense because when the withdrawal rate was reduced to 3% all the studied pension pots lasted 50 years.

What does this mean for you though? Well, I think it means, most people won’t go too far wrong with the 4% rule, but if you were planning on retiring super early or want to take a more conservative approach then swapping out 4% and replacing it with 3% could make sense.

Just know that opting for a 3% withdrawal means you end up with less from your pot. Here’s a quick example to illustrate:

• 4% of £500K is £20K
• 3% of £500K is £15K

The second four percent rule

The second 4% rule goes lockstep with the first. And that is because it is based on the same research. But we do use this one in a slightly different way.

We use it to calculate how much money we need to retire.

In other words, we can estimate how large a pension pot or investment portfolio we need to fund our life expenses without working.

Here’s a quick example of how it works.

Say you need £30K annually to live off. Simply divide that number by 4% to see how much you need to save up in total. In this case that’s £750K.

Of course following on from above, if you wanted to take a more conservative approach or were planning on retiring super early then using 3% might work better for you.

The third one

The two rules we’ve already covered assume you are invested in stocks and bonds. More specifically they assume that your allocation to stocks should be somewhere between 50 and 75% of your pot.

However, that’s once you are at the withdrawal stage of your pension journey ie you are withdrawing the money. What about when you are accumulating ie putting money into your account?

Here’s where the third 4% rule comes into play.

With this one, you simply allocate 4% of your money to stocks and the rest to bonds for every year you are accumulating.

So let’s say I’m 40 and intend to retire at 55. That’s 15 years I’ve got ahead of me before I start spending my money, so 60% of my money gets put in stocks and the rest in bonds. (15 x 4 = 60)

I’d be remiss if I didn’t mention the fact that there are other ways to come up with your stock and bond split. I like this approach but it’s definitely worth reading up on before you make your final decision.

You can read a lot more about this here if you are interested.

The forth!

The best research out there on stock market returns comes from esteemed finance gurus Dimson, Staunton and Marsh (Credit Suisse – Global Investment Returns Yearbook).

They make projections going forward based on over a hundred years of data. When they speak, most people in finance listen.

And would you believe their assumption going forward for the global stock market is non other than 4%.

In other words, based on their projections we can assume global stocks will go up 4% per year over the very long term.

These returns are real and so above inflation. Of course, nobody knows what inflation is going to be from one year to the next. We’ve had a couple of double digit doses recently, but over the very long term it has been about 3% in the UK (more on where this number comes from below).

If that were to be repeated and our 4% projections held true you’d be looking at returns of about 7% nominal going forward.

Part 2 – Property

The four percent rule for property

Would you believe that this 4% malarkey stretches over to the property market too.

And that’s because there’s a rule of thumb out there that goes a little something like this.

4% Bank of England base rates have tended to equate to average mortgage rates of about 5% and that turns out to be a sweet spot more often than not.

All things being equal, average mortgage rates below 5% tends to mean house prices are going up, whereas rates above 5% tends to correspond with prices going down.

As I write this that BOE base rate is above 5%! In other words, way over 4% and in other words it ain’t looking good for the property market!

The second rule for property

Here’s a quote from the London School of Economics based on over 150 years of UK property data.

Between 1845 and 2016, UK home prices grew at an average annual rate of 3.8 percent.
LSE

You might not be surprised to discover I’m rounding that one up to 4%.

In other words, over the very long term it’s not unreasonable to expect property prices to rise 4% per year on average in the UK.

Just to be clear though, this is a nominal return. This means it includes inflation. You may remember we are also expecting stocks to go up 4% too. Just know that the stocks number is above inflation.

During those 150 years in question inflation was about 3% so property only went up 1% above inflation.

The third one for property

Investment property can be a great wealth builder, but there’s a caveat. It only really makes financial sense if you are going to use a mortgage and let that property out to tenants.

Otherwise you may as well just invest in an index fund as you’ll likely get better returns from less work on your behalf. (You can read more on this here if you are interested).

That said, if you do use a mortgage and let your property out you’ll likely do much better than you would have done with index funds.

So the key being you need to take out a mortgage to juice your investment returns and then you need to let your property out to help pay for all your fees. Particularly your mortgage fees and particularly still, mortgage interest.

Property makes money from two sources, rental income and capital growth. Some people will sacrifice rental income if they think they can get more capital growth.

This makes sense because the big returns tend to come from that part of the deal. However, you still need rent to cover some of your costs, otherwise the numbers simply won’t add up.

So then the question becomes what is a good rental yield?

What is a good rental yield?

I’m hoping you’ll have an inkling already.

Because whilst not absolutley always, the cut off for a good rental yield tends to be just about 4%.

In other words, you’ll usually need a rental yield of at least 4% to make the numbers work for you with an investment property.

As an example, if you were looking to buy a £100K property, you’d need it to generate at least £4K annually to cover enough of your outgoings to make it work.

The rule of four for property

Any would be property investor should be aware of the house price to earnings ratio. This describes how many times the average annual UK income is needed to buy the average UK house.

There’s quite a big school of thought out there that suggests that number tells us a great deal about house values in the UK.

All things being equal, when that number goes above average, we should assume houses are overvalued, and when it drops below average properties are generally going to be good value for our hard earned money.

Any guesses for what that average is?………………That’s right. It’s 4.

Any time the house price to income ratio drops below 4 the sale bell should start ringing. Time to buy!

But anytime it’s over 4 that bell becomes a warning that things maybe a little over heated.

Of course, I’ve seen some property experts argue that things are different now and that the modern property market can’t be looked at the same way as in times past.

The bottom line being, they suggest in modern times that 4 becomes 6. Fair enough, that’s a dispute among experts that I don’t feel qualified to take part in.

What I will say, is this. Things aren’t looking cheap at the moment whichever which way you slice it. The fact of the matter is the current ratio is somewhere between 8 and 9 as I write this.

Savings

Hopefully, if you’ve got to this point, it won’t have escaped your notice that almost all of this is based on 4% so this next bit shouldn’t come as any surprise.

Nevertheless it’s worth saying that this section comes about because of some of the rules we’ve already covered.

I’d like to draw your attention back to a couple of points we’ve already covered that should help to put things in perspective.

First up, the original 4% rule: Withdrawing 4% of your pension pot or investment portfolio every year. Now this is based on being invested in stocks and bonds, but that’s because bonds on their own or cash can’t usually provide the investment returns we require on their own.

I say this because there is some risk involved with investing in stocks. Basically they have a nasty habit of halving in value every decade or so. And whilst they have always come back to reach new highs in the past, there remains a teeny weeny chance they may not in the future. At least not quick enough for your requirements.

So if we could avoid investing in stocks altogether we could remove that risk. Based on the fact that 4% is our target, it figures that savings rates above that start to become very attractive. Essentially because we can live off them without taking on any risk associated with stocks.

Of course we have to take inflation into account. Whilst this can be just about anything in the short term and we’ve even experienced a bit of the double digit variety recently, as already mentioned, over the long term it has been about 3% in the UK.

Now if we were subtracting a 3% inflation adjusted 4% from our portfolio that would increase your 4% number as follows:

• First year- 4% increased by 3% = 4.12%
• Second year – 4.12% increased by 3% = 4.24%
• Third year – 4.24% increased by 3% = 4.37%

The bottom line being if your savings are paying you more than that then you can live off your savings.

And this might make you move the money you have in stocks into a savings account or low risk equivalent. I’m talking about things like short term bonds or money market funds. There’s simply no point taking any risk if you don’t need to.

Next up, you may remember UK house prices increased just under 4% annually over the long term.

If you are buying a house to live in then this wouldn’t impact you, but if you were looking at it as a pure investment you’d have some thinking to do.

If returns from property that locks your money away, has all sorts of associated fees and work involved are 4%, why not simply stick your money in a savings account if you can get something similar return wise.

Yes, you can get better returns if you mortgage and find some tenants, but you’d be taking on some work and risk if you did that.

Simply buying and holding property becomes a whole lot less appealing when savings rates go above 4%.

As I write this both savings accounts themselves, and their equivalents such as short term bonds and money market funds both seem to be offering interest rates around 5%!

In other words, as things stands you could probably live off your pension pot if it was left in a savings account.

Cheat Sheet Summary

Calculate your retirement income

You should be able to withdraw 4% of your savings and investment balance per year for 30 years (adjusting for inflation as you go)

Estimate how much money you need to retire

To calculate how much you need in total to fund your lifestyle without working simply divide your annual income requirements by 4%

Work out your split between stocks and bonds

Put 4% of your money in stocks for every year you are investing

Estimate investment returns from stocks

Expect global stocks go up 4% annually on average (above inflation)

Get an idea of whether or not property prices are likely to go up or down

When BOE base rates go above 4% property prices are more likely to go down and vice versa.

Estimate investment returns from property

Assume properties go up 4% per year nominal (including inflation)

Get an idea of whether the numbers will work with a buy to let

You usually need a rental yield of at least 4% to make a buy to let worth it.

Assess whether the property market is currently under or over valued

When house price to incomes get below 4 property is probably cheap.

Know when savings rates are attractive

As soon as savings rates breach 4% they start to look very attractive.