Imagine a formula which could make you millions investing in the financial markets. A formula which is tried and tested, and doesn’t require an advanced degree to execute. The good news is, such a formula exists and has been put into practice for decades by some of the world’s savviest investors. The secret to attaining wealth doesn’t necessitate the use of complex formulas. It doesn’t require great intelligence either, just an element of resolve, fortitude and some savings. Indeed the formula for building great wealth requires just three variables: compounding plus patience plus time.
The great physicist Albert Einstein once observed that “Compounding … is the eighth wonder of the world”. It means that when an asset generates a return, that return should be reinvested to generate more returns. Imagine two investors both aged 30 opening €10,000 accounts, earning 5 per cent interest annually for 35 years. Investor A decides to spend the €500 interest earned each year. Investor B leaves all accrued interest within the account to earn more interest or to compound. At the end of 35 years, Investor A earned €17,500 in interest, yet Investor B earned €45,160 in interest. Investor B will have seen his initial €10,000 account grow to €55,160, having multiplied 5.5 times over 35 years. This is a classic illustration of how the power of compounding, patience and the resolve to stay the course have created wealth.
Since the mid-1920s the US stock market has returned an average annualised gain of about 10 per cent. This 10 per cent average annual return assumes a very important caveat: that those dividends paid throughout the years weren’t spent, but reinvested to purchase more stock. It’s been estimated that 45 per cent of the 10 per cent annualised US stock market returns are solely a function of reinvesting dividends and buying more stock. Had one spent those dividends, not reinvested them, the historical annualised gains for US stocks would have been roughly 5.5 per cent not 10 per cent.
A portfolio comprised of 70 per cent US diversified equity and 30 per cent allocated to a basket of US investment-grade bonds has historically averaged 8 per cent annually
Over a lifetime, earning 5 per cent interest won’t make us millionaires – but 8 per cent will. Wall Street professionals often site 8 per cent as the return benchmark investors should strive for. A portfolio comprised of 70 per cent US diversified equity and 30 per cent allocated to a basket of US investment-grade bonds has historically averaged 8 per cent annually. Historically the S&P500 stock market index comprised of the largest US stocks has averaged 10 per cent annually. On the other hand, owning a portfolio of US investment grade bonds would have earned roughly 5 per cent annually. This 70/30 equity and bond mix is considered by many US financial advisors to be a model portfolio meeting most investors’ risk tolerance objectives and capable of achieving annualised 8 per cent gains. For simplicity this allocation mix should remain constant, and rebalanced only at year end as new money enters the account.
Let’s revisit our example of the 30-year-old investor putting up $10,000 (€7,575), but this time, in a diversified portfolio of 70 per cent US large capitalisation stocks and 30 per cent US bonds. It must be stressed that withdrawals are not allowed and all interest and dividends must be reinvested with the purchase of additional bonds and stock. After 35 years the initial $10,000 investment would have grown to $147,853 (€112,009). Our investor’s account would have increased 14 times – but still a far cry from meeting our million-dollar objective.
The solution is for our investor to deposit $5,000 (€3,787) into the account at the end of each of the 35 years. Assuming our investor funds the account initially with $10,000, deposits $5,000 yearly, and earns an average 8 per cent annualised return, the balance on the 35th year would be $1,009,437 (€764,725). Millionaire status achieved, at least in US dollar terms!
Over the 35 years the investor would have deposited a total of $185,000, but earned roughly $824,437 in compounded dividends, interest and capital appreciation.
The 8 per cent annualised return could have been optimised higher had there been investments such as emerging markets, commodity exposure and the use of leverage included within the portfolio. It’s also important to note that an 8 per cent annualised return is just an average, and one should expect years of volatile returns, with the potential for years with large unrealised losses. There is also the possibility that the next 100 years won’t be as investor-friendly as the last 100.
There are few shortcuts to building wealth. Get-rich-quick schemes and the latest investment fads just don’t work over time. In the final analysis, the power of compounding, patience, time and the discipline to stay the course are the tried and true methods to building wealth.
This is the first in a 10-part investor education series which will be appearing every fortnight.
Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He also is a lecturer at the University of Malta and Institute of Investment Analysis.